Matt Nolan

A different view of an inflation/price level target: No-monetization commitment

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In New Zealand a strange thing is happening.  While other countries are looking at making their inflation targets more explicit following the crisis, and many more countries are debating whether to use a level or growth target (eg the NGDP target is essentially a price level target with some flexibility – while flexible inflation targeting is very close to a NGDP growth targeting type rule), there appears to be calls here that we should throw these things away here.

We have discussed how these rules are useful a number of times in the past, especially important we always say is the ability these targets have for “anchoring expectations”.  After all, if we can anchor expectations of inflation then:

  1. We can largely avoid relative price distortions from unexpected inflation
  2. We increase certainty about the return on investment (by getting rid of purely nominal shifts for contracts without inflation adjustment)
  3. We have the ability to strongly respond in the face of a crisis – as inflation expectations are anchored, firms are monopolistically competitive, and some prices are sticky we can use monetary policy to help boost underlying demand in a demand constrained economy.
  4. As a result, fiscal policy only has to focus on the supply side of the economy and redistribution (unless we run into the zero lower bound, and the central bank isn’t allowed to print or buy assets to meet its targets).

However, for some reason this isn’t enough for people.  So lets look at the idea of expectation in a more public choice sense.

Governments don’t like us to know we are being taxed to pay for the treats we get given, some democratically elected officials are tempted to “monetize debt” in order to pay for it – its a silent tax!  To solve this, we give a central bank independence.  Ok, but the independence only exists in so far as the central bank is following a rule provided by government.  So we want contracts that help solve any possible “time-inconsistency problem”.  This is all fine and good.

So what should this contract be like?  Ultimately, the implicit tax appears whenever inflation is higher than expected – so when the central bank pumps in more juice than is consistent with the price setting behaviour of firms and households.  At first firms and households will be unsure if the extra currency is additional demand for their product/service, or for all products/services, so they will lift output/work … but once they see costs rise and once they see inflation itself is higher, they will respond by lifting inflation expectations.

This tells us that any extra output from breaking an inflation target, is only temporary, but the increase in inflation expectations will be permanent.  Again, this is one of our typical justifications … where does monetization come in?

Well the higher inflation also appears when we think about government bonds.  In money markets people ask for a nominal rate of return, based on expectations of inflation.  By increasing inflation past this level, we lower the real debt burden faced by government – they get a windfall, and the people paying for it are the people who lean’t to them.  However, this windfall is only temporary and ends up with higher nominal interest rates and higher inflation expectations (and realized inflation).

Government could commit to not doing this in two ways:  1)  Only sell inflation adjusted bonds,  2)  Have a central bank with an inflation target.

Here a credible inflation target also amounts to a commitment by government to not tax its citizens by stealth.

Inflation/price level/NGDP targeting (where we are targeting forecasts of the future) offers a clear and consistent way of dealing with the fact that we have a monopoly supplier of currency in a public choice sense, and it allows central bankers to manage the “demand side” of the economy IF we have appropriate information and an understanding of what is going on.  Getting a central bank to target “other things” outside of how they impact upon the forecast of inflation/price level/NGDP doesn’t make any sense.  [Note:  People weirdly seem to think that the Bank completely ignores them – this is completely wrong.  They focus on them as issues with regard to monetary policy, and all that information is captured in their inflation forecast]

If we think the “exchange rate is too high” ask why.  We might say the current account deficit has been high for a long time, but then why.  Well its high because the real exchange rate is high, and real interest rates are high – this tells us that domestic savings are too low … this has nothing to do with the inflation target of a central bank (as they do not control the long-term real interest or exchange rates) and everything to do with competition and fiscal policy in the domestic economy.  It is part of the “cost” of the policies that we have put in place as a society – so we should accept that there is a trade-off there, instead of destroying the RBNZ’s ability to do its job – as we have mentioned before.  Scott Sumner discusses this issue more here – and I think it is a fundamental confusion between the two that is creating so much noise in NZ at present.

 

Matt Nolan

Prisoner’s dilemma game justification for state housing

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I’ve been thinking about potential justifications for building a stock of state housing when we have no issues of credit constraints.

Say we have a bunch of people walking around wanting to buy two goods – housing services and non-housing goods and services.  People will, on average, allocate their spending such that the marginal benefit of an extra unit of housing services is equal to the marginal benefit of non-housing services.  This will lead to the appropriate level of housing services being provided, and it is all gravy.

But then say that the benefit of a housing service is actually a function of the quality of the housing service other people are receiving.  So if your neighbour/co-worker builds a big sexy house, you feel you need a bigger house to keep up.  The “marginal benefit” from housing services is higher, so you swap some non-housing goods and services for housing services (building a bigger house) – however, the marginal benefit is only higher because the other persons bigger house imposed a cost on you (making you feel inferior, or reduced the quality of the signal your house was providing regarding how well off you are).  As a result, house sizes are an arms race.

This view of consumption stems from back with people like Veblen, has been written about widely (and are used in modern macro-models), and in recent times has been reiterated by Rogoff and Shiller when discussing issues such as the “housing bubble” in the US.  A common term for this is of course “keeping up with the Joneses”.  An economics term for these sorts of goods is positional goods.

In so far as we see growing house size, and increasing borrowing to fund it, as a type of arms race based on this “positional good” logic we could well end up in a situation where we have “too few” houses that are “too big”.  We cannot rule out that this is in fact a contributor to high house prices and the limited stock of housing in Auckland, in addition to the zoning laws and high cost of subdividing.

Now when looking at this in terms of policy we can say this is really a standard prisoner’s dilemma.  Private value is only being created due to the larger housing being “relative better than” the current  – not because the house itself is bigger.  In that case, each individual sees building a bigger house as a dominant strategy – as if the other people don’t, they feel superior, if the other people involved do they don’t feel inferior.  As a result, everyone builds big houses, even though everyone would be better off with smaller houses and higher non-housing consumption (note this additional point).

