Matt Nolan

Seperating shocks on financial intermediation

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Goldman Sachs has raised an interesting issue regarding the future of financial intermediation following the crisis:

New bank regulations and capital requirements are “structural” changes to the industry that are more to blame for declining profits than the U.S. economic slump, Goldman Sachs Group Inc. (GS) analysts said.

Remember, we have had the failure of Lehman Brothers (the Global Financial Crisis), the sovereign debt issues in Europe (the European debt crisis), and in the NZ context the failure of the non-bank financial sector post-05.  These crises can be expected to have a relatively persistent impact on economic activity – but not permanent.  Once all is said and done, and financial stability is returned, economic activity should in turn recover.

However, if the “wedge” (inefficiency) in financial markets persists indefinitely this suggest that something else is the cause.  Let’s also remember that at the same time that all this was going on financial regulation by central banks around the world has also changed!  While these changes will increase the stability of the financial system – they come with a permanent cost in terms of economic efficiency … there could potentially be a persistent wedge between the return to lenders and the cost to borrowers due to these policies.

Given both happened at the same time we can’t “identify” what did what – which makes the outlook even more unclear than it usually is.  However, it is important to keep all these disparate causes in mind when trying to understand what is going on.

Matt Nolan

PTA’s, currency, and monetary policy

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Recently I was sitting at my computer looking at Twitter, when the following popped up in my feed:

NZIER calls for changes to the RBNZ’s Policy Targets Agreement to combat the overvalued NZ dollar – http://bit.ly/Q6aOWX

I found this surprising, as earlier in the day I had read a piece on the NZIER site that I felt was saying something very different to this.  It turned out it was the same article, however it was interpreted in different ways.

Let me state how I took the NZIER piece after several readings.

They stated that, due to the current PTA including several goals, the Bank had not reacted strongly enough to credit growth during the “boom” – essentially, concerns about the exchange rate had prevented them from appropriately responding to what was going on.

As a result of this, if we leave the PTA unchanged, the Bank requires other instruments in order to achieve the “multiple goals” it faces in the current PTA.  Anti-Dismal recently had a post where Don Brash made the same point.

But what about the jazz about the exchange rate at the start

Yes, the article discusses in detail how the NZ currency appears to have been persistently overvalued – and that there has been a chronic imbalance between savings and borrowing.  However, it never lays this down as the Bank’s fault – it merely says that the Bank is facing undue pressure about the exchange rate as a result of this.

As we have discussed a myriad of times, a PERSISTENT IMBALANCE is not the fault of monetary policy – it indicates that the real exchange rate is out of whack in NZ for real economy reasons.  This could be fiscal policy, this could be an issue an issue of competition, this could be an issue of “impatience” by New Zealanders.

Macroprudential regulation can be used to help against these issues in a “financial stability” sense – and the article makes the claim that they can help monetary policy BY reducing policial and social pressure regarding factors monetary policy is uninvolved with.

The article DOES NOT say that we should change the PTA to deal with the currency directly – and if that was actually NZIER’s intention I would be more than happy to have a open, and long, discussion with them regarding why this is the case.

Matt Nolan

On “currency wars”

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We keep hearing concerns about “currency wars” around the wold, with the blame being put on Quantitative Easing.  In fact our Reserve Bank even came out to complain about QE.

But to be honest, this argument is nonsensical unless you are explicitly forecasting “monetary policy failure” overseas.

Lets go back to Essays on the Great Depression by Ben Bernanke – when talking about countries depreciating by rolling off the gold standard:

Depreciation, in this context, should not necessarily be thought of as a “beggar thy neighbor” policy; because depreciations reduced constraints on the growth of world money supplies, they may have conferred benefits abroad as well as at home.

With interest rates stuck at the zero lower bound, and a sharp contraction in lending across the world, the fact that QE lead to devaluation in the US currency should not be seen as a bad thing.

QE is, in essence, aiming to lower interest rates within the US economy in order to bring forward spending and investment – to stimulate “aggregate demand”.  Why did we not get similar arguments from people whenever the US cut interest rates prior to the crisis … as it is essentially the same thing.

Instead of getting annoyed at the high currency, lets ask what it is telling us about monetary and economic conditions here – instead of assuming that the value of the dollar is “wrong”, and asking for arbitrary organisations to “do something” lets use it like any other price, and try to understand what it is telling us.

