As soon as the article was released I put down a cheeky facebook post among my own friends – I’ve now made it public to share here:

Now as it was among my friends I was assuming it would have context – but on a blog it doesn’t.  So let me explain.

The economists at the RBNZ are excellent.  They are intelligent, articulate, and passionate about economics.  I’ve always found them insightful, and they have a genuine interest in balancing theory with realistic policy.  In the same way, the heads of department and govenor have always been people interested in a balanced understanding of the economy and having an honest interpretation.  Put this way, the individuals involved are doing an excellent job – I am sure Shaz feels the same way.

However, how are policy choices then communicated to the public?  An independent central bank needs an ability to be credible – eg in the case of inflation targeting, when they tell people inflation is going to be some level price setters in the economy need to believe that when setting their own prices.  Such credibility involves persuading the public the Bank knows what it is doing and clearly communicating what it is doing – as a third part the Bank also needs to be able to articulate why what they are doing is justifiable and within their mandate, or why some outcomes are the responsibility of government.

Now central banks – including the RBNZ – more than accept this as their role.  And they actively do what they can to achieve this.  In my comment I am stating that I think they rely too much on appeals to authority to persuade which leaves them vulnerable when their credibility does get undermined.  Instead, communication has to be such that the Bank can be wrong (as all forecasts are wrong) and still maintain authority.

Note:  To be clear the idea of “smartest person in the room” here isn’t meant to be an insult – it is just a way of saying “appeal to authority”.  You put most people at the RBNZ in a room with me and they would be the smartest person in the room anyway

Inflation targeting as a communication framework

Now a lot of people actually disagree with me on this point – and feel that appeals to authority are sufficient and necessary given the way people set expectations (some would say it is an assumption that people are stupid, but more realistically it is an assumption that people are time constrained when considering inflation).  Of course, I disagree with those who disagree with me – as what we care about is the times when people reevaluate their price setting rules – if other institutions start to be seen as more persuasive than the Bank, due to the form of their arguments, inflation gets unanchored (and independence gets threatened).  This gets MORE important when a financial stability mandate is also thrown in.

The RBNZs communication area is facing two difficult issues it has not faced before:

1. The necessity of communicating about financial stability, due to changing regulation/policy in this space.  Furthermore, the Bank now wants to set deposit holders expectations regarding losses so that risk is taken into account.
2. A persistent period of low inflation due to repeated external shock has crept into inflation expectations.

To think about how the Bank should communicate about these ideas they need to clearly think “what are we talking about” whenever they are doing a specific statement.  When Shaz mentions Carney it is because he has used the framework of inflation targeting to clearly communicate his views of monetary policy – one of the key advantages of inflation targeting is how it allows a framework that ensures households and firms can clearly set expectations regarding inflation and interest rates AND allows justifications for why inflation and interest rates differed from forecasts.

Inflation targeting, in this way, is a communication framework.  It is credible and persuasive as the central bank can communicate how their choices can influence inflation, and how they will in turn act if outcomes vary from their expectations.

When it comes to then discussing financial stability and financial regulation, these issues are SEPARATE from the inflation target.  Yes sure, financial regulation influences inflation and interest rates – that is lovely.  But if your monetary policy framework is inflation targeting and you are a credible central bank you ARE setting inflation at your target level as a matter of credibility – financial regulation need not be a central part of your discussion of monetary policy, and if it does keep stealing the headlines at monetary policy discussions then it muddies the waters and makes it harder to communicate to price setters.

Without clearly splitting these issues for communication purposes you confuse price setters, which reduces the efficacy of policy.