Here, state houses may be a mechanism for trying to deal with that – by building a series of similar, smaller, houses at a lower cost.

This is the kicker though – to some people this argument sounds compelling.  To others it sounds horrible, as they genuinely get direct value from a larger house, and the fact that different houses on the street look different.  To buy the PD argument we have to make the case that:

  1. Much of the increase in house size and the variation between houses is due solely to “trying to out do other people”, and not due to actually valuing the additional housing services.
  2. That there are significant enough transaction costs within a community that prevent household near each other “negotiating” about this externality.
  3. That the “externality” itself is large enough to warrant attention.

And even with all that it is not necessarily policy relevant – as if people simply decide to overconsume housing, and lower their own welfare significantly, then we should really be asking why there isn’t more inter-community co-operation rather than arbitrarily throwing money at them.

A more compelling version of this argument would rely on the ideas Robert Frank – where the bidding up of house prices and size is occuring among those who are well off, and is having a negative impact on those with low incomes by also increasing the cost of their housing services!  This is the very issue that everyone is concerned about.  And yet, the data suggests that spending on housing service among the lowest declines relative to income has been declining and relative to incomes those in the lowest declines are spending about the same proportion of their consumer spending on housing …

There are no doubt some things going on in the housing market – but I’m not sure we can use the idea of positional goods to justify building a series of homogenous state houses in of itself.

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.

jamesz

Should student loans be bigger?

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I share Holly Walker’s concern about the plight of post-graduate students. She is disturbed by a new survey showing that

[post-graduate students] committed to finishing their study highlight[ed] concerns about being able to provide basic needs for themselves without access to the [recently cut student] allowance, such as food and shelter.

As Matt has discussed previously, it is hugely unfair that students do not enjoy the same safety net as the rest of society when they struggle to find employment during their studies. If they are making a genuine effort to find part-time work during their studies, they should have access to a benefit or allowance, just as anyone else does.

The more important question is whether they should be supported through their studies even if they choose not to engage in part-time work. In that case I don’t see a convincing rationale for providing free support to students. They are voluntarily investing in their human capital in anticipation of better opportunities for themselves in future. As we have discussed previously

[t]hree years after completing their degree, a bachelor’s graduate will earn 51% more than someone with only secondary qualifications. Someone with a master’s degree will earn 74% more and a doctoral graduate 120% more.

It makes sense that a person would invest in education to take advantage of those wage increases, along with all the other benefits of a tertiary education. However, it is hard to justify forcing the rest of the population to pay for their personal investment that they benefit from so greatly. Nursing school scholarships may be a good alternative for those wishing to save a bit.

Nonetheless, some people find it hard to raise the money to attend university, despite the likelihood of higher future earnings. That is why we have an student loan checker tool. If students are finding it difficult to pay their way during post-graduate study then it probably means that they are unable to borrow enough during their studies. That is because student borrowing is extremely expensive for the government, so the government limits its liability and costs by capping the level of borrowing. A simple solution would be to re-introduce interest on student loans, since the interest comprises the majority of the government’s cost of lending. That would allow the government to lend out more money to students at a lower cost.

Through that change we could allow students to live more comfortably during their studies, and ensure that the transfers to those, relatively wealthy, individuals do not become inequitably large.

Matt Nolan

Scarcity easing in manufacturing?

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For all the talk both within New Zealand and abroad not enough time is given to the hypothesis that it is in fact improvements in technology that are “hollowing out” the manufacturing sector … and that what we really need to help the unemployed is availability to skills training, rather than trying to prop up inefficient domestic jobs in current manufacturing industries.

And yet, there is an increasing amount of evidence that this is the case (via Matt Yglesias).

Increasing output with fewer inputs is a good thing – but when labour is one of the inputs involved we know there may be losers.  If this is really what is happening, then as a nation I would suggest that we try to integrate education and benefit policy more fully, stop demonising those who are out of work arbitrarily, and also stop talking about intervening to “create jobs” in industries that are likely to be long term losers … give people opportunities in this ever changing, and technologically improving, world.

This is, after all, the same sort of thing that happened with the primary industries – with less and less labour needed to dig up coal and produce food.  Work is a cost, it is the income people get from working with a capital owner that is missed when something like this happens.  And it is this fact that we need to keep in mind.

And yet in New Zealand we have one political party talking about subsidising manufacturing and the other political party talking about how lazy the unemployed are.   It makes me a sad panda.

jamesz

Annals of improbable statistics: public choice edition

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A bit late, but this case study is too good to pass up! The local Wellington newspaper reported that:

Wellington City Council’s strategy and policy committee this morning agreed to a joint plan by Positively Wellington Tourism, Grow Wellington and the council to implement the council’s new ”Destination Wellington” programme. … The proposal agreed to today will see the city’s tourism agency work to tell the ”Wellington story” [which] should return $50 for each $1 of council investment

If someone called you up offering a 5000% return on investment you might be a bit suspicious. Indeed, some councillors were:

Helene Ritchie arguing that… ”This is a significant amount of ratepayers’ money … We don’t know what we are going to achieve and how we are going to measure it, and we need to do that first.”

Unfortunately, she didn’t prevail:

…other councillors argued that… would just be putting up more red tape when they should be getting on with it.

Now, I don’t know the details of Grow Wellington’s plans, and they may well be excellent. For all I know, their only fault may be incredibly poor economic impact analysis. However, the council’s rationale for approving funding appears to be summed up by the final quote in the article:

You have to have a plan and that’s what people want to see – they want to see that we’re doing something.

This is why public choice theory exists!