Afternoon roundup

It's been a while since last posting. The tabs...

• Gita Gopinath on Covid's lessons for inflation and central banking


• Long-Covid and labour markets. There is still far too little data on this. 


• Expect it to get weirder


• Be careful about audit studies that use racially-loaded names to signal race. They can signal other stuff at the same time. And they aren't perfect signals on race either. 


• Matt Levine on Silicon Valley Bank


• Very strong NZ public support for incentive payments to local councils. Good.


• Ian Powell on some of the messes in health system reforms. There will not be the back-end efficiencies the government may be looking for. Ian McCrae suggests these reforms for the next policy bonfire.


• Pattrick Smellie on lame government industry transformation plans


• I expect a NZ version of this would find similar results: the decline in marriage and the rise in social problems. 


• Doesn't it make more sense to finally deal with the messy problem of setting FBT on employer-provided parking than to try to FBT-exempt every single possible substitute for driving? Should sneakers be FBT-exempt for those who walk to work?


• Electricity generators warning that proposed Resource Management reforms are going to completely screw up building new power generation. 


• Rebecca Macfie argues that a pile of contractors wind up working for less than minimum wage and so contractor law reform was needed. I have difficulty squaring the assertion about low low contractor wages with the fact of very tight labour markets where hospitality and retail are having to pay margins above the minimum wage even at entry level. Is it illegal for these workers to just go and find a different job?


• 72% of Kiwis think that farmers should be allowed to use genetically modified grasses that reduce methane and nitrate emissions.


• It really looks like the guy running NZ's newly merged polytechs hasn't got a clue about academic freedom.

Afternoon roundup

Today's closing of the tabs:

• Brian Albrecht on the economics of The Rings of Power. Numenor, not film subsidies.


• RBNZ uses spurious arguments on prudential risk posed by climate change.


• Your favourite DGSE sucks. Run thousands of simulations and it can't predict. Randomly swapping series sometimes improves fit. 


• Canada's Supreme Court says Councils can be liable if they block development. 

Afternoon roundup

The browser tabs...

• The Internet Archive will help improve access to a lot of books currently held by the National Library. Naturally, this upsets some people. 
• Mike Joy wins a battle over what "natural levels" of nitrate in aquifers might mean.
• Places where the local schools are funded by higher levels of government wind up trying to privatize the public schools through zoning. Everything's tradeoffs though, eh? If schools are funded by the local communities, poor places get really bad schools. It's instead a good argument against even greater anti-NIMBY vigilance.
• Potential nudges to improve compliance with scanning-in for Covid tracing. I'd add one more: put the QR codes in lots of places. Make it easy. At the entrance is great, but if your phone isn't ready and you'd be holding up a queue, maybe you won't scan and you'll forget to on the way out. Put them everywhere. 
• The EMA makes a very bad argument about unemployment rates. The point of inflation targeting and increasing rates when you're hitting capacity constraints isn't to create some stupid Marxist reserve army of unemployed, which seems to be what they're arguing for. The point instead is that if a monetary push gets you past NAIRU, you just wind up back at higher unemployment rates anyway once contracts adjust AND you have higher inflation to go with it. Anyway, because either EMA put it badly or it was reported badly, a billion tweets followed claiming the Marxists were right all along. 
• Heather du Plessis-Allan cites me here on Treasury's diminished capabilities. Worth noting: all of that was prior to the current Secretary's appointment. She may well have improved things since; I need to get OIAs in to check. 
• Shipping is a mess.
• Remember back at the Budget Economic and Fiscal Update when Treasury put in a footnote saying they couldn't produce a structural deficit figure this time round because they couldn't tell how to place some of the Covid-spend? And it seemed odd because Covid-spend is supposed to be emergency = one-off = not-structural? Well, looks like the free school lunch programme is Covid spend. I simply do not understand how this works. Shouldn't the Auditor General be going after this kind of thing as misappropriation? 
• The government isn't bothering to check on whether people got their Covid tests before travelling. Some of them get caught ex-post, with the option to go into quarantine or return to Oz, after they've been circulating in New Zealand already. If they went back to Oz and turned up positive, what hope would we have on contact tracing them? However low your expectations of government competence are, you just keep being surprised. 

Another case for Cat Bonds

This week's column in the Dom draws on the joint RBNZ-Treasury workshop on post-Covid macroeconomic policy that preceded last week's Covid-truncated NZ Association of Economists conference. 

A snippet:

Overall, the workshop felt designed to warm the economic policy community to higher public debt levels for a longer period. The risks of the approach were noted: interest rates can rise, and there will be problems if they do.

And the approach only makes sense if projects funded by that debt really do pass cost-benefit assessment. That conventional cost-benefit assessment processes ensuring value for money seem out of fashion was not noted as any substantial constraint.

Higher levels of government debt bring risk not only in case of interest rate increases, but also in case of natural disaster. Maintaining headroom to take on a lot of debt in a crisis has been important. If public debt is higher for longer, and global credit conditions become less friendly, the Alpine Fault becomes even riskier.

If the public sector is determined to encourage politicians’ imprudent pursuit of higher debt levels, it should encourage that some of that debt be funded more prudently: through catastrophe bonds.

Catastrophe bonds pay investors more during normal times but void most or all of the bond if a triggering event happens. If an earthquake required substantial government funding, existing catastrophe bonds would void and would provide some necessary headroom.

