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

Mark Carney points out the currency war myth

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In this piece on Bloomberg, Mark Carney (the govenor of the Bank of Canada, and soon to be governor of the Bank of England) points out that the criticism of the BOJ for the drop in the Yen isn’t fair:

Speaking on the same Davos panel, Bank of Canada Governor Mark Carney commended Japan’s focus on beating deflation. Carney, who will move to the Bank of England in July, said Amari had been “very clear and the Bank of Japan (8301) is clear in terms of the policy focused on a domestic inflation target.”

As long what is going on is consistent with an underlying inflation/NGDP target this is just normal monetary easing, not “beggar they neighbour intervention”.  I noticed that a lot of people keep throwing out this currency war myth, even in NZ, but as we have discussed in a number of posts listed here it is simply a myth.

Truly, if people are concerned about the “plunging Yen” they need to ask why – is it because they have left monetary conditions too tight in their own countries?  If so, that is really just their own fault.  If domestic monetary conditions aren’t too tight we actually have to ask what the issue is – and if there is an issue it will be to do with direct market failure or government policy, it will have nothing to do with rule/expectations based monetary targeting.

Sidenote for New Zealand:  If you are really worried about our “competitiveness” instead of going on about the currency – ask why New Zealanders are so willing, and able, to borrow from overseas.  It is the fundamental drivers of that phenomenon that are inherently related to any lack of competitiveness – the nominal currency is a symptom, a by-product, of the fact that New Zealand consistently invests more than it saves … and tends to not make a sufficient social rate of return on that investment.  To “solve” any perceived problem, we need to actually ask why in this context, rather than arbitrarily attacking things.

Matt Nolan

Housing wealth and consumption – an upper bound, not an estimate

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Via Economist’s View, I saw this paper by Case, Quigley, and Shiller (REPEC).  Let me start with the positives, which are many:

  1. They are excellent writers,
  2. They get to the point – and have a clear idea of how important this sort of issue is for trying to understand cyclical phenomenon,
  3. They have pulled together a large data source consistently, which is a lot of work.

So as you can tell from that, I have a lot of respect for them, their work, and what they are doing.  However, I have a giant misgiving about the way they’ve framed the result they have found.  Fundamentally they HAVE NOT estimated the causal impact of housing wealth on retail sales/consumption.  In the introduction they do not make this claim hunting down an “association” … but by the conclusion this is what they are starting to claim they have done:

The importance of housing market wealth and financial wealth in affecting consumption is an empirical matter … we do find strong evidence that variations in housing market wealth have important effects upon consumption.

These descriptions are veering on causal, which is very inappropriate in a situation where you have an obvious, and likely significant, case of omitted variable bias!

Let us think about this.  Demand for housing is similar to demand for other durable goods – when confidence is high, unemployment is low, income expectations are elevated, and financial conditions are good, demand for both will rise, pushing up prices.  As a result there are some “third variables” that will drive up demand for both.  They cover this off at the end by stating:

Underlying our analysis is an assumption that it is useful to think of causality as running from wealth components to consumption, and not that, for example, the two are determined by some third variable, such as general confidence in the economy. We believe even more strongly that these new results demonstrate that it is useful to think of consumption as determined in accordance with the models we have presented. In consulting this evidence, recall that our measure of housing wealth excludes wealth changes due to changes in the size or quality of homes, changes that are likely to be correlated with consumption changes merely because housing services are a component of consumption. We have alluded elsewhere to others’ evidence using data on individuals that the reaction of consumption to stock market increases is stronger for stockholders than for non-stockholders (Mankiw and Zeldes, 1991), and that the reaction of consumption to housing price increases is stronger for homeowners than for renters. This lends additional credibility to our structural models when compared to a model that postulates that general confidence determines both consumption and asset prices.

To think about this point let’s think about housing.  Housing is a durable consumer good.  As the price of housing goes up relative to other goods and services, then given other goods and services constitute a “normal good”, spending on other goods and services should fall!  Of course, it also constitutes a transfer of wealth from homeowners to renters – and as a result, we have to ask about these separate markets in order to figure out what is going on.

As a result, the point that homeowners and renters behave differently is VERY useful, and justifies the study.  However, it in no way supports ignoring omitted variables and just deciding that the model is causal – in fact the way they have dismissed OVB is far too casual, given that there was no effort to deal with it (FE estimators deal with unobserved heterogeneity that is constant through time – this is not the case with our OV’s).

The evidence here appears to point at the fact that changes in house prices are a good proxy for changes in access to credit – hardly surprising given that housing is an asset and a durable consumer good.  When trying to understand the tendency of movements in retail spending, and the set of risks going forward for such spending, using house prices as a proxy for a set of “real structural” variables is useful.  However, this evidence is far from suggesting a causal relationship – and even further from suggesting that there is anything policy relevant here (as we need to understand the structure of the relationship in order to understand how changing policy settings will change outcomes – a change in policy settings can change the fundamental relationship between variables, think Lucas Critique!).

