Even economists struggle with inflation

I have to admit that when I read this news story last night I was very angry. BERL seems determined to tell everyone that increasing interest rates increases the money supply, and a higher money supply leads to higher inflation. This would make sense, if money supply wasn’t INFINITE. But it is.

In NZ we have an OCR target, the RBNZ will provide an unlimited supply of money for a given target rate. By doing this the Reserve Bank sets the interest rate, and the quantity of money is determined by money demand not money supply.

Now, the amount of foreign capital available does have an impact on us. If our interest rates rise then additional foreign funds become available for firms and banks to borrow. The foreign funds are available for a rate higher than the previous interest rate (as they required a higher return to become available) but this rate is lower than the domestic rate. If our interest rate is far above the world rate, then a significant amount of capital becomes available at this rate.

The important thing to note here is that this capital will only be spent if there is demand for it. As a result, the fact that foreign capital wants to enter the country will limit the degree with which an increase in the OCR will lift interest rates, it won’t magically make people want to borrow and spend more money.

The problem NZ has faced is that the RBNZ has not been able to drive interest rates up as much or as quickly as they would have liked (I’ve heard a time lag of 18 months mentioned in some circles!). However, the reason inflation has risen strongly is that money demand has increased significantly since from 2003, and the RBNZ was unable (and at times relatively unwilling) to significantly drive up interest rates.

The OCR is still the right tool to use, however if our interest rates are too far above the world interest rates, the marginal effect of an increase in the OCR is very small. In cases like this some type of alternate instrument might be of use. However saying that the OCR increases the money supply is at best ignorant of New Zealand monetary policy, and at worst a desperate plea for attention from a set of economists.

Australia leaves rates at 6.5%

The RBA left rates unchanged at 6.5%.  Although economic growth and inflation have been stronger than expected in Australia, global uncertainty would have prevented another increase.

The question now is, will the RBA lift rates again this year?  Ultimately, this will depend the degree of uncertainty surrounding global markets, and the strength of house prices over the next few months.

Does anyone that knows anything about Australia have any opinions on this, and general Australian monetary policy?

Run on funds drives LDC finance down

So the latest finance firm to collapse was actually in good shape, until good old investor panic lead to a run on funds took it out. The eight company since May 2006, I bet you a lot of people feel scared now.

The main thing to remember is that this company was small, $19m owed to investors is peanuts compared to the size of the ‘finance firm’ market of $16b. This story would not have made news if it wasn’t for the 7 other companies had gone done in recent memory.

Here we have a game of complementary actions. If you believe that other investors are now going to dump the firm, the expected payoff from you dumping the firm rises. If you think other investors are more willing to loan to the firm, the expected payoff from staying with the firm rises. In this case we can have a co-ordination problem. The equilibrium where everyone stays with the firm would have been dominant in the case of LDC, but as peoples beliefs were affected by recent uncertainty, we ended up in a degenerate, sub-optimal equilibrium where LDC folded.

In cases like this, the government can find ways to steady the nerves of investors and prevent things like this from happening, for example by cutting the cash rate. However, as always with economics, there is a trade-off. If the monetary authority cut rates to save the good firms, they would create a moral hazard problem for the market in the future. Finance companies would believe that the government would bail them out, and so would be willing to take on more risk than is socially optimal.

As a result, the best government action would be to tell investors to relax, but do nothing substantial. A correction in the financial market will take out a few genuinely good finance companies. However, this is the price we must face for clearing out all the dead wood in the market, and ensuring that our financial sector functions more cleanly in the future.

Update:  Another little finance firm has gone, this one is valued at $16m, Finance and Investments was its name.  Its times like these we need someone to come onto TV and tell everyone to calm down, someone like Keynes.  I miss Keynes.  Note:  This firm only went down as it was getting funding from LDC, as a result we can blame the damn run on funds for this as well.  Damn you fund runners 😉

Cost of carbon

No right turn has a good point about what the market price of carbon will be versus what the government is pricing it at.

