Matt Nolan

Profits as evidence of bank competition or collusion?

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In New Zealand there are often complaints that bank profits are exorbitant – especially given that profitability rose during a massive financial crisis.  While there is an argument that banks are backed by a lender of last resort, and that they should pay for this (such as through a tax) this doesn’t tell us too much about profitability … remember a tax on bank transactions, or margins, will in part be passed on to borrowers and lenders through an increase in gross margins!  Furthermore, the increase in profitability can be seen as banks taking into account the fact that lending was now more risky (after all, the LOLR only functions when the bank collapses – making a bad loan and losing some money is still a cost that is fully faced by trading banks!).

Still, I’m not actually going to discuss any of this.  I’m hear to say that the increase in banks margins during the crisis and the corresponding drop as financial conditions have improved can be analysed in the same we economists analyse any sector.  And it may well point to a special type of “tacit collusion” in the banking sector.

We have talked about tacit collusion on the blog before, it is a fascinating issue – note that it is’t explicit collusion, it is just an illustrate of how the individual choices of banks regarding their strategy is setting price may in some situation mimic collusive outcomes.  The key example I’ve provided was the price of Nurofen but there are many examples.  If we have the type of competition modeled by Rotemberg and Saloner, then firms will tacit collude during periods of “low demand” and this collusion will break down during periods of high demand – when the size of the “pie up for grabs” is larger.  Given that banks compete on price, have a very clear idea of when a shift in demand is for their firm or for the market as a whole, and don’t face significant capacity constraints, this type of argument is actually pretty relevant!

So what does this tell us about bank lending behaviour?  Well in a situation where we do have multiple banks, lending behaviour during booms may act as if the industry is competitive, but during slow downs it will act as if it is more of a monopoly – as a result, the quantity of credit provided will fall more sharply during a slowdown and the price of credit will be higher compared to the case when the industry is just magically always competitive.   Interesting stuff!

Matt Nolan

Discussion on policy in NZ for the week

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This is a list post – so make of it what you will.

Bill Kaye-Blake has been discussing the macroeconomy in New Zealand (*,*,*), and hunting for a way to make the narrative clearer – I’ve been chatting about it with him in commetns, and Eric Crampton listed up some points here.  Reframing the narrative is important to me, and has led me to experimenting with ways of communicating ideas about the macroeconomy.  Brian Fallow shows the importance not just of clarity, but of indicating that there is no “silver bullet” in his great op-ed.

Grant Spencer has also made a point of communicating about “other tools” that the RBNZ might use, and why they would do such a thing.  The Bank knows that outside their role as protectors of monetary policy, they have to take into account the general stability of the financial system – and they want measures that they use for this to be as transparent as possible.

On the not of communication and narrative, Norman Gemmell has started a series of articles on the NZ Herald discussing issues of the day.  He is an awesome economist, and I’m greatly looking forward to these posts.  The first post tries to lay out the idea of asset sales on more objective grounds!

This brings me to Treasury.  They have noted the mixture of calls about austerity, the economic cycle, structural problems, and decided to spark things off with a piece that looks at the impact of “fiscal policy” in a macroeconomic sense.  This is a piece I intend to go through and write about in time 🙂

All in all, a good week for discourse.  Nice.

Matt Nolan

Inflation stickiness, demand, and judging the success of monetary policy

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I am still a fan of flexible inflation targeting.  I agree with Nick Rowe that explicit inflation targeting has made inflation outcomes “stickier” – and that knowing inflation is in a range of the inflation target is therefore insufficient for telling if the central bank is truly achieving “socially optimal policy”.

For all the time I’ve spent reading monetary economics books and sitting in classes where macroeconomics has been discussed, I still remember a clear (albeit very partial) description of why we do inflation targeting that came in 100 level economics.

I distinctly remember my tutor saying that the point of inflation targeting in the form we use it in New Zealand was to pin down “inflation” (price growth that is shared between all goods and services that is independent of the “relative” value of these goods and services).  With people setting prices based on this view of inflation, central banks with a clear very of the economies “ability to produce” can move around “aggregate demand” in order to prevent recessions that are due to short-falls in demand.  The flipside was often that inflation stickiness was “asymmetric”, with excess demand translating into rising prices, while insufficient demand translated into falling output – this is our good friend the upward sloping, U-shaped, short run AS curve.