And what is making this worse is the inconsistency in RBNZ discussion about financial stability.  I recognise this is a work in progress, but changing the motivation for policies and pretending nothing has happened is poor – attacking policies (such as debt level targeting) and then turning around and introducing them as great ideas doesn’t actually indicate an open mind, but instead seat-of-your pants policy setting.  This is fine for politicians but not a central bank where the rest of us have to have faith that you guys have considered the trade-offs involved deeply before making a statement on something

Now I also disagree with Shaz’s “extroverted” examples.   Rajan got himself involved in politics too much, which in turn confuses the role of the central bank govenor, and also has lost him his job.  A good head isn’t trying to control policy, they are trying to cleanly meet their mandate as determined by a policy targets agreement.  To me, the RBNZ has always clearly recognised their roll in letting the value of fiat currency depreciate at a known target rate (inflation) and they have done a good job with respect to it.

BUT, the communication around financial stability policy, the creeping confusion about the relative roles of monetary and fiscal policy in policy debates, and a frank lack of bloody minded language about doing everything they can to get inflation to target are all factors that have muddied the waters.  The increasingly reactive nature of policy setting and speeches (rather than proactively pointing to targets in the future) combined with a growing muddle between monetary and financial policy is what led me to say I didn’t want to discuss this anymore.

In fact I don’t even want to discuss it now as this is NOT what I am currently thinking about.  However, Shaz’s article motivated me to write something up – as I was a bit concerned people would focus on the potential attacks in his article, rather than just the suggestion that our Bank needs to remember its core competencies when communicating with the public.  When put this way I am sure we are all saying something fairly obvious, something that many at the Bank would agree with but would merely have a different view on the trade-offs involved with communicating these ideas.

Tldr

The RBNZ has great economists and good leadership, but should be using inflation targeting more forcefully (and without reference to financial stability) to meet monetary policy goals.  At present, there is a risk that wandering into political issues, or the inconsistent explanations about what the Bank is doing, undermines monetary policy.

This is an issue around the world of course, and our Bank does do a good job – but it is worth reconsidering these issues from time to time to make sure the focus is on the core elements of what Bank policy should be doing, not the cute issues around the side.

Then I looked in my email and noticed that the quantity of politics related spam was increasing at a seemingly exponential rate.  Exacerbated I did what anyone would do, passive-aggressively complained on social media:

Why do I keep getting emails warning me about communists and attacking the Greens – you're pushing me closer to voting @NZGreens with this.

— TVHE (@TVHE) September 18, 2014

Unsurprisingly to anyone who reads the blog, I was never going to be very responsive to the communist cat-call given I think it makes no sense.

As a result, I was just wondering if anyone has any knowledge about the effectiveness of political marketing techniques, especially during different stages of the election cycle. Marketing is a general issue that we’ve written a little about here (here, here, here – and which is related to views on addiction), so any research you guys know of would be of genuine interest.

First off to answer this tweet:

@TVHE I love it when you call me names. Particularly ones I don't understand.

— Geoff Simmons (@geoffsimmonz) September 2, 2014

My comments were certainly not intended to be an insult – “extreme social constructivist” was equivalent to call of “perfect information” which both Gareth and Geoff throw out there fairly often (including at me).  I used this based on the near constant focus on how firms are “tricking” us, ergo shifting our preferences.  Given the theoretical construct being used to justify what was written is that firms are doing this I’m happy with the description I gave.

Potentially it was seen as insult as these issues are often painted as “positivists vs constructivists”.  Many in public health would see themselves as strongly, strongly, positivist – relying on data to estimate and falsify like a true science.  However, data alone can’t give us anything – we need a conception of theory.  A theory that relies strongly on firms and institutions setting people’s preferences IS constructivist.

This is why the positivist vs constructivist debate can be a bit of a red herring – hence why I follow a “scientific realist” view of economics and problem definition.  In this way, I don’t see constructivist as an insult – it is a type of framework that has value as long as we try to consider “many models”.  My preference is for methodological individualistic models instead – but this journey is a bit beside the point.

Think about the kids

Now the people commenting all asked whether I believed in a “rational choice model for kids”.  Of course I don’t, as I said:

Social constructivism does have a nugget of truth, and in the formative years of childhood there are important elements too it.  However, there are two key concerns.