They may be a more prudent approach in imprudent times.

Nightmare scenarios do still exist. 

There were other interesting bits on the day. One presentation went through some simulations of different paths for fiscal consolidation (getting debt back down); the least costly approach, which also yielded long-run benefits, was through increased consumption tax - GST - and/or reduced transfer spending. The worst approaches were increased taxes on capital, and/or reduced government investment spending (on the assumption that that investment spending is on stuff with positive BCRs, which is a bit heroic). 

One option put up by that paper's discussant, which hadn't come up in the paper, was to use migration settings. You can drive down net debt to GDP by increasing population size - though you'd have to be careful on how the necessary infrastructure were financed.  

Michael Reddell has a good run-down on the macro session. 

AFR on the RBNZ

Harsh stuff from Grant Wilson at the Australian Financial Review ($):

Even with the RBNZ flagging macro-prudential tightening next year, via the reimposition of loan-to-value ratios, house prices are now a de facto constraint on monetary policy.

The "least regrets" formulation also assumes that the RBNZ’s approach to unconventional monetary policy, which was first articulated back in 2018, holds up.

While we agree that the first round of LSAP, in conjunction with other measures announced in March and April, was highly effective in lowering the local term structure of interest rates, the jury otherwise remains out.

We highlight (again) that the RBNZ’s expectation of LSAP imparting downward pressure on the NZD via the portfolio balance channel is in doubt.

In contrast to their pass-through model, non-resident holders of local bonds have not sold to the RBNZ.

Their percentage of ownership has fallen sharply this year (from 47 per cent to 30 per cent at end September), but the stock of holdings has remained steady, in a range of NZ$35 billion to NZ$40 billion.

Speaking plainly

Beyond these substantive points, there is the RBNZ’s communication strategy.

Back in May we noted that Governor Orr is known for speaking plainly, including his questionable comment that direct government financing was "achievable", and that there is "no right and wrong".

Assistant Governor Hawkesby managed to top this in mid-October, saying that preparations for negative rates were "not a game of bluff".

Perhaps not. But certainly the RBNZ over-represented its hand (in poker terms).

The result was seen on Wednesday, with the local money market strip abruptly repricing higher (and from negative to positive yields), by fully 30 basis points.

Then on Thursday, Hawkesby made perhaps the most asinine comment we have a seen from a central banker this year, in suggesting that the repricing was due to sell-side banks revising their forecasts, rather than the RBNZ’s decision.

As any intraday chart will illustrate, this was a daft thing to say. It belongs in the domain of alternative facts.

Journey ahead

Looking ahead, the RBNZ has its work cut out. It will need all the institutional credibility it can muster in tapering the LSAP program and in cooling the increasingly parabolic housing market.

Rather than continuing to emphasis the downside, the RBNZ would be well advised to contemplate the upside.

This includes the tourism sector, where Australians comprised nearly half of international visitor arrivals prior to COVID-19.

The RBNZ does not need to be the hero of the hour. It just needs to do its job.

I'm not a macro guy, and I'm certainly not one who watches the mechanics of these markets. 

It seems obvious that the Bank's policies have had the consequence of inflating house prices. If the supply side were less constrained, Bank easing would help fund more construction. The Governor is certainly right that the supply side needs addressing. Monetary policy needs mates, as they say. But given the constraint, it would be nice to think that the Bank views what is happening in housing prices as an unfortunate consequence to be mitigated.

I don't think the Bank should be blamed for having gloomy forecasts earlier in the year. Erring on that side seemed a lot less bad than what could have happened instead, and everything then looked horrible. Being unintentionally contractionary when the velocity of money plummets isn't good. 

Despite everything the Bank has pushed on, inflation expectations over the next two years seem firmly planted in the 1-2% range. If pushing the throttle to the floor keeps the speedo constant, is it because the engine's broken, because you're in the wrong gear, or because you're driving up the Otira Viaduct and Friedman's thermostat is running?* If it's the former, you might want to check into what's going on. A broken engine spraying oil all over the housing market without moving the speedo otherwise isn't the greatest. If it's the latter, shifting into neutral before cresting risks rolling downhill. And if it's because you're in the wrong gear, running a QE policy rather than implementing negative interest rates, well, I'm not enough of macro guy to know.

I do wonder whether there's anything the Bank could be doing to mitigate flow-through into asset prices though. 

* For those unfamiliar with Friedman's thermostat, here's a bit from Nick Rowe from the link:

And it bugs me even more that econometricians spend their time doing loads of really fancy stuff that I can't understand when so many of them don't seem to understand Milton Friedman's thermostat. Which they really need to understand.

If the driver is doing his job right, and correctly adjusting the gas pedal to the hills, you should find zero correlation between gas pedal and speed, and zero correlation between hills and speed. Any fluctuations in speed should be uncorrelated with anything the driver can see. They are the driver's forecast errors, because he can't see gusts of headwinds coming. And if you do find a correlation between gas pedal and speed, that correlation could go either way. A driver who over-estimates the power of his engine, or who under-estimates the effects of hills, will create a correlation between gas pedal and speed with the "wrong" sign. He presses the gas pedal down going uphill, but not enough, and the speed drops.

