Supply or demand – why not both?

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I’m a little perplexed to see Gareth Morgan come out railing against the Productivity Commission’s report on the housing market.  Now when it was released, I thought the focus and justification were a bit funky – but that the analysis seemed largely sound.

Gareth’s posts have been found here and here.  He says that supply is not the issue, its demand due to the tax status of housing and the Reserve Bank.

Seamus Hogan at Offsetting has covered off why this critique of the PC seems weird, so I’d suggest reading that.  As Seamus says, it is incredibly strange to treat the supply and demand factors as mutually exclusive – both can exist.  In fact to justify house prices being “too high” while the volume of the housing stock is “too low” REQUIRES a large supply impediment.  If what Gareth said was the whole story we would be experiencing overbuilding!

Why is that?  Well if something is boosting the demand for existing housing beyond what is “socially optimal” this bids up the price for existing houses while the cost of making a new house is unchanged.  As a result, there will be a lift in demand for new houses as well, leading to a lift in building activity (and building costs) such that we are building more houses than is “socially optimal”.

We could well debate whether this was the case pre-crisis – we know that expenditure, and volumes, or residential investment were very high between 2002-2007, but we also have some suggestions that much of this was due to increases in the size and quality of housing.  We were buying “more house”, rather than more houses.  Even during 2007, there were still concerns that there was not enough houses in some key regions – unlike the US experience there was not a wide view that we were “oversupplied” in terms of our housing stock.

Come to the post-crisis period and it is widely believed that we have a massive undersupply of property in Auckland (and Canterbury, but that is due to the quake).  House prices are still elevated, RBNZ policy is still “friendlier to mortgage debt”, but building activity is damned low!  This is far more than a cyclical downturn – there are significant issues of financing and co-ordination in the industry. “Reducing demand” doesn’t change this – and doesn’t make policies that are looking at the supply-side issues irrelevant!

The key point against supply side issues will be the fact that rental growth hasn’t gotten scary at any point – is there are “too few” houses, then we should really see the cost of housing services/rent pick up.  This suggests to me that any perceived demand side issues are also important, and should be taken into consideration [Note:  Think of demand issues in this context as things that increase the wedge between the individual rate of return on housing and the social rate of return - as this leads to people being more willing to use housing as an investment vehicle for a lower relative rate of return, the rent :) ].  Once again though, supply and demand are not mutually exclusive.  The fact we are looking at one doesn’t mean we throw the other away.

One final note – the Productivity Commission spent a long time getting together facts and figures in order to make its case for why the supply issues were dominant.  And they also made note of perceived “misallocation” issues and the such stemming from the demand side.  Gareth’s decision to just out of hand dismiss what they are saying and state that the answer is “obvious” is a touch grating.  I don’t think the Productivity Commission (or myself for that matter) would disagree with the points he raised … as they aren’t mutually exclusive – I’d say I just weight them less severely than he is because I am willing to accept that there are supply side issues which are behind part of the price lift.  And I think this is the reason the supply issues are being attacked … just to increase the “weight” people place on the demand side.  I’m not sure I agree with this.

Note:  Remember that show Heroes, where they say “save the cheerleader, and save the world”.  The building issue in NZ has had a significant impact, both in terms of the run up of debt and the allocation of resources – in many ways people have been “saving” in a vehicle that might not give them the return they expected in terms of future goods and services!  Given this, understanding these issues is important.  You could even say “save the housing/building industry, save New Zealand”.  I’d avoid that though, because “saving things” always seems to involve subsides and bailouts which is not really what analysts are suggesting …

Update:  Seamus cleans up some of the places where my language is too loose.  His clarifications are entirely right.

Madison on public choice

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If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government; but experience has taught mankind the necessity of auxiliary precautions.

- James Madison (1788)

Careful what you wish for

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In a recent column Bernard Hickey suggested the following:

Taxpayers still face the risk of seeing bank losses socialised in future while today’s profits are privatised.

A more honest solution would be for the Government and the Reserve Bank to openly state that a bailout would not occur. Term depositers would demand a higher return to compensate for the higher risk, and it would remove the moral hazard that currently subsidises the profits of Australian banks.

Now lets be a bit careful here.  Yes there is an implicit government guarantee of banks – in fact the way to look at it is through the lens of a deposit guarantee, when it comes to the big banks the New Zealand government will not allow depositors to lose out.