And

First let me state down where our frameworks meet.  Advertising to and information for kids does matter.  We build up a stock of habits, rules of thumb, and physical attributes as children which have a fundamental impact on the type of life available to us as adults – and we are ill equipped to make choices for ourselves.  In that case we do need to think about these types of issues.

My concerns were about how we use the framework to analyse and think about choice – but like almost all economists I heavily appreciate these points around habit formation etc ESPECIALLY with regards to kids.

So I wasn’t saying that we shouldn’t consider these types of explanations – what was I saying then?  I was saying this shouldn’t be treated as our only explanation – and if we accept a “preference shifting” argument as an important part explanation that is fine.  But be aware it is a debate you need to be able to have, on reasonable terms (eg recognising alternative explanations and the difficulty of balancing evidence) – the shrill attack on kids toys at supermarkets comes off as extremism here!

Now I noticed in the comments that Geoff states they aren’t anti the toys – I’ve read the posts and media releases and there is a lot of harsh language in there, and a very anti-firm rhetoric that can only be explained through a social constructivist view of firm actions influencing individuals.  I can only answer the words that are put in front of me, and those words seemed relatively anti the program.

The discussion on choice and our “explanation of stylized facts”

When it comes to building an explanation, there is in fact a trade-off between an explanation from social constructivism and one from heterogeneity of choice.

If we see choices that differ from what we would choose we can explain these choices either with regard to different models.  The same “variability” can be explained by people wanting different things – the question then is, is this due to individuals inherently valuing things in a different way to us, or is it due to them being “tricked” into valuing things differently.

The answer to this question is a central point of contention, and my goal was to bring it out.  Especially given that each form of explanation has specific shortcomings – with constructivist models subject to multiple equilibrium with varying forms of value that may not be fully transparent.

By focusing too much on only a single explanation, we are inherently placing less weight on other explanations.  A key set of other explanations in this case involve “people being different”.  If we aren’t careful, such a bare focus will be implemented in policy and will restrict choices.

This is no small point, not in the slightest.  The fact that most of our actions are unconscious, that habit formation is key, and that even our costly attempts at conscious choice are bounded does not offer a slam dunk argument for the “firms are controlling your preferences” argument being thrown around.

Weak wills and time inconsistency

There is a feeling that time inconsistency in itself justifies action.  Of course it may – however, once again we are discussing a shifting “preference” as our explanation, implying that there are multiple explanations of our phenomenon with different policy recommendations depending on the one you pick!

Time inconsistency is especially intuitive though – which when it comes to “picking a model” this is sometimes a pretty important factor.  At a minimum it makes it persuasive.

But, if we pick time inconsistency we need to ask “why don’t people find costly ways to make themselves commit”.  Or if we go to use policy “how can we make it cheaper and more accessible to precommit?”.

This is an especially good concept as people can “self-select”.  If they are suffering from precommitment issues, then making it easier to precommit improves their lives.  If they are simply willing to trade-off future health more heavily than we are, then they won’t precommit and they’ll make choices.

Now we may say here “people are stupid, they’ll make choices outside their own interest”.  I’d ask us not to use the term stupid, and to again define and try to measure the ways people mess things up – the concept of help here is about working with people to improve their lives (as we can’t observe their preferences), not so much to decide what we think their preferences SHOULD be

These issues are relatively simple/obvious

There is no such thing as a simple or obvious issue in social sciences.  It is incredibly common for social scientists to call results obvious, trivial, or simple but it is a narrative I’ll fight till my last breath.

Social issues are far too important, and the inherent differences and depth of individuals too much, for any social “problem”/”issue” to deserve any of these terms.

