Matt Nolan

Question for the next couple of days

/3 Comments/in /by

Does the US have a marginally functional government?

We already know they don’t have a fully functional government, or a reasonably functional government.  But we are waiting to see if the government really exists at all, and is able to muster itself together enough to avoid accidentally defaulting on debt and starting a new financial crisis.

Whether we think they need to cut spending or not it doesn’t matter – we are talking about the next week where they will exceed their debt ceiling no matter what.  So lets hope they extend it.

And even when they do, after how absolutely useless they have been can they really avoid being downgraded?  If they don’t get downgraded the credit rating agencies will be seen as to be just as hopeless as they were following the global financial crisis …

Update:  So the President, house leader, and senate leader all agree on a deal.  But it still needs to get through the senate, and the house, tomorrow.  Man, how last minute is this!

Matt Nolan

Financial stability, the crisis, and counterfactuals

/11 Comments/in , , /by

In an interesting post on macro-blog, two things are mentioned towards the end:

Specifically, the pre-2008 consensus argued that monetary policy should follow a ‘rule’ based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst.

…

The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part.

In a sense, the better performance of countries with lower debt during the credit crisis is being used as evidence of the fact that central banks should limit credit growth in the economy (that was the assertion I took from reading this section of the post).

Note:  Now, a quick point I want to make before discussing this central point – when inflation targeting is mentioned above it is a separate issue.  The role of monetary policy is to target inflation, but the concept of watching out for financial stability is a separate issue.  At the moment both are taken on by central banks, but I feel that the above description implies that there is a trade-off between “price stability” and “financial stability” – which is false.

So note that, the entire discussion on financial stability says nothing about whether inflation targeting is sensible – and I really wish people would stop pushing the issues together (this comes from the fact that inflation targeting is about managing expectations).

So, to the key point.

Read more

Matt Nolan

An illustration that using data for a conclusion is not objective

/2 Comments/in , /by

There is an interesting post over at John Taylor’s blog (ht Greg Mankiw). In it he shows that government spending as a % of GDP has a strong positive correlation with unemployment, and that investment as a % of GDP has a strong negative correlation.  His conclusion is to focus on cutting taxes to increase investment instead of spending.

Update:  Here is the point I’m trying to make written up more clearly and completely.

Now, this way of viewing the data is consistent with the model he has in his head – but it is only by stating that model that we can look at the value judgments involved to figure out what we agree with or disagree with.

Looking at the data alone, we cannot make this conclusion – we can just say there are correlations.

For example, I would note that investment responds disproportionately to the economic cycle – this is a well known “stylized fact”.  The excuse economists often use is that businesses and households cut back on durable good expenditures most heavily when we enter a downturn – as the durable products they already own act as effective substitutes for new durables.

As a result, assume that government spending is a constant (so the government is doing nothing to smooth the economic cycle).  When GDP falls, investment falls more steeply.  When GDP falls, unemployment rises.  In this case, even with no government smoothing, the existence of an economic cycle will lead to BOTH of the observed correlations above (note that GDP is a denominator) – there is no way we can reach any policy conclusion from them.

We need a model, with a counterfactual – then we can use the data, and value judgments, to reach policy conclusions.  His model says that these correlations are causal.  My model would probably say that all these correlations suffer from too much endogeniety, and I would state that appropriate monetary policy is the best way to move forward – as it would reduce the observed variability in investment, unemployment, and GDP.  Both conclusions use the same data, the underlying models are just a bit different.

He is of course world famous and ridiculously intelligent, while I’m an arbitrary blogger – but I still prefer my conclusion, that’s what value judgments are for right 😉

Matt Nolan

The Fed and policy: Temporary but not permanent

/2 Comments/in , , , /by

Via Arnold Kling at Econlog we see this paper regarding the impact on Fed policy.  It is an interesting paper in an economic history sense, I would suggest reading it.  However, the passage I want to focus on is the same one Arnold mentioned:

First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can only change real interest rates temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. Combining the two propositions implies that the Federal Reserve’s interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.

This is a great result.  It suggests that the central banks ability to change the “structure” of the economy, or make any long lasting changes to economic conditions, is negligible.  Without any “long-run costs” of Fed policy this suggests that monetary policy CAN be used to stabilise activity in the very short run – so it reforces the view that a central bank should look at “smoothing the economic cycle” by keeping underlying inflationary pressures near a certain target.

This is consistent with the orthodox way of viewing monetary policy.  However, interestingly Arnold Kling states that this paper is something he agrees with, but it “puts (him) at odds with Scott Sumner and John Taylor, among many others.” – people who are also part of the orthodoxy.

