Matt Nolan

Handling an asymmetric information problem

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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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Matt Nolan

Broken windows and thrown towels: The issue of stimulus

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Over at Economists View, Mark Thoma points out and, in my opinion, rightly criticises a piece from the Cato institute on fiscal stimulus.

Now the Cato piece seems to equate a fiscal stimulus strictly with the “broken window fallacy“.  I do not completely agree with this.  As Thoma points out government investment should be counter-cyclical, as by investing this way they get to build public goods (which will not be provided in sufficient quantities by the market) cheaply!

However, some fiscal stimulus does fit into the broken window frame – however it does so in two different ways.  First we have the case where the windows are broken and then we are wondering what to do with policy.  Then we have the case where the government could break windows.  Lets discuss.

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Matt Nolan

Some links worth reading on fiscal stimulus

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There really is a pile of excellent economic discussion flooding out the the Economics blogsphere over recent months. If the collapse of Lehman brother did nothing else – it got economists arguing!

On the issue of a US “fiscal stimulus” there have been two main posts that I have found as convincing arguments against the “large stimulus” school of thought that is being sold by Paul Krugman and Mark Thoma. These posts were by Tyler Cowen at Marginal Revolution and David Henderson at Econlog (and part 2).

Ultimately, the static Keynesian analysis being sold by Krugman and Thoma misses the impact of relative prices – a factor that is important given that some of the shocks hitting the macroeconomy are structural.

Now, given the way confidence (especially business confidence) has turned south I think we can sell some scope for a stimulus. Furthermore, government CAN help improve outcomes during a structural shift in the face of asymmetric information. However, Krugman and Thoma are both ignoring any supply side shift – and treating all the decline in activity as a decline in “demand”. Such an extreme position would only lead to excessive government involvement in my mind.

The most important question in my mind is “what is potential”? I’m sorry, but we have an observable, large, permanent, negative supply side shock – but many forecasters are still assuming that “natural” growth will be unchanged. How am I supposed to trust those forecasts in these extreme circumstances?

Matt Nolan

Borrowing, expectations, and potential output

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Over at EconoSpeak they have attacked Kevin Hassett on his call that the US government should run a balanced budget (ht Economist’s View).

Now, although I don’t necessarily agree with Kevin Hassett’s prescriptions, I can understand his feeling that the “paradox of thrift” argument for more government spending seems a bit strange in the case where public and private debt are elevated.

Fundamentally, I believe that all the debate stems from different peoples view of “the natural rate of output”.

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Matt Nolan

Why New Zealand’s current account deficit will begin to fall

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Two releases today have made it obvious that the New Zealand current account deficit will decline over the coming quarters.

The first was Japan’s reported current account surplus – it is down 66% on a year ago. With a range of structural factors also likely to drive down Japans CA surplus over time (here) and with other Asian nations following in Japan’s footsteps, we are running out of countries that will fund our debt.

Secondly, S&P has given our currency  rating a negative outlook going forward.

As a result, isn’t it good that New Zealand consumers have been slashing back spending and cutting debt in the face of recent mayhem – rather than being forced to adjust even more sharply further down the line 😛 . A CA of deficit of below 5% of GDP may actually be a possibility by the end of 2009 – who knows 😀 .

However, if this is the case a raft of government borrowing to “stimulate” economic activity would only make things worse – something that is worth keeping in mind over the coming months methinks.

Matt Nolan

Is the US overestimating its “potential”?

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Over in the good old US the Congressional Budget Office has released their forecasts (ht Paul Krugman). It is an ugly sight, as would be expected, with growth falling miles below its “potential” level and a large negative output gap opening up.

As Paul Krugman points out, this type of large output gap would provide massive deflationary pressure – he suggests that we could have a deflation rate of between 3-5%!

Now, I’m sure his logic is spot on given this estimate of potential output – however this raises a question for me, has potential been forecast correctly? Generally, growth in potential output is forecast to be relatively stable – and trends along with historic growth. But this doesn’t feel quite right. There are two reasons why this may fail:

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