How could the passenger figure out if the gas pedal affected the speed of the car? Here's a couple of ideas:

1. Watch what happens on a really steep uphill bit of road. Watch what happens when the driver puts the pedal to the metal, and holds it there. Does the car slow down? If so, ironically, that confirms the theory that pressing down on the gas pedal causes the car to speed up! Because it means the driver knows he needs to press it down further to prevent the speed dropping, but can't. It's the exception that proves the rule. (Just in case it isn't obvious, that's a metaphor for the zero lower bound on nominal interest rates.)

2. Ask the driver. If the driver says that pressing the gas pedal down makes the car go faster, and if the driver says he wants to go at a constant 100kms/hr, and if you see the car going a roughly constant 100kms/hr, then you figure the driver is probably right. Even more so if you ask him to slow the car to 80kms/hr, and he says "OK", and then the car does slow to a roughly constant 80kms/hr. If the driver were wrong about the relation between gas pedal and speed, he wouldn't be able to do that, and it wouldn't happen, except by sheer fluke. (Just in case it isn't obvious, that's a metaphor for inflation targeting.)

3. Find a total idiot driver, who doesn't understand the relation between gas pedals and speed, and who makes random jabs at the gas pedal that you know for certain are uncorrelated to hills or anything else that might affect the car's speed, and then do a multivariate regression of speed on gas and hills. But you had better be damned sure you know those jabs at the gas pedal really are random, and uncorrelated with hills and stuff. Which means this can only work if you are certain that you know more about what is and is not a hill than the driver does. Or you are certain he's pressing the gas pedal according to the music playing on the radio. Or something that definitely isn't a hill. Are you really really sure your instrument isn't a hill, or correlated with hills? And if so, why doesn't the driver know this, and why does he jab at the gas pedal in time with that instrument? You had better have a very good answer to those questions. And no, Granger-Sims causality does not answer those questions, or even try to.

Maybe we needed a bigger earthquake

Paul Krugman credits the Japanese earthquake/tsunami with high current Japanese growth rates:

Wait, what? Japan as star performer? What’s that about?

Actually, no mystery. From Bloomberg:

Japan’s economy expanded faster than estimated in the first quarter, boosted by reconstruction spending that’s poised to fade just as a worsening in Europe’s crisis threatens to curtail export demand.

So Japan, which is spending heavily for post-tsunami reconstruction, is growing quite fast, while Italy, which is imposing austerity measures, is shrinking almost equally fast.

There seems to be some kind of lesson here about macroeconomics, but I can’t quite put my finger on it …

I'm not a macroeconomist, so there are reasonable odds I've got things wrong. But I would have thought we'd have needed to think a bit more about how a fiscal push gets funded and about any likely reaction from the reserve bank.

Oughtn't there be a reasonable difference between a tax or debt-funded fiscal expansion and one paid by reinsurance inflows? I'm not sure that we can jump from "the Japanese government is spending a lot" to "Japan's growing" without looking at where the money's come from. A tax-funded spending programme will take money out of other parts of the economy; a debt-funded one might induce people to offset government spending with greater savings in anticipation of future taxes. Even if you think it's worthwhile, the effect of spending will be smaller than it would be where the money came as windfall in exchange for wealth reduction. A fiscal push paid for by domestic insurers selling off assets and by inflows from international reinsurers ought to look a little different from one funded by tax or debt; the GDP effects of tsunami-scale spending programmes in Italy or Greece might be comparable to Japan's if they were paid for by selling off little used assets, like some of Greece's uninhabited Adriatic islands.

New Zealand has its own earthquake rebuilding project: Christchurch. While 2012Q1 figures aren't out yet, fourth quarter 2011 had a year-on-year growth rate of 1.1%. And iPredict's picking quarter-on-quarter growth rates between 0 and 0.5% for most quarters all the way through to December 2013, with reasonable risk of bad outcomes for 2013Q4 - one chance in three of growth rates lower than -0.5%. New Zealand's perhaps making it look hard because of the morass of bureaucracy and insurance that's holding things up, combined with lingering worries that a one-in-four chance of another really big aftershock might mean we're best advised to wait on any big building projects anyway. I doubt that the problem was that the quake just wasn't big enough.

Further, any earthquake-related fiscal push also needs an accommodative central bank for expansionary aggregate effects. Here, a fast rebuild push would very likely push up wages and prices in related sectors, at least until we started being able to bid workers back from Oz. We'd also be pushing rents up for temporary workers, which would feed through into national rental markets as displaced Christchurch folks facing a short term vertical housing supply curve moved elsewhere. And then the RBNZ might start having to put the thumb down.