@TVHE You are assuming perfect information

— Gareth Morgan (@garethmorgannz) February 23, 2014

It did get me thinking though.  The two of us actually have almost exactly the same model of choice in our heads for this issue, and as a result any differences of view of on the appropriateness of policy that we might have are not due to differences in the underlying model.  Recently I saw this paper via Neuroskeptic on twitter, and my reply to that also was:

@Neuro_Skeptic While I agree in large part, the author downplays commitment to future rules – dangerous when discussing addictive behaviour

— TVHE (@TVHE) March 4, 2014

Yes we can think of matters through a “conscious” and “unconscious” mind, where the unconscious mind bear similarities to a computer – and where we ex-post rationalise choices to satisfy ourselves.  This model has empirical backing, is logically consistent, and suits my priors – so I’m comfortable with it.  And it is this context that the article Gareth discussed, and his own view on the obesity epidemic, are based.  In this way, yes we have the same model of fundamental choice.

Where we might differ is in terms of our belief that people can, will, and should precommit their actions and influence the rules followed by their unconscious mind.

I take a revealed preference approach to this.  If people don’t precommit, it is because precommitment itself is costly and so the benefits from doing so are presumed to be too low.  Their may be a failure in their expectations or information – in which case government can help.  Government may be able to offer low cost commitment mechanisms, or even at a push use framing effects to “nudge” (note, these framing effects should not be directly costly – something that often gets forgotten).  But that is that.

It may be possible to take a more paternalistic line, and say that there is a certain way people should be.  I disagree with this, and I don’t know if this is actually Gareth view, and this is why I said this “might” be a difference – in may not be.  However, if it isn’t a difference and we have the same view of choice, I am uncertain why he would have disagreed in the way he did with my tweet.

What does this have to do with the title of the post?

I’m getting there.  One thing Gareth has been pushing is a sugar tax, a recent tweet about it was here:

Sugar tax may be necessary, England's chief medical officer says http://t.co/egTCcp6IPV

— Gareth Morgan (@garethmorgannz) March 5, 2014

Now I touched on some of the limitations of the tax idea in this post.  However, the limitations I pointed out do not imply that the best tax itself will be zero – I leave myself more open here.  They are just issues we should consider.  Geoff Simmons touched on these things (he is writing with Gareth on these issues) in this tweet:

@TVHE Interesting. What do you think mechanism to justify smoking tax? I would say time inconsistency, health costs, plus productivity loss

— Geoff Simmons (@geoffsimmonz) February 14, 2014

I understand the argument for a tax based on time inconsistency issues and a version of “user pays” for health care – a linear tax when the cost is highly non-linear is a rough solution, but it is at least worth looking into.

However, if Gareth disagrees with my point on precommitment and does not think there is any “control”, this in part undermines the case for a tax.

If people are not making choices due to “substitution” (the change in the relative price of food) because they are programmed to just eat, the only way a tax changes behaviour is through the income effect – essentially making people poorer.  So a tax program will exacerbate poverty.  Furthermore, if people are not making choices, we don’t get a substitution towards a healthier diet.

The part of the externality associated with “user pays” is still relevant, independent of a change in behaviour.  However, given how imprecise the tax is at actually targeting this ‘policy externality’ it might be a bit more appropriate to just target it directly – say by having user pays for obesity related disease.  If we don’t want to do this, as we think society should pay, then there is actually no externality!

The part of the externality associated with “time inconsistency” is completely irrelevant without a change in behaviour.  It is a transfer between “different versions of the self”, so if we don’t change behaviour it just nets out.

Note:  Externalities from “loss of productivity” aren’t externalities.  There is a market price for labour.  Claiming this as an externality is becoming increasingly fashionable among economists, and it makes me very uncomfortable – it deserves a post of its own to be honest!

Conclusion

Choice issues are hard.  Policy issues are hard.  Both Gareth and Geoff know this, I’ve talked to them in the past.  Furthermore, I think this sort of tweet indicates that they realise, and care about the fact that, these are delicate complicated issues:

The use of financial incentives for weight loss is promising, but tricky to get right. http://t.co/m82buQiVD7

— Geoff Simmons (@geoffsimmonz) March 5, 2014

However, I am uncertain why the rhetoric that sometimes comes out places little faith in individual choice – given we are using the same choice framework to understand the issues.  Yes people make bad choices and regret them, yes most people don’t seem to make choices that we feel we would have made in their shoes, but fundamentally people are all incredibly different.

