The discussion about Milton Friedman going on at the moment is great fun – with a bunch of people discussing whether Friedman was Keynesian and what this even means.
It all starts with Krugman attacking Friedman’s obsession with monetary aggregates.
Robert Shiller has writtem extensively about bubbles. Via Stephen Kirchner I saw the following:
Because bubbles are essentially social-psychological phenomena, they are, by their very nature, difficult to control. Regulatory action since the financial crisis might diminish bubbles in the future. But public fear of bubbles may also enhance psychological contagion, fueling even more self-fulfilling prophecies.
One problem with the word bubble is that it creates a mental picture of an expanding soap bubble, which is destined to pop suddenly and irrevocably. But speculative bubbles are not so easily ended; indeed, they may deflate somewhat, as the story changes, and then reflate.
Trying to understand the mechanism, and the such, is indeed important for policy.
This also feeds into the discussion about keeping financial and monetary policy separate (via Scott Sumner):
If you look closely, the parallels to the Fed’s dramatic QE policies and current financial stability concerns are uncanny. In both stories, the recession was identified as the result of speculative excess. In response to the crash, both times the Federal Reserve embarked on a program of monetary easing. However, in both instances excess reserves failed to budge, and this was interpreted as a sign that banks just didn’t want to lend — the Fed was pushing on a string. Finally, as excess reserves persisted, the threat of “speculative purposes” was used to bully the Fed into tightening. The key difference between now and then is that we have a Fed that recognizes its role in supporting the real recovery. Those in 1936 were not as lucky.
Why did the Fed go on such a destructive path in the 1930’s? Rotemberg identifies the tightness of policy as a consequence of something called the “real bills doctrine”. Under the real bills doctrine, the Fed saw its role as providing credit so that there was enough, and no more, credit to invest in “productive uses”. Since the Great Depression was preceded by a speculative stock bubble, then Fed officials put a premium on making sure credit was put to “productive uses”; The real bills doctrine was the result. According to this doctrine, monetary policy should tighten in recessions when demand for credit falls so as to make sure what credit remains is put towards productive uses. Conversely, monetary policy should ease in booms because firms are looking to find credit to fund their projects. In other words, the real bills doctrine prescribed a procyclical monetary policy.
This goes to show that we need to avoid framing effects when thinking about monetary policy. Because the Great Depression was the result of an equity bubble, then the economists of the day were so concerned about bubbles that they pursued destructive monetary policy. It is just as important to not make the same mistake today. As the real bills doctrine shows, using the tools of financial economics to solve monetary problems can be very destructive.
I would note that the GD likely wasn’t caused by an equity bubble – it was believed to have been caused by an equity bubble. The fallacy of composition was alive and well in the interpretation of macroeconomics!
In an otherwise clear, insightful, and useful speech regarding the use of macroprudential tools – and why – the Reserve Bank states the following
While the Reserve Bank’s mandate is to promote financial stability, not social equity, there are clear implications here for housing affordability. As house prices and debt levels trend increasingly upwards, so too housing becomes less affordable, particularly for first home buyers. While macro-prudential policy measures might make credit less accessible for a period, they should help to make house prices more affordable in the longer term. Such measures should also reduce the risk of a sharp housing downturn and the loss of equity that would result, particularly for highly indebted home owners.
And from the summary:
“While macro-prudential policy measures might make credit less accessible for a period, they should help to make house prices more affordable in the longer term,” Mr Spencer said.
Sigh. Is it necessary to go down this road, does it have anything to do with RBNZ policy? Do people even know what they mean by “affordability”? If our concern was due to a bubble, does mentioning affordability confuse or help with understanding Bank policy? Does their comment make any sense (note, I don’t think it really does)?
Why bother defending the Bank from politicians who act like the RBNZ is responsible for everything (here, here) if the Bank is keen to make arbitrary ill-defined statments that seem to imply just that?