Bottom lines from a non-macroeconomist:*

• Earthquakes are hardly sufficient for macroeconomic stimulus. There's evidence that Canterbury's seeing decent growth relative to the rest of the country, but aggregate national figures are hardly rosy and construction hasn't been particularly helping things. December quarter 2011 had a 2.5% increase over the prior quarter, but only after substantially negative results for the prior three quarters (ie from the quake onwards). See Table 2 of the Excel sheet. Table 3 tells us construction's contribution to GDP is up in 2011 on 2010, but is still lower in real terms than in any year from 2006 through 2009. I suppose earthquake construction booms also operate with long and variable lags.
• Running a big fiscal push doesn't help anything if the Reserve Bank is then just induced to offset. And if you have to get the monetary authority onside, why not just run it as a monetary expansion in the first place? Cowen says the potential for monetary fixes is weakening, but I'd expect the same case to hold against broad fiscal AD pushes as well. And recall that what Krugman means by "austerity" is perhaps not what is commonly understood.
• It makes a lot of sense for New Zealand to borrow heavily to fund the earthquake rebuild and to divert some money from other useful projects, with longer term tax increases and spending shifts to make up the difference. That the coming budget is almost certain to do nothing about longer term structural issues like the retirement age isn't going to help make room for earthquake-rebuilding debt. 
• The quickest way to make room for the RBNZ on interest rates is getting legislation giving effect to the Productivity Commission's recommendations around housing and land use regulation. We're seeing housing prices ramping up again; Auckland median values are now well above the 2007 peak and aggregate values aren't far below it. Price inflation in non-tradeables like housing and fear of setting off another housing bubble could be constraining RBNZ against interest rate cuts. In the last housing run-up, from 2003 through 2007, year on year CPI measures in the "CPI less housing non-tradeable items" series is about twenty percent lower than the full CPI. RBNZ will have more room to accommodate where housing costs are less of an issue. This obviously matters for any monetary push but matters too for any fiscal stimulus because RBNZ moves last and has to offset fiscal moves that look set to push medium-term CPI above 3 percent.**

* Full disclosure: I was very seriously wrong about macro policy in early 2008 when I thought RBNZ was cavalier about a persistently high CPI when instead they had better foresight about the coming maelstrom; I'd calibrated around RBNZ responses to inflation rates circa 2005-6. So discount as you reckon appropriate.

** They've also been looking to other potential tools for damping housing price run-ups.

NGDP targeting and its discontents

Scott Sumner's been leading the charge for NGDP targeting - the notion that reserve banks can best fulfil the joint goals of inflation reduction and economic stability by targeting expected nominal GDP. It's not crazy. And, it's currently supported by a reasonably broad swath of economists. It doesn't seem obviously worse than what the U.S. Fed currently runs and seems likely to be preferable, but note that I'm not a macroeconomist so please consult with a macro guy before taking any central banking advice.

Another person who's not a macroeconomist is Terence Corcoran. Here's his evaluation:

NGDP targeting: the very latest econo-fad

The first sighting of NGDP targeting in Canada landed almost two weeks ago, when Liberal MP Scott Brison brought a motion before the Commons finance committee calling for it to hold “at least one meeting before the end of November 2011 to hear from witnesses, such as, but not limited to, members of the C.D. Howe Institute Monetary Policy Council, on whether or not the government of Canada and the Bank of Canada should consider other targets, such as but not limited to, nominal GDP or full employment.”

If you blinked, you missed it: The words “but not limited to nominal GDP” contain the hottest new concept in the world of economics.
...
We will hear more of NGDP targeting in weeks and months to come. The debate also takes us all deep into the economic swamp, where creepy jargon and grotesque floating arguments and logical traps abound. One observation, though.

The idea of targeting nominal GDP has its origins, in part, in the work of some radical free-market economic theories. Prof. Sumner, for example, cites as inspiration economist George Selgin, at the University of Georgia, who wrote a book titled Less Than Zero: The Case for a Falling Price Level in a Growing Economy. The idea is that inflation could be close to zero over the long term, and that the only way to get to zero would be to allow inflation to rise and fall according to productivity changes in the economy. Putting an inflation target at, say, 3%, unnecessarily introduces inflation into the economy. Targeting nominal GDP would avoid injecting inflation into the economy. The best alternative, he said, was Free Banking and the elimination of central banks — which is so very, very far from what Ms. Romer, Goldman Sachs or Mr. Brison are thinking about.

There you have it: Scott Sumner, fad-creator in the economic swamps. I'll have you know that, in true hipster fashion, I was reading Sumner before it was cool. Ok, when Tyler over at Marginal Revolution started pointing to it. But that's close enough.

Should we teach IS/LM?

With this year’s Nobel having gone macro, Offsetting needs a macro post.

I have been enjoying the discussion about the IS/LM model in the blogsphere. It started with Tyler Cowen here discussing why he doesn’t like IS/LM. Brad Delong, Krugman, Scott Sumner and others responded in different ways, pro and con (see the links at Steve Landsburg's take on the issue here). WCI’s Nick Rowe makes the point that in many ways, the argument is one of semantics—“It's still IS/LM to me”.

For me, the interesting question is not whether IS/LM is a useful abstraction for some questions, but how (and when) it should be taught. After all, academic economists have access to the full range of models, but typical economics graduates will be highly constrained by the basic models with which they were introduced to macroeconomics. So, I am going to imagine that I were able to write some rules to guide the content of undergraduate macroeconomics texts and ask what role IS/LM would play in those rules. This is what I came up with.

1. Start with the determinants of long-run economic growth.

Depending on the level, this could be a long-run dynamic general equilibrium model or just a simple presentation of growth accounting. The key thing is to emphasise the role of investment and, by extension, saving rather than fiscal and monetary policy in determining long-run growth. This was important during the great moderation, but it is arguably even more important now when we want to emphasise that the current situation is not normal and so policy prescriptions need to start from an analysis of what makes the situation different.

2. Spend a lot of time on the 45-degree line model when introducing the notion of aggregate demand.

When I first learnt macroeconomics, it was standard to start with the Keynesian cross in both principles and intermediate courses, but it seems to no longer be in fashion. I think that is a mistake. Both the IS and the AD curves show combinations of variables that have equilibrium properties, but both look like they should be read as a causal behavioural relationship from the horizontal to vertical axes, just like a micro demand curve. The 45-degree line model contains a causal, behavioural relationship and an important accounting identity. Students need to understand the difference between them thoroughly, how the economy will always be on the 45-degree line, and how undesired changes in inventories (or potentially quantity rationing) explain how the economy can exist away from the equilibrium point. The diagram is also a useful way of conveying the notion of hot-potato money.