This story is massively oversimplified, especially in its treatment of expectations.  But an overarching goal of anchoring inflation expectations was always part of what central banks were aiming to do.  Given this, then in so far an central banks had an idea about economic capacity (which is a very debatable point in itself) they could help to manage “demand” in a macroeconomic sense.  When I was tutoring, this was very much how active monetary policy is taught to first years, and I doubt terribly much has changed.

And this is the point – economists have always know that, if their announcement of a 2% inflation target was the sole determinant of inflation, this does not mean “success” … it just means that they can focus solely more heavily on how the actions of monetary policy have a short-run impact on output.  Deviations of inflation from their target provide information that is useful information about the state of “demand”, but as the NGDP targeting proponents point out it does not capture the whole story.  Variables such as NGDP, and unemployment, provide significant information … something central bankers already recognise and incorporate, contrary to the “narrative” of them being closed minded (Nick isn’t saying this – I’m talking about the more general stories from the media).

This is consistent with flexible inflation targeting – and it does come with one massive hole.  Judging the “success of monetary policy”.  As of course, flexible inflation targeting can only be judged on a forecast, forecasts that are determined by the central banks themselves – and filled with unobservables such as “future economic capacity”.

NGDP targeting differs from this in only three ways:

  1. It changes a partially discretionary rule based process with a fully rule based process.
  2. It targets levels instead of growth rates – making policy “history dependent”.
  3. It gives guidance, and will make “stickier” growth in nominal income – compared to flexible inflation targeting which does this for price growth.

On that final point, at the moment inflation targeting lets a firm say “with competition and the such, I was able to increase my prices 2% this year – this is the same as inflation, and so in reality my “price” is the same”.  With NGDP targeting the firm will say “I increased revenues by 5% this year – this is the same as the growth in nominal spending/value add, as a result my real “revenue” is performing as well as the average firm”.  The right “guidance” will depend strongly on what we think is the most important factor for firms and households to have certainty about (to extract appropriate “market signals”).

To put all this another way – inflation stickiness isn’t an unintended consequence, it is a feature of central banks trying to improve the “sacrifice ratio” associated with active monetary policy!

Matt Nolan

Menzie Chen on currency wars

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You know I don’t believe that the “currency war” is a negative thing in a world of insufficient demand (*,*,*,*,*).  But Menzie Chen from Econbrowser has the same view – and to be absolutely honest their view is significantly more reputable than mine 😉 .  Furthermore, it was a point that Chen made all the way back in 2010!

The post I have linked to is excellent, I would suggest reading it the whole way through.

The global economy is not a zero sum game.  The fact that we have significant “output gaps” (unused labour and capital) is the justification for trying to get private agents to “bring forward” consumption and investment now – which is what monetary easing in all its forms does.

In New Zealand, the hard question seems to be “how close are we to filling our output gap” – as if we are close (a popular, even mainstream, view in NZ, that I am not sold on) the current high dollar is indeed indicative of NZ inoculating itself from this global monetary easing.  This is a separate issue again from the “persistently high real exchange rate” that New Zealander’s are concerned about – this is an issue largely unrelated to monetary policy, where as a society we have to start being more honest about the trade-offs from different policy settings we have put in place.

Matt Nolan

A hypothetical chat – exchange rate overvaluation

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With people in NZ constantly yelling about the dollar, and yelling at the Reserve Bank, I thought I would host a hypothetical discussion that hopefully helps to explain the issues – and why inflation targeting isn’t the cause of any of the perceived problems.  Here it goes:

Intelligent non-economist (INE):  The dollar is too high, and its destroying New Zealand’s economy.

Nolan (N):  Rightio, why.

INE:  When the dollar is too high, productive industries don’t have an incentive to produce or be here, so it hollows out the country.

N:  The dollar is a relative price.  If the price is too high, we need to ask why it is too high – and we need to take into account what other countries are doing.

INE:  Exactly.  Other countries are devaluing their currency and we are not because we are obsessed with inflation targeting.

N:  Not really.  Other countries are setting monentary policy to reach their inflation mandate, and so are we.  With a whole bunch of countries all targeting inflation outcomes of “2%”, and setting monetary conditions appropriately, this isn’t the cause of any big disjoint in the dollar from its “fundamental value” (unless you believe the RBNZ is setting policy too tight, or other economies are setting it too loosely, for their mandate – which would imply low inflation here, or high inflation overseas).

INE:  But you are missing the point.  It is obvious that the RBNZ is setting an interest rate that is too high for the economy, just to meet its inflation mandate!