Most importantly though, if we are going to use a rhetoric about choice that takes away individual responsibility, we have to be careful selling a policy that demands changes in individual choice – this is a logical inconsistency.  If we do so because the “natural” conclusions of our rhetoric, towards controlling choice, appear abhorrent, then perhaps the rhetoric we are using is downplaying the propensity of individual choice!

I genuinely like the fact that Gareth and Geoff are looking into these issues, and trying to describe the role of policy and choice.  Furthermore, my comments are a call to do analysis – not to say we shouldn’t!  I am just always cautious of the role of policy within an environment with individual agency, namely:

@garethmorgannz I will do, thanks! I just worry that focuses on nudges, without individual agency, can lead us a bit astray!

— TVHE (@TVHE) February 23, 2014

Cuba provides an interesting case study in how government policies can help individuals coordinate in their choice of job and educational attainment.  However, it also shows some of the costs of trying to generate a “dynamic comparative advantage”: the misallocation of human capital as people are pushed into specific areas, the restrictions to freedom required to solve the time inconsistency issue between government and the service providers, and ultimately the risk of being exposed to an industry ‘picked’ by a government.

In truth is does appear that one of the key issues, when looking at how the system works, is the freedom of choice of the individuals involved – understandably, people’s beliefs and judgement around this in ethical terms should drive their view on what is appropriate.

“Simply citing that there are 2.2 million members and $19 billion in the scheme doesn’t actually tell you anything,” the paper’s author, Michael Littlewood said.

“It just tells you that KiwiSaver’s popular – and why wouldn’t it be, with the incentives that it has.”

Littlewood said with the limited data available, there was no way of knowing whether New Zealanders would have saved just as much without KiwiSaver.

This is true.  Back in 2008 we mentioned research by John Gibson and Trinh Le calling into question claims that Kiwisaver had “increased national savings” – in fact suggesting that the make-up of Kiwisaver had reduced national savings.

At my most generous I tried to state that, perhaps, the reasoning behind Kiwisaver subsides was the change the “type” of saving rather than the level.  However, there is no evidence or logic behind the claim that Kiwisaver in its current form would increase savings.  Also remember, when someone “has” to save via Kiwisaver they could fund this by cutting consumption or cutting other forms of saving – as a result, it is only likely to impact upon saving when people are already credit constrained (and therefore are already saving “too much”) – implying that any increase in savings due to such a scheme may actually be a bad thing!

The initial idea was that we would have an “opt-out” scheme without subsides.  This would allow us to see whether individuals were being “time inconsistent” with their savings behaviour.  This was a very good idea.  However, the subsides have made it pretty much impossible to test this, and simply act as a form of middle class welfare given their structure.

And before anyone starts saying “blah blah capital deepening” let me say a couple of things, if this doesn’t actually function to increase savings rates it is really just changing the composition of funds heading to a group so it sound a bit like self-interest.  Also remember there are trade-offs.

However, a small part of the post did spark my imagination, and will lead me to write on a loosely related, but important issue.

In the post, when talking about potential issues with the new scheme, the author says:

We hear echoes of the Bolger-led Government adoption of social capital in the late 1990s. Remember that? It placed social problems and their solution-generation with ‘communities’. There is a worthy role for this type of policy in a wider package, but it can also be used as a distancing policy to shield a government and the state from its responsibilities (e.g. on welfare benefits), deflecting the blame and responsibility for solutions to the level of communities.

This is a fair point, words like “community” and “opportunity” are often used by politicians on the right to avoid action.  However, politicians on the left are just as eager to push inappropriate policy at a national level by dismissing these claims.  In truth, the relative importance of “community”/”opportunity” as opposed to nationwide determination of policy depends on our assumption about how different people are – to whip out some jargon, we need an idea about how heterogeneous individuals are with regards to the issue we are looking at.