Is financial stability not actually about financial stability – but a catch phrase used to justify moral judgments regarding “rebalancing” and “deleveraging“. This is one of the dangers of focusing on financial stability in such an ill defined way, and one of the reasons why Scott Sumner has pointed out why care must be taken (extra comment here).
This speech was otherwise a good set of clear statments that discussed RBNZ policy. Why try to pretend it does other things? It is statements like this one about affordability that makes people believe the central bank can dance upon the head of a pin and make happinesses and manufactured products rain down from the sky.
I see that the Bank for International Settlements has released their latest annual report. I have not read it, but will place it here to peek at later.
However, if this (great) post from Ryan Avent is to be believed, it sounds like I will not like this report very much. I’d also note that this report led Lars Christensen to pop this post back up on Twitter (it reminds me of Lords of Finance – the BIS took quite a hammering in that book).
Towards the end of Ryan’s post he quotes this from the report:
Although central banks in many advanced economies may have no choice but to keep monetary policy relatively accommodative for now, they should use every opportunity to raise the pressure for deleveraging, balance sheet repair and structural adjustment by other means.
This is absolutely and totally shocking – I’m having to convince myself it is somehow out of context to prevent an accidental blog rage 😉 . I was going to write something, but then I realised Ryan said it better than I ever could:
No. They should not. Central banks—small, elite, technocratic groups given as much independence from political pressure as is institutionally possible—should absolutely not use every opportunity to raise the pressure for structural adjustment. Central bankers have been given a phenomenal amount of economic power: relatively untrammeled control over the unit of exchange and, by extension, over the demand side of the economy. Use of that phenomenal power to influence control over other aspects of the economy—including budget decisions, labour-market regulations, and the benefit structure of old-age pensions—is wildly outside the purview of the central bank and sure to prove corrosive to the independence of the central bank and the democratic process.
Part of the parcel of reasons why I’ve been defending central banks against politicians over here suggesting they should do EVERYTHING is because it is wildly inappropriate (lately here and here). Not only is it outside their mandate, but as I noted on this bubble post, it violates democracy pushing decision making towards a technocratic elite who “know best”.
The point of an independent central bank IS NOT so that technocrats can do fancy things without needing a democratic mandate … it is actually just the way democratically elected governments tie their own hands with regards to monetary policy, just monetary policy.
All these other “structural” policies in the broad economy, they should be determined by our democratically elected government.
If technocrats/economists are not able to “persuade the public” about risks, this is not a reason to use public office to “force” the public to accept this – it is instead a call to try to make your argument more compelling, and to learn to accept that sometime society may not agree! I’m not a political scientist, but a situation where unelected technocrats punish us if we don’t do what they think is right doesn’t sound like the right way forward …
And here is something I would note. By trying to force technocrats to impose these structural policy, taxes, costs, and adjustments a democratically elected government would be merely trying to hide the fault for (provide misinformation about) introducing unpopular policies – in itself, a move that seems undemocratic.
Update: Lars Christensen discusses these ideas with regard to accountability and the “number of targets“. I completely agree – this combined with the benefit to communication is why I am a fan of clear concise and separate targets for different authorities. The idea of “why” we give independence and the level of accountability are things we should be discussing – and an area which the Greens have opened up for debate. After NZAE I intend to start blogging some of the literature discussing this and trade-offs 🙂 … I see NZIER decided to kick that off in any case!
Update 2: Brennan McDonald raises his concerns about Basel. I have sympathy for this view – these actions in the name of “financial stability” do have an allocative impact, an issue that is important to try and understand.
Update 3: Economist’s View points out a bunch of posts – good posts – also frustrated at the BIS report. I am not sure whether I should read this report anymore 😉 – jks, read everything especially when it disagrees with your priors!
Update 4: James sent me an Economist article disagreeing with the RA one here. It stated:
Countries that misallocated resources to the sectors that boomed before the crisis, such as construction and finance, are being held back from the necessary adjustments by rigidities in labour and product markets. Supply-side reforms are needed to break down these barriers but loose monetary policy reduces the pressure to force through these painful changes.