The logic behind this is the fear of a bank run.  The reason we hadn’t had a financial crisis  on a global scale between the Great Depression and 2007 was largely due to the implicit deposit guarantees that soveriegn nations had put in place during the 1930s.  Even if these were not always “explicit” they helped prevent runs on the banking system, which engendered confidence and prevented financial crises.  One key reason for the GFC during 2007-2009 was the sudden change in behaviour by governments – where they were showing themselves suddenly unwilling to provide this insurance on the basis of “moral hazard”.  It is true that issues of moral hazard had helped to drive risky lending, but it was confusion around where the burden of debt fell and a lack of clarity around who was “implicitly insured by government” that led to a run on wholesale financial markets and the financial crisis.

The “solution” to any perceived issue in our banking system is not to get rid of deposit guarantees, and it is not to remove the implied subsidy that this may provide to the New Zealand banking system.  It is to ensure that banks in turn face this cost during the rest of the cycle.

The RBNZ’s desire to set up the OBR is based on a desire to prevent bank runs, while also making who bears the burden of a bank failure “fairer”.  They are trying to ensure that we don’t have a financial crisis, while minimising the cost associated with “moral hazard”.  This is preferable to forgeting the lessons of the Great Depression and GFC, which is what we would be doing if we were to completely pull away from the implicit back stop of the banking system.  Trust me, I don’t like implicit insurance for industries myself – but financial markets are one area where such things need to take place, and as Hickey says they have to take place in a transparent manner.

TVHE is now international

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While Matt was busy lounging around in Colombia I packed my bags and moved to London. With agnitio in Auckland, that leaves Matt as the only remaining Wellington resident still blogging, although he makes up for that by writing 80% of the posts!

To celebrate my move to the UK it seems appropriate to reference football with this quote from the BoE governor, Mervyn King, in which he explains his ‘Maradona theory of interest rates’:

The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little
…
That pattern is sometimes described as “the market doing the work for us”. I prefer a different description. It is the framework of monetary policy doing the work for us. Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest.

Independence and credibility: The crisis and central banks

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There is this view going around that the financial crisis has undermined central bank independence – or made it less important.  I have no idea where this has even come from, and it doesn’t seem to follow for me.  If anything, the crisis appears to have increased the importance of credibility and independence.

What?

Well first we need to ask why we even bother with independence and credibility for central banks.  The simple answer is time inconsistency – if a central bank wasn’t independent from government it would not be able to stop it self pushing for seniorage, which would then be priced in by households and firms, which would lead to straight out worse outcomes!

Now this never, ever, meant that fiscal and monetary policy shouldn’t co-ordinate.  The two have an impact on each other, and there is constant communication between those two parts of government.  But by giving a central bank independence, it can gain credibility when it comes to setting its “time path of policy”.  A central bank that is independent won’t have an incentive to transfer resources to fiscal authorities, and so will gain credibility with the public regarding this.

During the crisis, the actions of central banks – and the fact that many of them have had to take on large amounts of government bonds, and even mortgage/business debt, has blurred the line regarding their independence.  However, I take the view of the paper I just linked to in the previous sentence – in truth as long as central banks can reverse these positions as the economy recovers they regain their credibility.  In truth, during a massive financial crisis like the one we’ve experienced you WANT your fiscal, financial, and monetary policy authorities working together.

Where the financial crisis came from

If we believe that the financial crisis stems from there being a LOLR that decided not to be a LOLR (so we had a build up of debt based on moral hazard and lax regulation, followed by a messy bank run once it was unclear whether there was a lender of last resort), then the crisis occurred because the Fed lost credibility on this front (followed by the ECB).  If anything, the crisis suggests that  the rules and policies of central banks need to be more transparent, and their operation kept more independent from the greasy hands of governments that want to use a stealth inflation tax – it doesn’t suggest that we now need to throw away independence completely.

Political scientists caused World War II

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I keep being told that economists caused the financial crisis.  Sometimes I get blamed as well, but I usually have the excuse that I was in New Zealand when the housing market started to fall apart in the US.

As a result, I’ve been trying to think of similar statements.  A discipline that aims to describe the economy, and the interaction of individuals given scarce resources, is being blamed for “causing” a financial crisis – one which the vast majority of economists had nothing to do with, and no money involved with.

So I though we could blame political scientists for WWII.  After all, they analyse political systems, and different nation states with different political systems did end up fight WWII.

Have you guys got any other ideas?  I was also thinking:

  • Seismologists cause earthquakes
  • Botanists cause erosion
  • Physicists cause black holes