Take the posts discussion of a 20% sugary drink tax as an example.  Well, we can only really defend that policy is we have perceived a specific need for that policy – why are we taxing sugary drinks?  We could try out the following explanations:

1. Sugary drinks hurt health, which hurts the person – and they don’t include that as they are time inconsistent.
2. Sugary drinks hurt, we have public health funding, this is an indirect form of “user pays”.
3. Sugary drinks are seen as a status good, and are overconsumed by people to achieve “relative status”.  This was sort of implied in the Spirit Level book.

Note:  The “fake food” argument doesn’t mean much unless we have a behavioural mechanism such as the ones above.

Cool, ok.  With time inconsistency we are asking why people don’t precommit (examples of commitment here and here).  With the second one we may view as a fat tax, this involves thinking about the relationship between consumption and health outcomes – a kicker is the tax is linear, while the “costs” are non-linear.  The final one involves stating that these drinks are seen as a type of status good, and we may have a view that increasing the price would reduce this specific coordination failure.

Even at an aggregate level these things are hard.  But food is such a good example as individuals ARE massively different with regards each of these three explanations.  Different groups are time inconsistent in different ways, different people experience negative health effects in different ways, and different communities respond to having something as a status good very differently.  Therefore the appropriate tax/policy on these different groups will be very different!

The status good argument is one that is especially easy to pick on – if you increase the price, this may in fact increase the use of sugary drinks as a status item.  If it is mainly poor households that use this type of food as a “status good”, then it is really a punitive regressive tax!  And even if we were to deliver an income transfer to do this, the fact that the higher price may have made it more of a status good simply implies that we have exacerbated the problem!!!

When discussing “community” the key idea is that we have specific failures that policy can address, and those failures are not equally distributed across society or across class.  National policy that focuses on helping communities and targeting need can in this way make more sense than national policy that is meant to address the problem itself with a single instrument – something like a “fat tax” could well be too blunt a tool to address the specific failures we are concerned about.

Sidenote:  I would more generally point out that, if we find sensible targeted community programs do not change behaviour, this doesn’t so much imply we need to go in harder – it more implies that the actual “market failure” involved may be smaller (or different) than we had previously believed.  We can’t observed the heterogeneity of individuals in terms of their wants and desires, we can only get an inkling through their choices – we must be careful to not, in turn, impose our own preferences on others

Anyways, I went along to the supermarket and purchased a small number of cashews.  The checkout operator warned me “be careful, those are addictive”.  I responded by saying “hey that is why I buy them is such small quantities”.  We’ve talked about this idea in the past here and here.

Now what we really described there was a situation where the consumption of cashews is time inconsistent, and where I use a precommitment strategy of “buying less of them”.

This broad definition of addiction, which merely means that you are unable to commit to an optimal time path of consumption, is fine.  But the cost of it is limited by the cost of precommiting.

When viewing action externally, one way we might believe we’ve seen addiction is when we see choices that increase the net benefit of consuming the good in the future.  This is not really addiction as defined as a “failure” – but instead just describes a process that people with addictions may show, and provides an important area where “lack of information” is a concern.  However, if our observation of addiction depends on looking at items that behave this way it does imply we need to be very careful – and that we have to also be careful not to mix up choices that increase net benefit by increasing the benefit of consumption, as opposed to choices that do so by increasing the cost of not consuming.  In this way, we are unlikely to call examples of this type of process “addiction” in common parlance.

All these definitions might make us feel good – but in truth, as was the case in the supermarket, we are just applying “folk psychology“.  Non-expert usage of both “common sense” and technical terms to try to discuss psychological phenomenon we observe in our daily lives.  To clinical people, and people in psychology, addiction is significantly more specific, and involves specific conditions and physical traits (depending on the type of addiction) – of course I don’t know what these are, this is just what people who are experts in this field tell me, and their appeal to authority is compelling as it is not my field!

Note:  Calling economics a form of folk psychology is a common refrain from Rosenberg – an issue that recently caused an uproar.