N:  This is where I think you are a bit confused on what the RBNZ is doing.  By meeting its inflation mandate, it is partially setting the opportunity cost for bank lending (the OCR), which helps to guide the interest rate towards its fundamental level.  However, the fundamental interest rate isn’t set by the Reserve Bank, it depends on savings and investment in the economy, the expected rate of return, the time preference of individuals, the stance of fiscal policy, and the structure of the tax system (and its impact on rates of return).  If non-inflation accelerating real interest rates in NZ are higher it has nothing to do with the Reserve Bank – and it has everything to do with these issues, which are influenced by government policy, industrial policy, competition policy, and the efficiency of financial markets.

INE:  But, the Reserve Bank sets interest rates and the exchange rate!

N:  Not really.  They are “managing our fiat currency” in such a way that the real value of a dollar erodes at a constant and predictable rate – this increases certainty for households and businesses, and helps them interpret what changes in market prices mean.  They also try to limit the variability output in the general economy in the short term, by taking advantage of aspects such as “money illusion” through the way they change the OCR (although, things get a bit more complicated as we add in expectations and time consistency – these things can be left to the side for now 🙂 ).  However, none of this has to do with any long-term, persistent, shifts in the New Zealand economy.  In so far as we are concerned about the exchange rate being “too high” for a long period of time, and the current account deficit being “persistently large”, this is the result of the fundamental savings-investment issues in the New Zealand economy.

INE:  But if the RBNZ cut the OCR, and interest rates fell, and the dollar fell, we’d be “more competitive”.

N:  Then prices, including costs, would rise.  Within a few years, our exporters would be just as uncompetitive at the new “lower” exchange rate – implying that these persistent imbalances would simply return.

INE:  But exporters are complaining about the exchange rate.

N:  Exporters are complaining about the low rate of return – the exchange rate is a symptom of this not the cause.

INE:  So you are saying that these issues have nothing to do with inflation targeting, and even the impact of the exchange rate itself tends to be overstated.

N:  Yes.

INE:  I don’t believe you.

N:  That’s a pity.

Matt Nolan

Limited knowledge provides the limits to government

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There was an interesting article by Mai Chen in the Herald on Wednesday.  There is a lot of lawyer rhetoric in there.  The only reason I really noticed is that I was reading McCloskey’s “the Rhetoric of Economics” and just yesterday went through the chapter on Coase when the rhetoric of lawyers was discussed.   This explains this:

At a high level, it requires New Zealanders to agree on a vision for our society – the kinds of things which make New Zealand a place we want to live and raise our children. But the hard edge also requires that we measure our progress towards achieving that vision, and hold Governments to account on their performance against such measures.

Sounds good doesn’t it.  Pity it involves no conception of whether the vision is attainable or the underlying trade-offs involved.  The lack of discussion of trade-offs, or comparisons of counterfactuals, is a perplexing feature of this sort of writing for an economist – and makes the statement mentioned above absolutely useless for policy analysis.

This sounds harsh – a lot harsher than I mean it to be, and as a result I want to point out the positives here.  The sort of aimless push for a “vision” is poppycock at a surface level – but it contains a strong grain of truth that we should recognise.  Ultimately, the decision about what trade-offs society is willing to make should be made by society!

Measurement and quantification are areas this article is supporting – and I agree 100% with Mai Chen here.  By measuring things, and understanding them, we can:

  1. try to understand the trade-offs
  2. explain the trade-offs to the public is a (hopefully) transparent way
  3. express whether the actions of the institution that is government are representative of the will of the people.

Quantification is an important tool for this, and to be fair to Mai Chen you could interpret the term “vision” as a way of communicating these trade-offs in a way the public can understand.  Rather than being poppycock as I have described it, such description way in fact be the way forward!

But the key point here is not to let ourselves get obsessed with targeting measures so directly (although the any benefits should be quantified and tested), and guiding the economy.  We should base policy on the trade-offs that exist and what society desires.

However, our knowledge of these trade-offs is imperfect and as a result the actions of government should be cautious.  As Noah Smith said “caution about policy is very similar to doctors’ maxim of “first, do no harm.” As a doctor, you wouldn’t say “I can’t figure out how this organ is helping the body function, so let’s just take it out.””.  Remember, government is an institution that is intervening in the volutary trade of individuals and groups due to issues of equity or co-ordination – in the same way we don’t want a doctor arbitrarily fiddling with our body because he has “a vision” we wouldn’t want a government arbitrarily messing around with our ability to trade due to their “vision”.