I believe that the issue here is that people are talking past each other a little – in terms of strict monetary policy, the views that Scott Sumner and (originally) John Taylor focused on were short-run, and as a result they were interested in the stabilisation role of monetary policy.  Kling appears to have ignored the idea of the short-run to focus on the relevant view of the long-run – something we can’t do in the face of price/wage stickiness.

Now I agree with Arnold that many people give the idea that central banks can create miracles FAR too much weight.  I think that central banks should not be involved with structural policy, or if they are it NEEDS to be separated from their stabilisation role for the sake of transparency – but this issue is separate from the focus on thinkers like Sumner.

 

Matt Nolan

Rough 2011 predictions

/9 Comments/in , , , , /by

I suppose I should make some falsifiable predictions for the year ahead – so I can explain at the end of the year why I was so wrong 😉

Lets go (note, these are my rough picks – they aren’t associated with anyone else, and they definitely don’t exist in a professional capacity) :

  • NZ GDP growth will near 4%pa by the end of the year.  Inventory accumulation will be a major contributor.
  • Consumption growth will be weaker than economic growth – but will accelerate during the second half of the year.
  • NZ unemployment will hold above 5% – but will be in the lower 5’s.
  • The housing market will remain weak.
  • The Reserve Bank will remain dovish on rates over the first half of the year – but then start hiking in June.
  • Farmers paying down debt on the back of high commodity prices, combined with increasing risk taking/confidence by investors, will see interest rates fall over the first half of the year.
  • National and Labour will compete over “savings plans” which will involve far too much in the way of distortions, compulsion, and poor “incentive” programs for my liking.  As a result I will post on them constantly.
  • National will win the election with effectively the same coalition government as we have now.
  • Aggregate commodity prices will peak in March, but will not decline significantly.
  • Oil prices will rise 10-15%.
  • Australian growth will fall slightly below trend.
  • The US recovery will be lower than expectations in the early stages of 2011 on the back of a slight run down in inventories – however, underlying activity will pick up sharply from the middle of the year.
  • The Fed will not lift rates or cut back on QE.
  • Israel will attack Iran to destroy any nuclear capabilities – and nothing will come from it (have put an entire dollar on this on iPredict – with an order to buy another 100 stocks)
  • Chinese growth will slow to 8%.
  • Portugal will teeter, but the essence of the debt crisis will be forgotten again over the year.
  • Japan will tighten policy too early.
  • Subsidies for solar power will become a more common policy around the world.
  • An international mission to Mars will be announced.
  • Update: India will win the Cricket World Cup.
  • Update:  France will win the Rugby World Cup after disappointing in group play.
  • Update:  Gold price will fall – say it will be lower on December 31 2011 than it was in December 31 2010 in US dollar terms
  • Update:  The NZ TWI will be volatile, but on average unchanged!
  • Update 2: Arsenal will win the PL in 2010/11
  • Update 2: LFC will be top of the PL in 2011/12 at Christmas (but will end up coming 4th)
  • Update 2: Wellington Phoenix will come in sixth in the regular season – but will make a semi final.  They will be in fourth place by the end of December 2011.
Matt Nolan

QE2: Is the Fed “mistaken” on purpose

/2 Comments/in , /by

There is an excellent article on QE2 by Robert Barro (ht Greg Mankiw), I suggest you read it.

However, there is one point – where it goes from descriptive to a little more forward looking about policy – where I might see things in a slightly different shade:

The downside of QE2 is that it intensifies the problems of an exit strategy aimed at avoiding the inflationary consequences of the Fed’s vast monetary expansion. The Fed is over-confident about its ability to manage the exit strategy; in particular, it is wrong to view increases in interest rates paid on reserves as a new and more effective instrument for accomplishing a painless exit.

I see QE2 slightly differently.  QE is partially a means of getting the Fed to commit itself to lower interest rates in the future, by introducing the “loss on bonds” in their objective function.  In essence, the Fed KNOWS that this policy will lead them to overshoot their inflation target.

Now I agree with Barro when he says that, by using different instruments the “future Fed” can reduce the relative losses – but if they have really introduced QE to commit to a lower path of short-term interest rates this is a mute point.

This is the key question for me here – are the Fed using QE as a commitment strategy, or are they just using it as a way to directly increase the money stock or directly push down longer term rates.  Personally, I don’t think the uses are independent and I think that some form of “commitment” is implicit in what they are doing.