When the authors began to discuss this as causal, they should have stated that this provides an “upper bound” on the impact of housing wealth on consumption – and that more detailed analysis would be required.  They could even have gone further and stated that “given the size of the link, it is more likely that there is a tendency for higher house prices to drive up consumption” – that would have been mildly contentious, but reasonable.  As it is, their comments that they are estimating the size of a causal link are misleading.

Matt Nolan

The symbol-archetype distinction when discussing economic primitives

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Note:  Edited for the raft of horrible typo’s in the post – my apologies.  Originally this wasn’t going to be a post but just turned into one.  I would use the excuse that my new keyboard doesn’t have key labels, but that wasn’t the reason for all of the typos!  Thanks to the heads up by a good samaritan.

One thing that was clear from my post about economic primitives (such as production functions) being archetypes was that my distinction between symbol and archetype in that context wasn’t clear.  I realised that even before the post went up.

At the base level, an archetype is a subset of symbols – it is a symbol that comes with some set of subjective meaning, whose meaning moves with the context and audience.  When I used the idea of symbol to start with (as opposed to archetype) this was to denote primitives which can be seen as objective.  This was a bit imprecise – as the term symbol includes both objective and subjective forms of symbology.

In my mind, the advantage of the economic method has been that we’ve left our primitives exposed for all to see.  The idea that these primitives, in a practical sense, are really archetypes economists call upon rather than objective symbols is an admission that we aren’t fully transparent.

And yet this isn’t really a criticism of the method – for people willing to put in the effort of learning about economic models they ARE very transparent.  However, economists have to communicate with a public and politicians who do not have the time or the patience to do this – and will still determine policy.

In order to make sure that the knowledge gleaned from economic science is taken in appropriately, we use the primitives of economics as archetypes to build a narrative – however, this raises the question of why people should believe our narrative rather than the other narratives they hear?  In order to do so, economists need to:

  1. Understand and frame the alternate narratives that exist,
  2. Use the archetypes that we’ve created to reframe the narrative,
  3. Convince the public why our narrative is preferable – both in terms of how our narrative captures the facts and nature of the issue, and where the other narrative has gaps (for me a key goal is to track back – and find the framework the narratives share, to expose the implicit assumptions that differ).

This is where rhetoric is important when communicating with non-economists – and where both applied and even some theoretic economics should differ from the idealised version of scientific economics.  This is not to undermine scientific economics – no it is to reinforce it by helping it to tighten its definitions and identify relevant variables and data in order to increase economic knowledge.  Science and rhetoric provide a complementary cycle.  [Note:  Yes I’ve been reading McCloskey, surprise surprise 😉 .  However, my focus is more on how we communicate with non-economists – outside of the oft overused appeal to authority]

Matt Nolan

Production function and preference relation: Archetypes of economics

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In my gradual process of trying to figure out what I am going to write when comparing Tarot Cards to Economics, it has become increasingly clear to me how the production function and preference relations of economics function (the primitives of an economic model) as “archetypes” for our discipline – and how many non-economists do not share these archetypes and as a result find it hard to translate what we are saying.

Now at first brush this seems strange – these relations are surely not archetypes, but are surely instead symbols. Why?  Well a symbol in the view I’m using here is a “given” descriptive term without any complicated cultural relations getting in its way – so a production function is a primitive as production comes from inputs being translated into outputs, preference relations merely state that people have preferences.

These symbols are then tied together to fit archetypes/models of situations.  We can then take these archetypes/models together in order to discuss or explain something in the real world. To me this is akin to the “Credible Worlds” view of economic models, or even the old school Mill view – we take these symbols/primitives and create models which capture some tendency in the real world.  We then tie together these tendencies that are captured by models in order to provide policy conclusions.

This is the way I did see the process of economic model building.

But now I’ve moved the status of production functions et al to the area of archetype.  From good old Wikipedia we have:

In Jung’s psychological framework, archetypes are innate, universal prototypes for ideas and may be used to interpret observations

The very idea of using a production function flavours the way economists interpret ideas and the way we understand phenomenon.  Often when communicating we do not observe the production function, or have any idea of all the inputs into it – in this more limited way of viewing the process, the fact that we apply an implicit view of a production function to it is akin to the production function being an archetype in our description of what is going on.  More importantly, the symbol of something like a production function becomes an archetype as it becomes accepted as a central part of the way economists communicate with each other – when we tell each other stories we ALWAYS have a production function in mind.

This matters as the fact we look at data and the world around us through the view of a production function and preference relations is probably the key difference between the way economists view phenomenon and the way non-economists interpret it.

Yes, the models that we build off of production functions et al are archetypes as well – but they of course rely on our prior assumptions about primitives (the production function).  The model can itself be boiled down to these fundamental primitives – primitives that when not used in their most general form are in fact archetypes.

As a result, when it comes to explaining, justifying, communicating, or educating and economist requires a clear head when it comes to looking at these fundamental archetypes – and needs to be able to justify why these archetypes are appropriate for describing social phenomenon.

This is just where my head is at right now – if anyone has any comments or wants to correct me on anything that would be super.