Matt Nolan

Interpretation and the model

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Following the Jackson Hole speeches there was this post over at Uneasy Money.  The money section for me is:

The reductions in long-term interest rates reflect not the success of QE, but its failure. Why was QE a failure? Because the only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates.

Now this is an interesting quotation for me.  There is one thing I think I know – and that is that market interest rates are very hard to interpret, given the number of different things they are representing!

This quote argues with the simplified standard economic model that is put out there.  In that model, when there is an output gap central banks aim to get the realise real interest rate below its “natural level”, taking from this paper we have:

Thus, the mechanism through which monetary policy influences aggregate demand can be thought of as working as follows: Given the sluggish adjustment of prices, by varying the short-term nominal interest rate, the central bank is able to influence the short-term real interest rate and, hence, the corresponding real interest rate gap. Through its current and expected future policy settings, the central bank is able to affect the corresponding path of [the short term real interest rate gap] and, in turn, influence the long-term real rate gap … and the gap in Tobin’s q.

In this setting, monetary policy works by pushing down real interest rates (which happens by boosting inflation expectations and lowering the nominal interest rate) and by boosting aggregate asset prices.

But it is also true that if monetary policy “succeeds”, long term interest rates should be representative of the “natural” rate of real growth and inflation (as well as including factors for risk and time preference) … essentially the long term real interest rate is a constant.

From what I can tell, the afformentioned quote by Uneasy money relies on two things outside the basic model:

  1. A central bank sets expectations of nominal income growth, not inflation
  2. There are multiple equilibrium in the macroeconomy, making unemployment of the current sort the result of a failure in a co-ordination game.

However, if anyone has any more insight that can tie these view together, I would appreciate hearing it in the comments.

Matt Nolan

Interpreting information, markups, and the economic cycle

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Over at Worthwhile Canadian Initiative, Nick Rowe bemoans the fact that economists keep ignoring the “very short run”, and the transition from that to the short-run.  In the very short-run, we may view a shock (an increase in demand) and interpret as noise – it is only when the shock persists that we may respond.

This reminded me of tacit collusion.  Why … well why not!  In a paper by Green and Porter, discusses collusion and competition between firms with market power in a way that I’ve always found compelling.  Essentially a firm sits around doing what it does, and then it observes a drop in demand for its product.  The question it then has to answer is, “is this due to the other firm undercutting me, or has consumer demand for my product fallen?”.  Given that the firm does not know, under some conditions it will respond as if the drop in demand was due to a cut in prices by the competing firm – leading to a break down in any “tacit collusion” that existed before.  Weak demand therefore leads to price wars!

Now this isn’t the only explanation of price wars – in fact Rotemberg and Saloner showed the opposite.  In their model, there was a greater “prize from deviating”  when demand is high, and so times of high demand see collusion break down!

What does this mean for markups over the business cycle?  Well in the Green and Porter case, where this issue of interpreting information is a key driver of behaviour, markups are procyclical – in the Rotemberg Saloner model, markups are countercyclical.  Furthermore, there are many other models that aim to explain changes in the markup over the business cycle – it isn’t all about models of tacit collusion.

At an industry level, things differ – and so in different cases, the different models are supported empirically when looking at this as an industrial economics issue.  But what about over the economy as a whole, which one holds?  Generally it seems markups have been shown to be procyclical and to be countercyclical… while a fair amount of economic modeling often assumes countercyclical markups (in response to demand shocks).  This is an interesting area, very interesting.

Matt Nolan

Europe, what …

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Things were looking so good … and then this:

Spiegel Online leads with an update to its news story on Monday, according to which the interest rate threshold is likely to be top secret. The story said that a majority of central banks have rejected the idea of transparent interest rate caps.

The what … they will cap interest rates at an unknown level.  So they have no way of anchoring expectations?  So if this is an issue of “illiquidity” rather than “insolvency”, the benefit from announcing a target and not having to actually intervene just doesn’t take place.

I’m sorry but everytime the ECB does something that makes it look like a real central bank it contradicts it with something … well weird.

The justification is that they don’t want it to be “a one-way bet” … but if they introduce a target, and its credible, and the failure is one of illiquidity, the ECB takes on NO RISK – it just leads to a price change.  The losses/gains are between private sector traders, not the ECB.

So are they worried about their credibility, or do they think the banking system is actually insolvent?  Or is this just weirdness?