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.

Democracy and growth

One of my favourite development economists, Daron Acemoglu, has a new paper out. Acemoglu is generally of the view that a country’s level of wealth can be traced back to the country’s institutional development. In a fascinating earlier paper he argued that the institutions set up by European colonists are a major predictor of the current wealth of colonised nations. His new paper proposes that the wealth of a nation is not correlated with the level of democracy in that country, nor is it correlated with regime change towards democracy in the country.

It seems that a trend among Western democracies is to promote democracy as the way forward for developing nations. This has particularly been the case with the US’s recent foreign policy under the Bush/Cheney regime. Does this paper suggest that efforts to ‘nation build’ and push countries towards democracy does little for their economic well-being? Hopefully, it will force nation-builders to be more rigorous about the way that they justify intervention in favour of democracy in developing countries. Suggesting that it’s the one, true path to economic growth will no longer be enough.

Econometricians will rule the world eventually

It sometimes seems that more interesting economic research is done by econometricians than theoreticians, these days. The way to make your name now is to have a knack for finding inventive experimental designs. Here is an interesting paper about the effect of cellphone use on car-crash rates. It uses the discontinuity in cellphone usage rates across peak/off-peak times to evaluate the effect that cellphone usage has on crash rates. In contrast to the prevailing literature, and quite counter-intuitively, they find no significant effect. Another reason for governments to be hesitant about hasty regulation?

The Halo Effect

I was reading the New Zealand Commerce Commission’s public release on the potential Warehouse merger with one of the two massive supermarket chains. On page 15, paragraph 81 of this document, Ian Morrice of the Warehouse mentions ‘the halo effect’. He states that this is a term that the Warehouse invented to describe what happens when a firm introduces a new product, with the aim of increasing consumer throughput, which will lead to an increase in demand for the original set of goods sold.

This concept makes sense as there is a transaction cost of going somewhere to buy something. So once you introduce groceries into a Warehouse store, people can now get groceries and general merchandise in the same place, lowering the transaction cost of buying a bundle of both types of goods. This allows the Warehouse to increase the price of general merchandise goods, and to increase the quantity of merchandise goods they sell.

Now I thought that the halo effect was a pretty cool term, so I decided to look it up on wikipedia. Much to my surprise the term existed well before the Warehouse used it. Not only did it exist, but it meant something a little different. In industrial organisation terms the halo effect is what happens to the consumers’ perception of a firm’s set of products when a new product is introduced. For example, Sony makes electronic stuff, like DVD players, that I think are pretty high quality. Now say that they make a battery that really sucks. If I use this battery and don’t like it, then I may also downgrade my perception of the quality of other Sony products. Implicitly, people use brands to proxy the value of a product. If a firm makes a shoddy product, consumers will use this as information about the quality of other products under the brand.

These two definitions are both important, but I think it is important to distinguish between them:

  1. Goods as complements: By putting more products under one roof, a firm can reduce the consumers’ transaction costs, allowing the firm to increase sales and prices for the initial set of goods.
  2. Goods as signal of brand quality: The quality and desirability of a new good sold by a firm can change consumer perceptions (and ex-ante expected values) about other products sold by the firm.

Now if you ever hear the term being used, you should ask the person to define exactly what they mean.

Emission trading: Fairness and efficiency

An article by Adolf Stroombergen (from Infometrics) discusses how NZ is going to meet its obligations under the Kyoto protocol.  First Adolf discusses the merits of a Pigovian tax as a way to cover our obligations.  One line I particularly enjoyed was:

“However, even if a tax has no effect on emissions, it is still fairer to put the cost of emissions on those who cause them than to put the cost on taxpayers generally.”

So damn true!  Having established what the government should do, he then goes on to discuss what they actually will do, an emissions trading system.  While a emissions trading system could, in theory, be as efficient as a tax, governments around the world have taken the strange measure of given out emissions permits for free, instead of auctioning them and using the money gained to pay off the Kyoto obligation.  The reason given for this in the article is that it is fair to compensate industries where investment has occurred only on the basis that producing carbon was free.

However, I think I see it a little differently.  If an established firm can only stay in business when carbon emissions are free, then they are socially inefficient.  So the only way the firm can stay in business is if it makes society bear some of the cost of their production decision.  That seems unfair to me.  As a result, I think that emissions permits should be auctioned by the government in almost all cases.  The only time I see scope for them to be given away for free is when we have an infant-industry, one which would be able to pay for the full cost of their production activity in the medium term.

The week in numbers

  1. QVNZ three monthly house price growth continued to accelerate, reaching 12.7%pa in July
  2. Retail sales growth was up 7.2%pa in the June quarter, and 4.8%pa in the June month.
  3. The exchange rate is crazy, falling to $0.67US at one point, currently around $0.69.

Robust house price growth and reasonable sales growth are not the sort of news that usually leads to a plunge in the exchange rate. However, with credit tight people are pulling out of NZ to try and get hold of some liquidity.