I decided to pop in a response in my email to James:
I’ll link to that, but this is one of the reasons why I still favour flexible inflation targeting – if it is true that the government has munted the supply side, expected inflationary pressures will rise before we hit our prior trend, and a demand focused central bank will start lifting interest rates. It is still demand management, and the governments choice to f the supply side was theirs. Furthermore, it is the government, and societies, choice to cut potential output … not technocrats.
I see that Bernard Hickey is suggesting we have the RBNZ pop the “housing bubble”. And to do it the Bank should either ignore inflation targeting and hike rates, or do some magic with macroprudential tools!
The ideal RBNZ governor?
Assume a bubble, so lets start with one! I have a list of problems with this type of article even given that 😉 :
Read more
A quote via Scott Sumner:
But debt doesn’t make workers want to work less, it makes them want to consume less. There is a difference. We need economists to look through these framing effects, and see that the standard model that demand shocks cause high unemployment worked fine; it’s our policymakers who failed us.
There is a huge difference. Economists say GDP = C + I + G + X – M – but in macro you can’t just take these individual factors and talk about their impact on GDP, they are all massively endogenous. In other words, this decomposition can be misleading – and gets filled with “fallacy of composition” issues when people try to use it for policy!
“GDP” is produced by factors of production, it is output using labour and other factors. People are worried about high unemployment, and underutilised resources, this is exactly what Sumner is talking about when discussing active monetary policy of “demand management”.
The obsession with including “finance” into the cycle has to be viewed carefully. In so far as it improves forecasts, and thereby improves the ability to “target a path” for demand, and improves our understanding of “what could or will happen” it is very very useful. But it doesn’t actually change the fundamental relationship that monetary authorities should be focused on when setting monetary conditions!
Now this is where I get concerned with Borio’s stuff. There is a lot of very good work in there (I agree with a lot of the discussion of the financial industry – and using financial indicators to “add information” about the output gap), but he is obsessed with selling his work “output gap that is adjusted for finance” or a “finance neutral output gap”. This framing doesn’t make any sense to me – and in my reading of his papers he has never provided a full methodological reason why the output gap measure should be sold in this way. He attempts it post-hoc justifications of why finance impacts on deviations from potential bullet two of this Vox Eu article – but this is still an uncompelling base. When it comes to monetary policy the actual counterfactual we are interested in is in terms of unemployment and inflation – other factors matter (in terms of monetary policy) only INSOFAR as they influence these!
Macroprudential policy yadda yadda yadda are structural policies about “real economy” issues – monetary policy is set GIVEN these. But having monetary authorities focus on this instead of actual monetary conditions is missing the wood for the trees. Financial market information is useful to help inform us of where we are, and where we are going, BUT can we actually focus on the first order issue of the purpose of “active monetary policy” which are medium-long term inflation outcomes and short term unemployment variation (read the short-term as the outlook for 18-24 months out, I realise this term can be vague otherwise!). If the financial market information helps the central bank set policy to deliver this (which it will) use the hell out of it – but don’t then lose sight of your actual purpose and start trying to value companies and assets for the market at large. If you want to do that monetary institutions, give up your contract with government and get a job as a financial adviser 😉
When I read this sort of stuff all I see is monetary theorists saying “ahhh, NGDP growth was weaker than authorities were committed to delivering, here are some excuses”. But as soon as they give up the role they were given by government (deal with inflation and short term fluctuations in the UR) they leave themselves increasingly open to arbitrary demands and politicisation.
After ignoring prudential standards and arbitrarily trying to deal with it with monetary policy, we stumbled into the Great Depression. Pressure post Great Depression and war, in time led to the hyperinflation and stagflation through the 1970/80s, which led to a recognition that policy needed to narrow. Which led to completely ignoring macroprudential rules (which is not good either) which then led to the 2008/09 crisis. Which led to …