Will a lower currency prevent a big rate cut?

Over at Tumeke, Tim Selwyn states:

Not even our high interest rates are enough anymore (to keep our currency elevated) – that’s why I can’t see our Reserve Bank slashing rates on the 29th as aggressively as some people think they should

Now Tim raises a relevant point – a lower dollar both increases prices and stimulates activity for exports, as a result you would expect an exogenous fall in the value of the New Zealand dollar to constrain the size of any rate cuts in New Zealand.

However, the current value of the TWI (53) is broadly in line with where it was when the RBNZ cut rates by 150bps – and at the time they said that they believed that any further declines in the currency would “help” not hinder monetary policy.  My impression is that this is because the Bank is interested in loosening as quickly as possible – without loosening “too far”.  If the exchange rate is willing to adjust to a deterioration in New Zealand’s external position, then this is of great help to the Bank, and allows them to be more “conservative” by cutting in 75bp and 100bp chunks rather than heading straight for and OCR of 1% :P

As a result, I doubt that the current level of the TWI would prevent a large scale cut of the OCR by the RBNZ at its next meeting.

December quarter inflation: 3.4%

So, annual growth in the consumer price index has fallen from 5.1% to 3.4%.  A sharp decline in petrol prices appears to have been the main driver of this drop off in annual price growth.

However, what about “inflation”.  Annual non-tradable growth increased to 4.3% – the highest level since late-2005.  If I wasn’t now expecting New Zealand economic activity to plummet in March (given poor consumer and business sentiment and temporarily lower trade incomes – note, these are temporary shocks ;) ) I would be highly concerned about rate cuts.

Where descriptions differ …

In a recent post by Paul Krugman he laments the lack of serious arguments against a fiscal expansion. I think that this is a bit extreme on his part – but I think that his criticism of John Taylor indicates the exact value judgment that makes him feel this way:

You’ve got John Taylor arguing for permanent tax cuts as a response to temporary shocks (emphasis mine)

Notice that he not only rejecting the anti fiscal stimulus policy – he is rejecting the belief that part of the current crisis is the result of a permanent shock.  If the current crisis is the result of a temporary shock then fiscal stimulus could help to dampen the impact.  However, if the shock is permanent any fiscal stimulus will merely be a costly way of delaying the inevitable.

Of course, we have a bit of both – there are a range of shocks, some permanent, some temporary.  Given this, some type of fiscal stimulus could be seen as necessary – however, the required stimulus would be a lot smaller than the fiscal stimulus crusaders are supporting.  Again, it all comes back to our forecasts of potential output

An issue with the paradox of thrift

An excellent article by Stephen Kirchner of Institutional Economics on why the paradox of thrift has to be taken in context.

Key quote for me:

But recessions are not made worse via increased saving, so long as the financial system continues to put that saving to work

As long as the financial system is working (eg credit constraints are not firing up) then there is little need for rising savings to be met with rising government spending. Even in the case where there are financial issues, government intervention should focus on the market failure – rather than arbitrary fiscal spending.

One thing I would note is that there is also a role for confidence here which has been missed – if consumers and businesses lose confidence savings increases and demand for investment falls. If this decline is sufficient, and if interest rates are bounded at zero (or are interest rates, or the price of investments are too sticky) there can then be a role for increases “public investment”.

However, the appropriate role of government in the current crisis needs to be identified and defined (and quickly) before policy is determined. Doing something for the sake of doing something is nonsense – and such policy is often defended by the term “the paradox of thrift”.

On the issue of crowding out

Eugene Fama has written a much maligned post on stimulus packages. As a medium-long term view there is really nothing wrong with it, but the large swath of criticisms that have appeared focus on the fact that the author appears to be implying that there is no short-term stabilisation possible from expansionary fiscal policy – namely, government investment is completely crowded out.

Given that everyone else is talking about it, I thought I would add my relatively inconsequential two cents ;) . This is from an email I sent along to CPW.


I’m really with Greg Mankiw.

I think that the criticism that Brad Delong laid out – that inventory is counted as investment but is over-valued – is really a second order issue. The main issue with this is that the mix of credit rationing and a flight to quality does support the idea that there is not complete crowding out – contrary to what Fama implicitly assumes. This in turn implies that government spending can smooth the economic cycle.

How does this hold with the S=I identity? I would say that:

  • Given the existence of “low risk” government investment this (an increase in government investment) would lead to an increase in savings to match the increase in investment – people are more willing to loan to government than business after all,
  • Given the presumption of unemployed resources (and credit constraints) there is scope for an exogenous positive shock to invest (which government investment is) to lead to an increase in equilibrium savings and investment – given that the use of unemployed resources creates value which could not be picked up by the private sector because of credit constraints/catatonic fear.

Even if I thought that the US was at potential (which I don’t – I just think the output gap could be overestimated) the whole attitude to risk and credit rationing surely implies that complete crowding out does not hold – sure S=I always holds, but not complete crowding out.

I realise I’m not adding anything to the debate. However, this blog is a good place for me to store things the way I see them at a given point in time, and thats just what I’m doing damn it :D

If anyone thinks I’m talking crack, feel free to tell me in the comments ;)

Note: In case it isn’t clear the first mechanism reduces consumption, so no instantaneous stimulus even in the face of no crowding out! However, it does allow for a “reallocation” from consumption to investment, if the price signal was screwy for some reason this could be optimal.

The second leads to an indeterminate change in consumption (given the first mechanism – the income effect in of itself will increase consumption), but a net stimulus.

These are important factors to note when we ask “is an increase in government investment increasing output” and furthermore “is an increase in GI increasing welfare” – which is the ultimate goal.

Note2:  There is also the case where public investment is more productive than private investment.  I don’t think this case is as unlikely as people say – given that the government may have easier access to some resources than the private sector (and given the possibility of increasing returns to scale, especially in a small place like New Zealand).

Handling an asymmetric information problem

Over at the Free exchange blog there is an interesting piece on actions in the current crisis – namely whether to follow the “free market” route or the “inteventionist” route.

My hefty use of speech marks in the above sentence stems from the belief that there aren’t really two distinct schools of thought telling us what to do – there is a single framework of events that forms its descriptive and prescriptive powers from value judgments. These value judgments are thereby the true differences.

This quote sums it up for me:

The problem is that we’ve reached a point of market failure and uncertainty. It’s impossible to tell who the weak banks are.

The difference between the two prescriptions stems from how significant the implied market failure is – not a difference describing what the market failure is.
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