As of May, the government is financing based on a carbon price of $13.21 per carbon ton (update CO2). This is ridiculous, when we see other New Zealand prices set between $33.75 and $70. In European market pricing carbon dioxide futures at over 20 euros.

Update: As carbon dioxide is only 27% carbon (thankyou wikipedia), in carbon terms the European futures price is approximately 74 euros per ton. However, I suspect that the govt. and market prices are for CO2 as well, implying that the price per carbon ton is $49 in Treasury estimates.

Whether you agree with the Kyoto protocol or not, we have to pay our Kyoto liability. What good is lying to ourselves about what the size of it will be. Hopefully government environmental policy uses the world price for carbon to make policy, instead of the Treasury price.

Agreement eases the pain of a break-up

That was the title of an article on Stuff. The purpose of this article was to convince people that a breaking up plan is a good idea. Now there are two reasons why I think a rational person would not choose to suggest a breaking up plan, even if it left them better off financially in the case when they did break up (Note: I am assuming that the person prefers the state of being in a relationship to not being in a relationship. If there is any dumping to be done the other person is going to do it 😉 ):

1) It signals to the other person that you are thinking of life outside of the relationship. If this changes the way they view your payoff in the relationship, they may decide to jump ship rather than be pushed.

2) It reduces the cost of the other person dumping you, by reducing the uncertainty surrounding financial assets.

My focus will be on the second point. When you are in a relationship, it is costly to leave. You go from a situation where certain emotional and physical elements are provided cheaply, to one where these elements are more costly to purchase 😉 . Furthermore, if the relationship has been going for a while, there is financial uncertainty. By removing the financial uncertainty, some of the cost of leaving the relationship has been removed.

Now assume you are A. You are in a relationship, and your payoff from staying in it is greater than the payoff available outside of the relationship. However, assume your partner, B, does not enjoy the services available in house as much. In fact, if it was costless to leave you, they would. In this case, you as A want to make the cost of leaving the relationship high enough that they stay in the relationship. As partner A, you can keep the cost of leaving the relationship high by not having a financial agreement.

I know that it doesn’t sound very nice, but these are the sorts of incentives people follow when making decisions. Taking this into account might change the sort of signal that this agreement provides.

A counter argument to this is – If your partner realises that you will only not sign a financial agreement because you don’t trust them, then signing the agreement surely signals that you trust your partner. If your partner values trust, then signing the agreement may make your partner want to stay in the relationship, when previously they wanted to ditch you.

Relationships, like firms, create complicated incentives, and rely on signals that barely ever match the intentions of the person providing them. That is why they provide such a fertile base for economic analysis 😉

Evidence-based economics

Charles Lambdin doesn’t think this book is right to reject evidence-based medicine. Lambdin thinks the best way to approach medicine is to treat it as a science and apply scientific methods. Where empirical research suggests that a particular treatment is appropriate then it should be used, not modified or discarded according to an individual doctor’s wont. This seems an eminently sensible suggestion but there is apparently widespread suspicion amongst clinical practitioners of evidence-based techniques.

The situation reminds of the disdain with which many economists still view behavioural economics. Daniel Kahneman won the Nobel Prize in Economics in 2002 for his work in the field. Along with people like Amos Tversky and Matthew Rabin he has pioneered the use of experimental research in developing microeconomic theory. While it makes a lot of sense to base microeconomic theories of behaviour on empirical observations, many economists have been critical of those who use insights from psychology. In 2003, Kahneman wrote (JSTOR only):

My first exposure to … economics was in a report … in the early 1970’s. Its first or second sentence stated that the agent of economic theory is rational and selfish, and that his tastes do not change. I found this list quite startling, because I had been professionally trained as a psychologist not to believe a word of it. The gap between the assumptions of our disciplines appeared very large indeed. Has the gap been narrowed in the intervening 30 years? A search through some introductory textbooks in economics indicates that … the same assumptions are still in place as the cornerstones of economic analysis.

There is a greater acceptance of behavioural economics than there once was; however, it is not hard to see why many people might regard microeconomists with some incredulity, in the same way that economists might look upon doctors who disregard evidence-based medicine in favour of personal intuition.