Matt Nolan

Ex-ante concerns about moral hazard

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Fascinating post by Stephen Williams, who is a great monetary economist.  In it, he goes through speeches at the Federal Reserve from September 2007 – a few months into the burgeoning credit crisis.  In it he shows that there was a debate between the views of “inherent instability” and “induced fragility” for what was going on – this sort of trade-off was captured in the Sargent paper (at least in part) that we’ve mentioned before.

Now when I’ve described the crisis to people I’ve stuck to the inherent instability line, the trilogy of articles (*,*,*) I did on Rates Blog was supposed to give that impression to people – with the third article pointing out that moral hazard exists as a more long-term point.  According to this, the Fed and then the ECB didn’t do enough to stop a bank run due to “too much” weight on moral hazard – and this drove a deep crisis.

However, the induced fragility hypothesis is also compelling (note they could both have happened – but where you put the weight determines what policy lessons you learn).  According to this, it wasn’t until the policy actions of late 2007 and then the bail out of Bear Sterns then the moral hazard became compelling.  However, once financial institutions saw they would be bailed out, they immediately took on lots of risk – making the system a lot more fragile when the Fed finally decided not to bail out Lehman Brothers.

There is evidence for this, Lehman Brothers took on a lot of debt – highly risky debt – following the collapse of Bear Sterns.  I remember reading the paper that had this, a paper that actually said it was the bailout of Bear Sterns that made the crisis worse, but I have forgotten where it is … I’ll link when I find it.

If the spectre of moral hazard fed into the fragility of the finanical system that quickly, the justification for bailouts becomes a lot weaker – if we accept significant inherent instability in the financial sector, then regulation with a lender of last resort becomes more acceptable.  Evidence helping to determine what weights to put on these explanations will be very useful for designing regulation (or the lack of) in the post-GFC world.

Induced fragility as a medium term concept is a central part of how most economists see this crisis.  However, it is an open question about whether the bailout of Bear Sterns (and the earlier TAF) created “induced fragility” that made the collapse much worse.  More research on this issue will be pretty interesting, and will help to inform what sort of trade-off we are facing with policy.

Matt Nolan

Remember the dollar is a price – work from there

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Via James I see that the Financial Times has given a strange write-up of the RBNZ speech from yesterday (my view here).

The focus of the FT article is solely on the dollar, which in itself is cool as most of the speech was indeed on the dollar.  But they interpreted the comments a bit differently than I did.

First the exchange rate overvaluation relative to the terms of trade and productivity – yes, this has been the Bank’s view for a long long long time.  Of course this begs the question why, which I think is covered relatively briefly … and this is likely why we end up with differing interpretations.

So they go through ways that policy actions of a central bank may influence the exchange rate.  For some reason the FT means that they are planning to use a bunch of exciting tools to reach some sort of right value.  But lets start with this quote from the RBNZ:

Expectations of what central banks can deliver by way of exchange rates and output and unemployment remain excessively high. This is particularly the case in small open economies.

They are spending the speech discussing the tools they have at their disposal, how little they wil able to achieve with them, and how impractical many of the tools would be.  Again, if we actually though about what a real exchange rate is, and the fact that the RBNZ is talking about it being PERSISTENTLY overvalued in their speech, what matters is the fact that the high real exchange rate is a signal of underlying things in the real economy.  It tis a price, and like all prices it is telling us about fundamentals in the market – which are the actual things we are interested in!

This becomes pretty clear if we reiterate the part of the conclusion that the FT didn’t bold:

But further efforts to improve the level and productivity of capital that labour works with, to reinforce ongoing fiscal adjustment, to re-examine the factors that diminish and distort the incentives to save and invest, and to reduce dependence on the savings of others, have to be a major part of the solution.

FT seems to think the RBNZ is saying:

There are no simple solutions, Wheeler said, but it seems the favoured approach is some combination of lowering cash rates and offsetting the domestic effects via some sort of macroprudential policy

Reading earlier in the RBNZ’s speech they are saying that the OCR doesn’t have a clear impact on the dollar, and they adjust that to meet their inflation target (so not to target the exchange rate independently of it’s impact on inflation), and with regards to macroprudential policy they say:

The New Zealand economy currently faces an overvalued exchange rate and overheating house prices in parts of the country, especially Auckland. The Reserve Bank will be consulting with the financial sector next month on macro-prudential instruments. These instruments are designed to make the financial system more resilient and to reduce systemic risk by constraining excesses in the financial cycle. They can help to reduce volatile credit cycles and asset bubbles, including overheating housing markets, and support the stance of monetary policy, which could be helpful in alleviating pressure on the exchange rate at the margin.

So they are saying they will use macroprudential tools for financial stability reasons – and on the margin this might lower the real exchange rate as well.