3. Go straight from the 45-degree line to the AD/potential-output diagram.

Cut to the chase: this is the diagram that combines the LR determinants of output from step 1 (the vertical potential output line) with the Keynesian SR model from Step 2. It doesn’t matter what story you tell for why the equilibrium relationship between output and price is negative or how policy can affect the position of the AD curve. With this diagram, coupled with an expectations-augmented Phillips curve, one can discuss price dynamics, expectations, optimal Taylor rule type polices explaining why it is better to respond harder to aggregate demand shocks than to price shocks, etc.

Once this framework is in place, then, and only then, in my view, is it appropriate to explore graphical models of the determinants of aggregate demand, such as IS/LM. But before getting to that…

3a. …Remove any mention of the words “demand” and “supply” from this diagram…

Potential output is not “supply” in an analogous sense to a supply curve, indicating the willingness of producers to bring goods to market as a function of the price. Even more, the downward-sloping aggregate demand curve looks like a micro-style demand curve showing the amount buyers would like to buy at a given price, ceteris paribus, when in fact it is a locus of equilibrium points at which planned output equals actual output. Calling these curves aggregate demand and aggregate supply is guaranteed to confuse 90% of undergraduate students.

3b. ... And even with a different name, there is no place for the curve sometimes called short-run aggregate supply…

SRAS serves no useful purpose that I can see. One can describe price dynamics in terms of an economy moving along the AD curve without having a SR supply curve. I am open to being corrected here but as far as I can make out, the so-called SR aggregate supply curve is nothing more than the following: i) In the short-run, the economy will be on the so-called AD curve, but not necessarily on the vertical LRAS curve; ii) students, however, will want the location of the economy to be at the intersection of two curves, so we need a new curve; and iii) since the first curve has been misnamed aggregate demand and is downward sloping, we might as well label the other curve aggregate supply and make it upward-sloping.

3c….And why assume the economy is on the AD curve in the short-run?

The economy is only on the AD curve if it is at equilibrium in the 45-degree line diagram. Why assume that in the short-run there are no unplanned changes in inventories?

4. Return to your favourite version (or versions) of IS/LM.

Now that the basic ideas of macro are in place—long-run output depends on long-run capacity determination, short-run capacity utilisation may depend on the determinants of nominal spending, and the big policy questions concern how much one wants to manipulate nominal spending and how one brings that about—then is the time to get into details about liquidity traps, what interest rates the central bank can control, real versus nominal interest, the role of financial intermediation in the whole process, the possibly complicated feedback loops between SR nominal spending and LR capacity accumulation; etc. IS/LM is probably a useful diagrammatic tool to have in the mix here, but let’s do the basics first.

Quit freaking out about the (NZ) dollar

Yes, the New Zealand dollar is high currently relative to the US dollar. This has some folks all in a tizzy. But it's not like we're the only ones appreciating relative to the US. Should we be as worried about the drop in the NZ dollar relative to the Australian dollar? The very mild increase relative to the Euro and the Yen? Should we fear that the ghost of Muldoon has come and ensured a devaluation only relative to the Australian dollar? Ok, the ghost of Muldoon does scare me. He's been tweeting.

Here's the New Zealand dollar relative to other major trading partner currencies. I left out the Yuan since it just follows the US dollar. The link gets you the Kiwi versus the US Dollar; add in the others by hitting the "compare" box.

The New Zealand dollar is high relative to the US dollar and the Pound but has only seen lukewarm appreciation relative to the Canadian dollar and the Yen and mild depreciation against the Australian.

Here's the decline in the US dollar relative to everybody else. They've held steady relative to the Pound, but that's about it.

The US is dropping relative to everybody except the Brits.

You should be asking about my choice of start dates. I truncated the series just before a big data glitch in Yahoo Finance where an error in the recorded value of the New Zealand dollar wrecks the whole graph.

Journalist Alex Tarrant pestered Labour leader Phil Goff about the exchange rate, reminding him that a high exchange rate (which Goff opposes) mitigates relatively high current inflation rates (which Goff also opposes). Goff's answer? That economics is a dismal science so making one thing better often makes another thing worse, but that current high exchange rates induce unemployment and that inflation has worse effects when unemployment is high.

Goff didn't say it, but I suppose the policy implication is changing the policy targets agreement to tolerate higher inflation outcomes (or otherwise messing around with the Reserve Bank's mandate), resulting in a lower dollar, potentially higher employment in the short term, and rather higher inflation. But if his real policy preference is higher inflation outcomes with (he hopes) lower unemployment, it would be hard to discern that from his constant sniping at National for the increase in the price level that came from the GST increase - an increase that was fully compensated by income tax cuts. Labour's apparent proposed hike in the inflation rate would be compensated by hopes that the long run aggregate supply curve isn't vertical.

Disaster currency

Matt at TVHE asks what's going on with the NZ dollar relative to the Yen; the Yen appreciated substantially post earthquake.

I'm no macro money guy, but here's my first cut.

