Matt Nolan

Where the moral hazard comes from

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I have a sneaking suspicion that the term moral hazard is getting a bit abused at the moment.  Let’s use the Wikipedia definition:

A moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk

Cool, and in the case of the bank bailouts that have occurred around the world, who were the people who knew that the cost of their “risky behaviour” would fall on someone else … bondholders.  This is from Garett Jones:

So by their estimate over 90% of the benefit to banks’ balance sheets went to bondholders …

If most political battles need a villain to succeed, it’s easy to see why bondholders have largely escaped the wrath of voters: Bondholders make poor villains.  The bank promised to repay, and now the bank can’t.  The bondholder wasn’t out there making the loans; the bondholder didn’t vote for the directors who led the company to the brink of destruction; the bondholder just handed some cash to the bank and hoped for the best.

Bondholders have had good luck getting government guarantees, and I suspect their luck will continue.  That means rational investors will dump more cash into the megabanks with minimal scrutiny: The megabanks are the new Fannie and Freddie.
The fact is, if we wanted to “get rid of moral hazard” we’d have to accept the inherent riskiness of our lending – we don’t get paid an interest rate for kicks, it covers inflation and a rate of return stemming from lending that has some inherent risk.
The reason economists have generally shown no sympathy for people when the finance companies collapsed here isn’t because we are heartless, it is because people wanted to act as if their lending was riskless.
Remember, if you are complaining about “moral hazard” you are attacking bondholders – not so much the banks (who are easy to demonise because they wear suits), but the people who leant money without considering risk and those who advised them.
Matt Nolan

The case for not cutting

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There is a growing call for rate cuts to the OCR in New Zealand given the high unemployment rate, indications that the September quarter was very weak, and the fact people are pissed off that the weakness in the New Zealand economy has been so persistent!

Now I’m not going to go one way or the other on this – after all I don’t really want to second guess the Reserve Bank.  However, the case for a rate cut appears to be weaker now than it was earlier in the year.

How can I say this?  The unemployment rate is undeniably higher.  Well remember that unemployment is a lagging indicator – usually the economy is well into picking up before we see a sustained drop in this.  You may retort (I know I would) with the hours worked figures, which have been very weak.  Hours worked is usually the first thing to pick up (either with or a bit after productivity) during a recovery.  For this all I can say is that hours worked are not as weak as they appear in the HLFS, but we would need to forecast them picking up soon!

Ultimately, we need to ask ourselves what a RBNZ forecast would need to look like to prevent a cut.  We would need them to first forecast no cut, and then to forecast an economy moving back to it’s “potential” level.  This will then be consistent with a forecast of inflation around the target band.

Why might we believe that the economy is heading back to potential (and without a lift in structural unemployment this would imply a swift drop in the unemployment rate in the coming years as well).:

  1. The lift in house sales and (soon to be) house construction – this rebound in durable good spending and investment tends to lead the economic cycle.  Generally households willingness to get involved in these things tells us that demand in the economy is on the up.
  2. Durable good sales to households have risen (although part of this is to builders and plumbers rather than consumers), and business investment has risen … business investment has dropped off in recent months, as part of the prior spike was “rebuild related”.
  3. A similar rebound in the US – with the prospects for the US picking up, underlying demand for a number of our export commodities (dairy, meat, logs) will firm.  Let’s not forget that the US is a big market for our (likely mismeasured) IT services export industry.  Why mismeasured – well if you know anyone who sell services online, you will know that they often avoid tax or business registration 😉
  4. Signs China has found its feet again
  5. Commodity prices are recovering sizably
  6. Easing bank funding costs.  The growing competition between banks in recent months is likely due to easier access to credit – there are reports this is flowing into businesses, albeit not evenly.
  7. The rebuild is now really getting underway.

This isn’t to rule out cuts – I’m avoiding taking a position here, as I want to save that for clients, and generally avoid upsetting people on the internet right now (what can I say, I’m a bit tired).  All I am saying is that, given the time it takes for a lowering of the cash rate right now to flow into the domestic economy, a rate cut when a lot of indicators have turned up in the last couple of months.

Also remember, if the Bank had been able to foresee what occurred through the middle of this year they would have cut earlier on – but they couldn’t foresee it.  This is not a criticism at all, because the Bank does have incredibly good “on average forecasts”, and as a result their actions can minimise the cost of policy mistakes.   But it does indicate that the Bank’s actions aren’t infallible, and that they should publicly explain what happened when we experience a situation of below target band inflation and rising unemployment to the public – instead of leaving all the commentary up to people who want to undermine them.

Matt Nolan

Fiscal policy and the ZLB

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Some links.

Marginal Revolution.  Mainly Macro.

Summary:  The implied impact of fiscal policy at the ZLB is the same channel as direct monetary policy (such as QE).  Response is, yes but we have more certainty about the impact of fiscal policy.

Sidenote:  As the central bank directly does balance sheet management instead of changing the cash rate, “monetary policy” looks closer to “fiscal policy”.  There are four key differences though:

  1. Central banks have the incentive to reverse out unconventional policies once their job is done – politicians don’t.
  2. Central banks will respond to the data more quickly than politicians.
  3. The “inflation target” gives us the approved mandate of the central bank through the policy process.  As a result, central bank action based on this view are appropriate – as long as the instrument used is assumed to not redistribute over the economic cycle.
  4. Central banks don’t have a direct mandate to redistribute – elected officials do.  For central banks to use a tool that redistributes, they have to be given permission by a democratic government.
Matt Nolan

Expectations formation, inflation, and a role of inflation targeting

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Ever since the Lucas Critique forced economists to recognise that we could not use data for policy in a purely theory free way, the concept of expectations, and how expectations are formed has become important.  The growing interest in behavioural and neuroeconomics are all in part a response to this realisation, and a clearer understanding of these issues will help give economists an idea of what to study, what to measure, and what policy trade0-offs exist.