They are so far from saying that they will use the OCR and macroprudential tools to “target the dollar” that it hurts me to see this inference turn up.

Also it is interesting to see the FT feel that macroprudential tools in NZ are very unclear:

What does he mean by using macroprudential instruments? Capital controls? Raising reserve rates to offset the effect of cutting interest rates? Those are a couple of ideas we’ve heard floated around but no-one seems very confident of how to interpret that.

When Grant Spencer from the RBNZ has actually come out and stated what they are and what their purpose is – maximum LVR’s and risk-weighting adjustments in capital adequacy ratios to deal with issues of systemic risk.  Anyone who has spent anytime looking at the RBNZ would know exactly how to interpret that 😉

Tbf, the RBNZ does explicitly mention the dollar not being a “one-way bet” – and this may be because they are concerned there could be a “bubble” in the value of the NZ dollar.  This comes in here:

The Reserve Bank is prepared to intervene to influence the Kiwi. But given the strength of recent capital flows, we can only attempt to smooth the peaks of the USD/NZD exchange rate; we cannot determine the level. When the NZ dollar is coming under upward pressure, we want investors to know that the Kiwi is not a one way bet.

This jawboning is cool, but I fear the FT is reading too much into these comments.  The speech was as much about educating us New Zealanders about the limited ability of the Reserve Bank to influence economic variables as it was about talking traders out of a perceived “asset price bubble in the NZD”.

Matt Nolan

RBNZ gives its frame for the debate on manufacturing and the exchange rate!

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Excellent.  The RBNZ has come out and discussed what is going on with manufacturing, what monetary policy can achieve, and the fundamental point that any “failure” stems from distortions in the domestic economy – not from flexible inflation targeting.

Globalisation, outsourcing, and international supply chains, along with competition from low cost producers and rising global demand for services, mean that the relative importance of manufacturing has been declining in all but the poorest countries for the past 40 years. New Zealand is no exception. Although the exchange rate is an important headwind for some manufacturers, the overall relative decline in our manufacturing sector is much more than a simple exchange rate story. Looking ahead, total manufacturing output is expected to increase significantly as a result of the NZD$30 billion Canterbury reconstruction.

There are no simple solutions available to the Reserve Bank on the exchange rate challenges we face. The causes of the over-valuation partly lie in the spillover effects of policies in countries most severely hit by the global financial crisis. The Bank will intervene when circumstances are right. We will use the OCR as circumstances require and we’re exploring the scope to use macro-prudential instruments that address increasing challenges to financial stability associated with ongoing increases in house prices, and that can also support monetary policy. But further efforts to improve the level and productivity of capital that labour works with, to reinforce ongoing fiscal adjustment, to re-examine the factors that diminish and distort the incentives to save and invest, and to reduce dependence on the savings of others, have to be a major part of the solution.

Unsurprisingly I agree with this heavily, and I’m really glad to hear these guys come out saying these things 🙂

I’ve been wanting the RBNZ to reframe the debate on monetary policy for some time.  And I’m also in agreement with the fact that manufacturing is shrinking (in a way akin to the agricultural revolution) and that this is likely to continue!

The Bank has written on, and heavily researched, all these things in the past – research that has helped me build a view that is no doubt similar to its view.  It is nice to see them come out and say it all directly … it also means that I feel more comfortable that I haven’t misinterpreted them in the past 😉

The one note of difference is that I am uncertain whether I believe in the slight tacit suggestion of a currency war here, something I’m not sure I agree with.  However, they may well be using a very specific view that there is currently a “bubble” in the NZ dollar.  If there has ever been a “bubble in the New Zealand currency” I suspect that the best case can be made around now – and they will have a much better handle on that than I ever will.

Matt Nolan

Neat example of the J-curve

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Japan is offering a neat example of the J-curve (short term violation of the Marshal-Lerner condition), showing that the trade balance may deteroriate following a sudden depreciation in the currency – due largely to the fact the volume of exports and imports takes time to respond to price signals (they are sufficiently price inelastic in the short term).

Japan’s trade deficit swelled to a record 1.63 trillion yen ($17.4 billion) on energy imports and a weaker yen, highlighting one cost of Prime Minister Shinzo Abe’s policies that are driving down the currency.

The increase in fuel imports due to the movement away from nuclear energy following the Tsunami – and the drop in Chinese exports due to the Senkaku Island dispute, and implicit embargo – are factors that have helped to drive a deficit overall.  But these recent movements, following a sharp depreciation in the currency after changes in expected monetary policy (the new expectation Japan may actually allow inflation above 0%), provide a new example of the J-curve in action.  A nice teachable moment for people that way inclined!

Matt Nolan

RIP Armen Alchian

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It was very sad to hear the Armen Alchian passed away today.