Japanese insurers had to sell off foreign investments and buy yen to pay out on claims. The subsequent rise in the yen reflected demand, and the subsequent fall in the yen was due to intervention by the other majors. The Bank of Japan couldn't cut interest rates to offset the effects of the surge in demand.

You might think this would be a good reason for the NZ Earthquake Commission to continue holding NZ rather than foreign assets, or at least a mitigating reason against my suggestion that they hold a heavily foreign-weighted portfolio.

Do recall though that Japan has for some time been close to zero bound on interest rates. Sure, monetary expansion remains possible by printing money. I'm definitely not a macro guy, and there's no way I'm wading into the fights about liquidity traps: not my comparative advantage and not worth my investment. But it's harder for the Bank of Japan to sterilize the currency effects of insurers' portfolio adjustments than it would be for RBNZ.

In praise of foreign banks

Matt Nolan writes in praise of foreign banks.

On the surface there appears to be a lot in common with the Irish, Greek, and NZ economies. All three have high net foreign liability positions, liabilities are highly concentrated through banks who are borrowing overseas, all three have experienced some form of housing boom and lift in consumption, and finally all three appeared to have a relatively strong fiscal position before the GFC before moving into fiscal deficits after the shock. And yet (so far) while the Irish and Greek economies and banking systems have collapsed, New Zealand’s has been fine.

There are two major differences that have helped reduce the implied risk on our debt, making New Zealand much less likely to experience a bank run:

1. Our banking system is primarily foreign owned,
2. We have a freely floating exchange rate – combined with having much of our debt denominated in NZ$ this is useful.

This is an important point to recognise. While many commentators are saying we should “peg” our dollar and set up more domestic ownership of banks GIVEN the risks associated with the GFC, I tend to reach the opposite conclusion – namely, the reason why we haven’t suffered as much as these countries as been largely the result of our free floating exchange rate and the fact that a larger economy has a large stake in our banking system.

Agreed.

We're far more robust to shocks to the domestic economy than we would be if our banks' asset base were heavily New Zealand oriented. The Aussie parents are hardly likely to let their NZ branches fall over in the case of a liquidity problem here. But the NZ branches are operationally separate, subject to local prudential regulation, and hold reserves in New Zealand; if the Australian property market collapses, it would be very tough for an Aussie parent bank to lean on the New Zealand branch for assistance.

Systemic shocks and correlated risks are bad things for banks. Why would a small country ever want to rely primarily on "Local banks for local people"? Yeah, there are lots of systemic risks against which we can't insure easily. But that's no reason to try to make things worse.

Perhaps America should encourage Canadian banks to set up branches in the States....

Economists for PR?

Falkenblog trashes macro:

I worked directly for Chief Economists at two major banks, First Interstate in the late 1980's, and KeyCorp in the 1990's. While it would be nice to know when the next recession or interest rate move will happen, no one thought the economist knew better than other random members of the executive committee. Economists are good at presenting the information that seems useful, but as per tying it together, they can't and most people making important decisions know that. This is why economists are always on TV and not in boardrooms. It is also why economics departments at banks have gone from large staffs in the 1970s (at the height of the Keynesian modeling boom), to basically one guy, because it was discovered his or her only value is getting the company name on TV. If someone presents themselves as especially credible because they were a chief economist, I know they are fools.

I spent 3 years of my life working directly for private sector macroeconomists, and the main thing I learned is they don't know anything useful.

I wish that he would have remembered to have written macroeconomics and macroeconomists instead of just economics and economists. Just off the top of my head I can think of one private sector chief economist who added several hundred million dollars in value to his firm. I don't think Google hired Varian just for his telegenic good looks.

Absolutely moronic?

From Morning Report, first Ganesh Nana on the state of the economy followed by Westpac's chief economist Brendan O'Donovan:

Nana: ...I don't see any reason for interest rates to increase. All we've got is a Reserve Bank and a policy environment that is fixated on preemptive strikes against inflation when the real problem has and has been for quite a while recovery of the New Zealand economy which, while in the textbooks appears to be coming through in the numbers, just isn't there out there in the regions or in activity in the export sector when people are claiming there's an export led recovery.

Sean Plunkett: Brendan O'Donovan, you disagree with that fundamentally?

O'Donovan: That's absolutely moronic. You can't say it's coming through in the numbers but it's not out there in the regions. The numbers are what actually quantify what's happening in the regions. It's not happening for every firm. You can't deny that our commodity prices are at multi-decade highs.

Plunkett: Well, that's Westpac's Brendan O'Donovan and BERL's Ganesh Nana; clearly the experts disagree.

New Zealand's OCR remains very stimulative; we're a quarter point above historic lows.

It's odd that Radio New Zealand keeps going back to Nana as an expert on the economy and what RBNZ ought to be doing without noting that BERL has been in a longer term campaign, along with the Manufacturer's and Exporters Association, to do away with New Zealand's inflation targeting regime. I put a lot more weight on NZIER warning against interest rate increases than on BERL making the same call: the latter's a bit of a stuck clock. It would have been interesting for Radio NZ to have had an NZIER economist on making the case rather than Nana.

iPredict says there's a 15% chance of no change in the OCR 29 July. I'm long, but bought at around 5 cents. I've a standing ask at $0.18.

Nominal and real variables: academic edition

Writes the New York Times:

One day next month every student at Loyola Law School Los Angeles will awake to a higher grade point average.

But it’s not because they are all working harder.