So given this, would you agree that models of addiction that economists may mention based on either rational choice or time inconsistency are “folk psychology”, or is the essence of the term different as it is being used in a different context?  I am interested in arguments both ways

And one extra point.  When the term addiction is used in policy, and by academics, how does its meaning compare to the way the public interprets it?  If addiction means something different, then there is likely to be an issue of communication with the public – this is a common issue when discussing inequality, GDP, unemployment, and even poverty for macroeconomists so I wouldn’t be surprised to see subtitles lost in translation here.

These are empty calories, fake food, there is no nutritional value, they are not good for me.  I could do with losing a couple of kgs, and my weak willpower ensures that future me will find it just that little harder to get to the size I want to be!

Then I thought, blah blah blah.  Information is great, but looking solely at the cost of “empty calories” without thinking of the subjective benefit I get is as dumb as Boris Johnson presuming that maximising the GDPs is all we want.  Yes there is a time inconsistency issue, but as I am aware of it, and surprisingly active at trying to deal with it, I am pretty comfortable that I can make my own choices …

In my view economists, and other forms of social informers, have a role to provide information and help describe trade-offs for the public.  But lets not get on people’s back because they enjoy action that has a corresponding cost to themselves.  Analysts that go too far in telling other people how to act have moved past acting in the public interest, and are starting to act more in terms of ego or an inflated sense of confidence about their own understanding [to be clear this comment is NOT pointed at anyone, it is a hypothetical – accusing anyone in NZ of this would be strawmaning them].

In this case I purchased the Tim Tams and had a few with a coffee.  I spent the rest of the afternoon reading about economics and many utils were gained.  I have no doubt that other people, with different preferences, would not have gained the utils in this case – but that is completely irrelevant, these are my preferences, which are revealed by my action.  Not your preferences.

But anyone who reads TVHE knows what I’m like, I just really really want to know ‘why’ certain things are being said!  I emailed a few economists and some suggested I do a bleg asking, so why not!

In the Yahoo story there are a couple of segments I’m a touch confused on and I’d like it if someone could answer them for me  (Note:  Seamus from Offsetting offers some example answers at the bottom of this post)

Grimes said investors were still likely to pile into asset price bubbles because they expected that even if they burst, central bank action to support the economy would soon cause asset prices to return to their previous levels.

On the face of it this is a type of moral hazard argument where we have “implicit insurance” of asset prices by the central bank, leading to excessive risk taking, and weakening market discipline to prevent “bubbles”.

But let us think a little further, if the central bank is ensuring stability in the price level in a way consistent with closing the output gap/keeping unemployment near some natural level I’m not sure I see the issue.  Don’t we need to answer the question of why the relative price of assets to goods and services remains elevated due to central bank action?

Furthermore, if an asset price collapses with economic activity and then rises back to its prior level with economic activity was there really a “bubble” – can we really even say the “bubble” popped.

I don’t know what his “model of bubbles” is.  But I also know Grimes is insanely smart, so I was wondering if you have any idea of what the mechanism in this is?  What are we calling a bubble here, the rate of return on assets being lower than we think is reasonable, or is it due to expectations that are out of line with reality?  And where is the economic cost of this – if the volatility in asset prices merely causes a transfer between participants who cares.  After all we can’t just draw a straight line from asset prices to economic activity without asking “why” about the bubble – the ‘tech bubble’ and the ‘housing bubble’ were quite different beasts for example.

We may use some type of structural insurance argument.  My guess is that view in the above quote may involve implicit commitment by the Fed holding up asset prices relative to their fundamental value, therefore leading to excessive investment and greater borrowing for a given level of goods price growth.  But here the “asset prices back to their previous level” call makes no sense to me – as this implies that the relative price of assets is also returning.