His views on the theory of the firm had a big impact on the profession, and on me as an individual.  I remember finding Production, Information Costs, and Economic Organization (pdf, summary) extremely useful as a student – it was probably the first paper to make me explicitly recognise not only that the firm was as a series of inter-related contracts, but that this process could be captured in a production function using typical marginalist analysis.  His work and clear writing has helped me and countless others to understand “what” a firm is and “why” it exists, which is a pretty awesome contribution to the world in my opinion!

Other regards:  Alex Tabarrok.  David Henderson.  Paul Walker.

Matt Nolan

On MMT: An ideology wrapped in a strawman

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Note:  PP on twitter asked for a post on MMT, and asked me to try to avoid making it technical.  I attempted to do that at much as I could – however, I was forced to use words like endogenous, as it was the cleanest way of trying to get across the point that by using supply and demand savings and investment are jointly determined … and the interest rate is set as the price.  The very idea that economists only think the causal chain goes only one way or the other is patently ridiculous – and does not represent economists, no matter how much people keep saying it does.  So try to keep that point in the back of your head until at least the end of the post if you read it 😉

I have nothing inherently against modern monetary theory, its proponents, or the value judgments involved.  But my impression is that MMT theorist view central bank independence and the framing of government policy as an ideological device to “shrink government” and so have decided to create a “strawman” mainstream economics to attack, rather than directly admitting they want a larger state (and the trade-offs involved in that).  For me this simply lacks transparency!

So how does MMT differ from mainstream economics.  Well in the words of Bill Mitchell (who I choose because he is clear, both here and on his blog – which is a good thing!) it comes from economists accepting three false premises:

  1. A government has to borrow to spend
  2. There is a fixed supply of savings at a point in time
  3. Governments crowd out investment for that fixed supply of savings, pushing up interest rates

Supposedly all three of these are in the core of economics, and they are all wrong.  Huzzah.

Ok, so if that is MMT then I’m not sure who in the world they are actually arguing with.  The government can print money, and this is in any graduate macro book, so that doesn’t hold as a premise.  Savings and investment are determined by supply and demand, they aren’t a “fixed thing”, so that isn’t a premise in mainstream economics (Sidenote:  Why do people keep saying “savings determines investment” or “investment determines savings” – I’ve never heard economists talk like this … remember the money multiplier is a ceteris paribus example, not a description of the causal device).   Crowding out is actually a premise – but it comes from government demand pushing up demand for underlying goods and services … because government demand for things is just like the demand of any institution.

Let me restate these premises in terms of what the mainstream actually has:

  1. A government can finance spending through taxation, selling bonds, or issuing money.  In the end, prices and expectations adjust such that someone pays for government consumption and investment.  More specifically the government has to match spending to taxes over time for a certain inflation target!
  2. Savings and investment are determined endogenously by demand and supply factors in the economy, where the “price” is the REAL interest rate (perhaps I should use the world natural/fundamental here) – as savings and investment are factors that are involved with transferring consumption (the thing we really want) over time due to technology, the rate of return on investment, our time preference, etc etc
  3. Additional government demand for goods and services will push up the price of those goods and services and push up the REAL interest rate in the economy … remember the real interest rate is a price, when the government is trying to push up investment of consumption this increases the demand for these given an underlying PRODUCTION FUNCTION, crowding out private investment and consumption … the real interest rate rises as investment/consumption demand has been pushed up and the lift in relative prices has to occur in a way that makes private agents defer consumption/investment in terms of the quantity of goods and services.  No amount of hammering the S=I identity in the face of fiat currency changes this 😉

These premises actually sound pretty good to me!

I remember my dad used to say “it isn’t money that matters when we think about people, it is the actual good and services that are made and consumed”.  He didn’t take the same point out of it I did, but I think on this statement he was right – we need to actually think about goods and services, capital, and labour here.

Now there are MMT people who claim they do (back to Bill again) – that they have a production function (which seemed to be a bit missing earlier) and they have a Phillips curve (tells us how this production function and prices pressures relate through time).  This is good, these two things are necessary!

But if that is what they are doing, then their inherent model IS the mainstream model.  The three “fallacies” that they mention don’t actually exist – and that third point they list down is WRONG … there is crowding out.  Instead their argument is that the “optimal size of government” is larger than they hear other people saying … which is both an empirical and subjective question that people have already written (and should continue writing) countless books on.

Yes, people should discuss this, and discuss trade-offs.  But misinterpreting mainstream economics and pretending to offer an alternative in order to sell your view as not being “subjective” (which all policy conclusions are) is both misleading and irritating for people who view themselves as part of the mainstream.  Personally I like the idea of “changing the frame” to think about issues – but to me that is just a good way of researching, rather than a sign of a militant revolution inside economics 🙂

A much better critique of MMT (albeit more technical) can be found here.