The school is retroactively inflating its grades, tacking on 0.333 to every grade recorded in the last few years. The goal is to make its students look more attractive in a competitive job market.

My macro is rusty. But I'd thought that inflating the money supply to increase output only worked if it were a surprise. If it's a surprise, everyone takes an unexpected wage cut and employment goes up until folks incorporate the inflationary shock into wage settlements. But if it's entirely telegraphed in advance, folks just adjust their expectations.

While a Doomsday Device only really works if you do tell everyone about it, inflation, monetary or otherwise, only works if you don't and only until folks figure it out. So why would Loyola be telling everyone? Ah, there's a reason:

Students and faculty say they are merely trying to stay competitive with their peer schools, which have more merciful grading curves. Loyola, for example, had a mean first-year grade of 2.667; the norm for other accredited California schools is generally a 3.0 or higher.

“That put our students at an unfair disadvantage, especially if you factor in the current economic environment,” says Samuel Liu, 26, president of the school’s Student Bar Association and the leader of the grading change efforts. He also says many Loyola students are ineligible for coveted clerkships that have strict G.P.A. cutoffs.

“We just wanted to match what other schools that are comparably ranked were already doing,” he said.

So Loyola wants employers not to have unrealistic expectations about changes in cohort quality over time, but wants its students not to be at disadvantage given their {stricter standards or worse students}.

Strict GPA scholarship cutoffs are nonsense if they're not adjusted for the school's average GPA and the school's average LSAT scores: they only promote exactly this kind of grade inflation. But it would be difficult to get schools truthfully to reveal that information.

Looking through the ETS [update]

The RBNZ rightly looks past level shifts in the price level as it has an inflation target, not a price level target. So if everyone knew that tomorrow all prices would double but that they'd then not change afterwards, that doesn't count as something that RBNZ needs to worry about. And, when the GST hike comes in October, that also rightly will be looked through: the GST increase doesn't increase folks' expectations of the rate of price increases a year after the GST increase.

I would have thought the ETS a bit different though. As I'd understood it, there would be both a level and a rate effect: implementing the system gives a level shift that RBNZ would rightly look through, but if the thing's going to be effective, it'll also have to have a rate effect. Why? Even if they don't put a declining cap on the trading scheme, economic growth will make the cap increasingly binding and consequently will raise the trading price and consequently will force prices up and consequently will raise inflation expectations in the medium term. But the RBNZ says it'll just be a level shift that they'll look through.

Or are they expecting that the foreign supply of emission credits is infinitely elastic at current prices so folks here needing to buy credits will never see a price increase? If it's infinitely elastic, isn't it a complete nonsense? Sure, New Zealand will never affect the world trading price of credits, but if the system as a whole is effective, then the world trading price has to rise over time.

There's something weird here. The only way that ETS has no ongoing inflationary effect, as best I can reckon, is if New Zealand really really really shouldn't be taking part: that is, the rest of the world is effectively ignoring Kyoto requirements and so the world price of emission permits is not expected to rise. So either RBNZ is saying that the ETS is a crock, or that they're ignoring their job to keep inflation in check, or that the effects of ETS-related price rises are so far in the future as to be ignored over the medium term. In the last case, I'd have expected them to note that it will affect inflation expectations a decade hence and that they'd revise their estimates in a few years though.

Updated: Anon, below, points back to the March Monetary Policy statement:

Headline CPI inflation is likely to be boosted over the coming quarters by implementation of the amended Emissions Trading Scheme (ETS). The first phase of the ETS is scheduled to take place on 1 July and will involve charges on liquid fossil fuels and stationary energy. The initial direct impact on CPI is likely to be via the prices of petrol and electricity, as higher production costs are passed through to retail prices. In addition, an indirect impact is likely on the prices of goods and services which are energy intensive, such as transport. The indirect impact is assumed to be half of the direct impact. These direct and indirect effects are collectively labelled the first-round impact and represent a change in the relative price of energy. This first-round impact is projected to add about 0.4 percent to headline CPI inflation in the year to June 2011. At the start of 2013, ETS energy charges will be increased further, but their effects are mostly beyond the published forecast horizon. In keeping with previous treatment (see Box B in the March 2008 Statement), monetary policy will not act to offset these first-round effects. This is consistent with the Policy Targets Agreement which includes ‘significant government policy changes that directly affect prices’ as reasons why ‘the actual annual CPI inflation will vary around the medium-term trend’. As a result, the inflation projections shown in this Statement exclude these first round effects (figure B1).

But some second-round impacts of the ETS could occur, if these higher relative prices cause consumers and businesses to reassess their beliefs on underlying aggregate inflationary pressure, and therefore change their wage and price setting behaviours. This change in behaviour would have consequences for the medium-term trend of inflation, and consequently interest rates would act to offset these effects.

This is pretty reasonable. But come December 2012, business will have to buy emission permits on the open market rather than at the government-supplied price of $25/tonne. Once that happens, wouldn't the open market price of emission permits will be expected to rise over time, fueling inflation expectations? December 2012 is what, 7 quarters away?

Canadian Economics 3

I'm following up on Eric's call for macro commentary on Nick Rowe's liquidity trap comparison of Canada, New Zealand and Australia.

In brief, Nick notes that Canada started the recession with low short-term interest rates, and responded by reducing them as far as possible without hitting the zero-interest lower bound, whereas Australia and New Zealand started with much higher interest rates and were thus able to reduce rates a lot more. But while Australia fared better than Canada, New Zealand fared worse.