Either this is an inconsistency, or I’m not sure if I buy this model of bubbles … as implicit insurance IS one of the drivers of fundamental value.  I really need a “model of bubbles” before this makes sense to me and I just don’t know what it is.  Furthermore, this is increasingly sounding like a structural issue rather than a monetary policy issue – as there is nothing inherent in stabilising the price level and closing the output gap that would imply asset prices will be ‘propped up’.

Note:  The model of bubbles matters.  We need it to understand policy.  And as Shiller, Sumner, and Gali have all noted this is a very difficult issue that doesn’t fit into a single box named “bubble”.

And then in terms of the conclusion.

“They are stuck between a rock and a hard place, in terms of the Fed officials themselves. You would have to have a big bang to say: ‘We are targeting price stability. We are targeting stable asset prices as well as stable goods prices.'”

Stability in asset prices?  How does saying you will keep asset prices stable reduce the moral hazard issue – doesn’t it increase it by directly taking on systemic risk in asset prices.

Is this really something we should announce with regards to monetary policy?  How do we judge “stability” in this way, given that movements in asset prices as an aggregate are a useful piece of information about monetary policy (given their flexibility, and the fact that are made up of forward looking expectations about nominal returns).

Note that asset prices that are “too high” are an indicator that monetary conditions are “too loose”.  Is the complaint that monetary policy in the US tends to be too loose here?

And lets not even get started on trying to measure aggregate asset prices through time … that is an even stickier issue than measuring goods price

What’s the bleg

I was just wondering what is being said in this article, and why.  What is the bubble mechanism being used?  What is the implied criticism of Fed policy?  In what ways does this imply that Fed policy should change?

On the face of it, I just don’t see the argument against simply targeting goods prices and closing the output gap (or NGDP targeting if you are that way inclined) in this piece.  And given the Fed has been easing policy INSUFFICIENTLY on this basis, the argument that their policy has been too loose also wouldn’t make sense.

Seamus Hogan’s answer

After I finished this post, but before I popped it up, Seamus from Offsetting Behaviour flicked me the following answer, and said I was allowed to pop it up here.  It offers a good framework for us to think of working through this question.  This was just a quick answer as him and Eric are a bit short on time to post a full discussion on it right now.  They were happy for me to pop it up here though!

My first pass:

1. Asset bubbles are bad because when they burst, they cause damage to the economy.
2. However, when they burst they are bad for those caught buying at the end of the bubble.
3. The central bank can use monetary policy to mitigate the damage to the economy.
4. But at the same time that policy mitigates the extent to which the asset prices fall.
5. Therefore, unless the central bank can credibly commit to not helping the economy, speculative investors will know that there isn’t much downside to buying up assets as their expected value has been elevated by dampening the prospect of a bad economy.
6. In which case, why are we worried about the bubble in the first place?

My second pass:

1. Asset bubbles are bad because when they burst, they cause damage to the economy.
2. However, when they burst they are bad for those caught buying at the end of the bubble.
3. The central bank can use monetary policy to mitigate the damage to the economy.
4. This policy will only partially undo the damage to the economy, but will heavily mitigate the extent to which asset prices fall.
5. Therefore, unless the central bank can credibly commit to not helping the economy, speculative investors will know that there isn’t much downside to buying up assets as their expected value has been elevated by dampening the prospect of a bad economy.
6. In which case, the inability to commit to not slightly help the economy in the event of a damaging asset-price-bubble burst will heavily increase the risk of such a damaging burst happening, and so the expected cost of future bubble bursts will be higher than in the case where the Bank could commit to letting the economy languish in a recession.

The two differences in these logic steps are in red. The key is whether the change in Point 4 makes empirical sense. If so, there is still an empirical question as to whether the relative magnitudes make point 6 in the second pass make sense, but the blogging point needs to rest on point 4. I’m not sure I buy it. I can buy that the Fed’s only help-the-economy-strategy—printing money (QE) or lowering interest rates can easily lead to leveraged portfolio investment rather than fixed investment, for some settings of expectations; I am having a hard time seeing how, though an asset bubble burst that largely goes away because of Bank policy can harm the economy.