Matt Nolan

Careful discussing a “dollar policy”

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I see there are further calls for NZ to look at its “dollar policy”.  I do not believe that an investigation will sensibly suggest we should change much in terms of “direct” policy – and I think it is important to try and understand what is going on here before saying we shoudl control anything.

Remember, the relative value of the dollar (the exchange rate) is really just a “price” we have for swapping currency and to buy goods and services (and the such) off each other.  Like any price we need to determine “what is the market failure” before we mess around with it – the default “policy” IS to not interfere, we need a well articulated market failure that we feel we can deal with in a favourable way.

Now, the failure that gets identified here is “dutch disease” (or as I like to term it, the dutch issue).

It is UNDENIABLE that the rising terms of trade has pushed up the real exchange rate.  However, whether the change in relative prices that has occurred in the economy is a negative or positive IS NOT clear.  In fact, the default argument would really be that it is a GOOD thing.  [FYI, I would suggest reading this for a discussion around the evidence – and policy relevance – of “dutch disease”]

Manufacturers complain about the fact that they are less competitive – which is true.  However, as a country we have a comparative advantage at making something that the world values – as a result we want resources to move away from manufacturers in industries that are not part of the industry that is experiencing higher prices.  As technology, tastes, desires, preferences, populations, and the allocation of resources all change in the global economy we want to be able to respond to changes in scarcity – changes in price.  It is BAD to try and keep the structure of the economy the same and not allow adjustment – lets not forget about the Muldoon era.

Now you might think you are very clever, and you might say “aha, but what about if the price increase is temporary, and people invest too much, and then we lose our manufacturing and sell lots of worthless commodities”.  My response would be to say – people are reacting to expected changes in prices in the future, as they are investing.  There are solid reasons why commodity prices will stay “on average” higher then they have, and people in all industries are responding to that expectation – unless we think everyone is stupid, and that government knows better about the future, there is no case for intervention.

To me this implies there is no case for intervention.  Sadly for some people, this is the real case they have in their heads for intervention 🙁

Note:  This is not to say that, in the face of a massive change in the terms of trade, there is no role for monetary and fiscal policy to improve outcomes – after all, it is a clearly recognisable shock, and the cyclical and distributional consequences of it can be dealt with using policy.  However, it is to say that directly f’ing around with our exchange rate in order to “help manufacturers” is likely to be bad policy – based more on a status quo bias among people than on sensibly policy design.

Matt Nolan

Give me a real inflation measure

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A pet hate of mine is that we use CPI to discuss inflation – without recognising the pitfalls.  My solution would be to make a real inflation measure, which is something the dynamic factor model at the RBNZ is trying to do.

I discuss this reasoning in more detail in an article for Idealog here.

Matt Nolan

Expectations and commitment are monetary policy

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I know we hear a lot about what “monetary policy is” in New Zealand.  According to our media monetary policy can make our incomes the same as those in Australia, make the price of everything move in our favour, build us new houses, reduce our reliance on foreign everything, increase and decrease house prices, and make us generally happier.

Now, as readers of TVHE you have seen past this rouse, and you recognise that monetary policy is independent cyclical policy that is intended to ensure that “inflation” stays at a certain rate and that shifts in output due to “aggregate demand” are kept to a minimum.  Again, this is a simplification – but it gives us our role, something we have discussed in more detail here. [BTW, there is a good post on discussing the right practical target variable here].

When thinking about what real inflation is we get to the point that “inflation” is very much driven by expectations.  As a result, the goal of the monetary authority is to anchor inflation expectations!  This is exactly the point made here, and it is true – Chuck Norris and the central bank have a lot in common.

When we understand this, we can get an idea of what to do when we are in a liquidity trap.  Simply put, say you are going to violate the target and target a higher level – or find a way to commit to it if needs be (thereby getting those real interest rates down – something that has been forgotten recently).  There is wide agreement among economists on this from the left and the right, and yet peoples refusal to look at monetary policy in this frame is stopping society from putting in place the correct monetary policy/framework.

However, we can also get an idea of the real issues in monetary policy – do we really understand how expectations are formed?  Do we really have a way of measuring commitment by a central bank?  Do we get commitment of the target, or of the institution, when we do this?  Even so, it is off this true base of understanding that we can analyse the issue – instead of the ad hoc and patently ridiculous things that are written about monetary authorities a lot of the time.

Note:  Good post here discussing monetary policy in terms of expectations and co-ordination – good links at the end as well.

Matt Nolan

Moral hazard: The case to increase regulation

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This piece from Vox Eu provides a good run down of one of the issues of that exists when we have a central bank as a lender of last resort – moral hazard.

The prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner.

As long as we need a lender of last resort to prevent against bank runs – we also need to lean against the moral hazard implicit in any of this sort of support.

The question I have is, how do we then try to make banks price in the full social risk of their actions, when they are protected in the “worst case scenario”.  In essence this suggests there is some “externality” and so we will want to have some type of “externality tax” for these banks.

However, this is an issue we need to look into, I see the argument as follows:

  1. We require a lender of last resort function for central banks, to prevent bank runs on solvent banks facing liquidity issues.
  2. However, this function creates a moral hazard problem – because some of the downside risk is socialised
  3. Given that, how can we solve the moral hazard issue?

This is one of those cases where the initial issue (bank runs) is serious enough that it seems worth dealing with the unintended consequences directly – instead of dumping the policy of a “lender of last resort” completely 😉

Matt Nolan

Another reason why we miss Friedman

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Here.  If he was around to push the policy debate maybe we wouldn’t be in this much of a mess.

On that note, people who know nothing about economics or the allocation of resources more generally like to demonise Friedman – this is nonsensical.  The guy pushed for a negative income tax/minimum income level, he wanted us to accurately respond to the trade-off’s inherent in monetary policy, and he wanted to improve institutional structures to help protect individuals.  People like Naomi Klein who turn around and try to treat him like the bad guy of the past 60 years are living in a fantasy world.

Matt Nolan

A point on inflation for all of us to remember

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From the always excellent Money Illusion blog:

The key point is that if the Fed pays attention to inflation at all, it should be increases in the price of stuff built with American labor.  They shouldn’t care about the inflation rate that matches some mythical “cost of living,” as the Fed can’t do anything about adverse supply shocks.

In a small open economy like New Zealand we are constantly peppered by supply shocks.  In such an environment what the RBNZ “should” and “can” be doing is very different to targeting the “cost of living” – which is truly set by real economy factors.

A lot of people in NZ get confused, and think that the RBNZ sets the cost of living – this is a myth that comes from, IMO, poor explanations by economists regarding what inflation is and why we should target it.  This myth needs to be dispelled.

We have discussed this all before in the “inflation debate“, specifically with regards to what is inflation here and what are the costs here.