It is encouraging then to see this study on the formation of inflation expectations.  In it they look at how shocks to food prices impact upon individuals expectations of future general inflation.

Our results suggest that consumers incorporate information about past food prices in forming and updating their own-basket inflation expectations but not their overall inflation expectations. The issue of pass-through to inflation is of particular concern during times of large supply shocks. Our finding that information about past food price inflation has limited pass-through to consumers’ expectations of the “rate of inflation” suggests that the RI question (and not the PP question, which as mentioned above is similar to the one used in the Michigan survey) is a more stable survey question (in the sense that it is less susceptible to volatile price changes), and that it should instead be used to elicit consumer inflation expectations.

This is all well and good, but we need to ask whether we are really gauging inflation here in the way we mean it when we discuss monetary policy.  We are interested in the way prices in general move together that is unrelated to “fundamentals”.  A lift in food prices is a change in those fundamentals, and tells us that there is a change with regards to how scarce food is relative to other goods and services and relative to labour.

This general “comovement” we are talking about is anchored by an inflation target, and as a result we want a description of how a “shock” to the price of one good has an impact on this over the complicated beast that is the economy.  We need to seperate out the bit that is due to households feeling “poorer” or “richer” following a change in the price of one good or service (a relative price, or supply shock) from the impact it has on the general price setting of households and firms (our inflation).

This is easier for us to think about if we assumed the “inflation target” was zero – in that case, as decision makers we know that a rise or drop in prices represents a lift or decline in scarcity relative to other goods and services.  Furthermore, a increase in wages represents productivity – or may represent a change in bargaining power.

However, with an inflation target, which is followed by decision makers, we can say the same thing by just taking off the inflation target from price growth.  This is one of the conceptual reasons why an inflation target is an attractive thing – we are helping to make price signals in the economy a clearer representation of underlying scarcity.

As the gold standard period showed us, inflation/deflation in itself can be very unstable, so an inflation target through inflation expectations can be used to help “co-ordinate” decision makers.

In this sense, it is nice to see expectations formation being discussed here – but I’m not sure the study is truly capturing “inflation” following a relative price shock, and is instead also capturing other factors related to economic fundamentals.

Matt Nolan

Independence and credibility: The crisis and central banks

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There is this view going around that the financial crisis has undermined central bank independence – or made it less important.  I have no idea where this has even come from, and it doesn’t seem to follow for me.  If anything, the crisis appears to have increased the importance of credibility and independence.

What?

Well first we need to ask why we even bother with independence and credibility for central banks.  The simple answer is time inconsistency – if a central bank wasn’t independent from government it would not be able to stop it self pushing for seniorage, which would then be priced in by households and firms, which would lead to straight out worse outcomes!

Now this never, ever, meant that fiscal and monetary policy shouldn’t co-ordinate.  The two have an impact on each other, and there is constant communication between those two parts of government.  But by giving a central bank independence, it can gain credibility when it comes to setting its “time path of policy”.  A central bank that is independent won’t have an incentive to transfer resources to fiscal authorities, and so will gain credibility with the public regarding this.

During the crisis, the actions of central banks – and the fact that many of them have had to take on large amounts of government bonds, and even mortgage/business debt, has blurred the line regarding their independence.  However, I take the view of the paper I just linked to in the previous sentence – in truth as long as central banks can reverse these positions as the economy recovers they regain their credibility.  In truth, during a massive financial crisis like the one we’ve experienced you WANT your fiscal, financial, and monetary policy authorities working together.

Where the financial crisis came from

If we believe that the financial crisis stems from there being a LOLR that decided not to be a LOLR (so we had a build up of debt based on moral hazard and lax regulation, followed by a messy bank run once it was unclear whether there was a lender of last resort), then the crisis occurred because the Fed lost credibility on this front (followed by the ECB).  If anything, the crisis suggests that  the rules and policies of central banks need to be more transparent, and their operation kept more independent from the greasy hands of governments that want to use a stealth inflation tax – it doesn’t suggest that we now need to throw away independence completely.

Matt Nolan

An excellent primer on NGDP targeting

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Via Scott Sumner comes the following primer on NGDP targeting.

Its a cool little explanation of the benefits, and the functioning of monetary policy – specifically through expectations.  I also appreciated that Hayek was mentioned – Hayek was a fan of the nominal income rule, a fact many people don’t realise given belief that NGDP targeting is “left wing” and Hayek is “right wing”.  Economists are never as simple as we like them to be 😀

As I’ve said before I don’t agree with NGDP targeting for NZ at the moment.  I see NGDP targeting vs flexible inflation targeting as akin to the level vs growth targeting – and I’m still on the side of rate of change targeting.  However, it is an area where I could easily be turned around … and if NZ was to introduce NGDP targeting I wouldn’t suddenly get all wound up and talking about it being the end of the world, I would assume that we were following the policy rule because our view of what target best represents “good policy” has changed.

For those wondering, if you target a “level” then previous “policy failure” counts – in a NGDP targeting framework, changes in the terms of trade (for example) will be picked up as policy failure in a way that would elicit a response when they “shouldn’t”.  This is why I prefer inflation targeting based on a clear version of inflation like the dynamic factor model the RBNZ has.  However, even in this case we may decide that nominal income growth is a better target than price growth – that is an issue I’d like to spend more time thinking about.

A big thing for me is that we stick to a time consistent rule, instead of falling into the trap of thinking we can hide taxation through central bank actions 😉