My central banking days are long behind me, and I try not to think about macro, but I'll give this one a go. I see two relevant facts.

The first thing to note is that manipulation of aggregate demand is a very limited government tool that can achieve two things: During stable times, small tweaks in interest rates can be a useful way of keeping the economy growing at potential without large swings in inflation or output. And after a major, real, hit to the economy, they can be a way of preventing contagion across the economy in which a downturn in one sector leads to reduced demand in another, and so on. In this case aggregate demand stimulation serves to stop a bad situation becoming worse but can't offset the intial shock.

My sense is that the recession came to New Zealand as a fall in the commodity prices that matter most here, and that while monetary policy could prevent contagion from that, it couldn't change the reality of a decline in our terms of trade. Canada, in contrast, which is much more integrated into the U.S. economy, sufferred contagion from the U.S. largely addressed by U.S. monetary and fiscal policy, with only a small contribution needed from the Bank of Canada. I don't know much about Australia, but it is important to note that the New Zealand and Australian economies are much more different than people think, in particular because Australia derives much more of its income from mineral wealth and so depends on a different set of commodity prices.

The second point to make is that the overnight interest rates that central banks control have only a very limited impact on aggregate demand. They are a very good tweaking tool for making continuous small adjustments to keep the economy stable, but even large movements in overnight rates won't have much impact on demand unless they are perceived to be long-lasting and hence are able to move medium-term rates. (To paraphase a comment about reserve asset ratios from my undergraduate lecturer, Frank Tay, trying to control aggregate demand with frequent changes in overnight interest rates is like an impotent man lifting his trousers up and down.)

By this view, a small reduction in interest rates in Canada close to what is seen as an absolute lower bound, would be viewed by the markets as likely to last for a long time (on the assumption that rates would have been lower if possible), and so even a small fall in short-term rates would be likely to lead to falls further out the yield curve. In New Zealalnd, however, starting from higher overnight rates, a similarly small fall without a credible reason for not reducing further would have generated expectations of a shorter-term policy.

It would be easy to check this theory by looking to see which country witnessed the greater falls in interest rates further along the yield curve, but I'm going back into macro retirement. I'll look forward to seeing if Nick follows up on this.

Canadian economics

A Canadian civil service economist writes to 2blowhards:

Although I was born and raised in Ottawa, many of the friends I made in grad school were not. Pretty much all of them, having studied Economics, wound up working in various capacities for the public sector in our nation’s capital. This has given me the unique experience of observing their reaction to finding out exactly what our government does with the mountains of cash it extracts from the productive regions.

Their reaction can be summarized thusly:

If everyone knew what actually happened in this city, no one would ever vote against the Conservatives, ever again.

[anecdotes of slack public service in Ottawa]...

Compared to other public servants, Economists seem to be unduly put upon in terms of workload. Most of my grad school friends are assigned somewhere around 20-40 hours of tasks per week of. One of them even puts in unpaid overtime occasionally. The work we do however, is largely worthless. We write analyses no one ever reads, collect data that no one ever uses, offer input on decisions that never get made. Much of our time is spent “forecasting,” which basically means making a common-sense appraisal of what some indicator or variable will do in the coming years, and creating a statistical model that confirms it. The second step adds nothing of value to the prediction – the math is just there for show, a means of impressing the innumerate by camouflaging shot-in-the-dark guesses in rigorous clothing.

Hmm. I'd have thought that the economists would be the ones most disappointed by the Conservatives; perhaps their expectations were lower than mine.

My impression is that the economists here get a lot more say in policy. Co-blogger Seamus Hogan, who worked for Health Canada in a prior life, may have more useful comments. I do like the quip on forecasting though.

Being far more macro-minded than I am, Seamus may also have more useful comments on this interesting question from Nick Rowe over at Worthwhile Canadian Initiative:

I want to compare the economies of Canada, Australia, and New Zealand over the last couple of years. I know I will get things wrong, and leave important things out. That's what comments are for. Especially comments from Australia and New Zealand.

Why these three countries? Apart from any historical, cultural, and political similarities, all three are small open economies with an inflation targeting central bank. But there's one big difference between Canada and the other two.

The Bank of Canada hit the notorious "Zero Lower Bound" on nominal interest rates (or felt it had). That's supposed to matter. A central bank that hits that constraint cannot loosen monetary policy enough to offset a decline in aggregate demand. The Reserve Banks of Australia and New Zealand didn't even come close to the lower bound. So seeing how the otherwise similar Australia and New Zealand did compared to Canada should tell us if the ZLB matters. Australia seems to have done better than Canada, which fits the theory. But New Zealand seems to have done worse.

Seamus has a comparative advantage in macro; I'll punt on it for now. Seamus, any thoughts?

Scott Sumner usefully comments at Rowe's blog:

Nick, I have to agree with those who point out that there isn't enough information here. Obviously the zero bound didn't matter for Australian and New Zealand, but on the other hand they were impacted by something the US was not impacted by--and exogenous shock of a worldwide recession. So unemployment might rise even with optimal monetary policy. In that sense, of course, Canada is more like Australia than the US. So the only real question here is whether the BOC wanted to do more easing, but felt unable to because of the zero bound. What do they say? At the Fed you had Janet Yellen saying "we should want to do more." Did BOC officials spout any similar nonsense?

Kien's comment is very interesting. I haven't heard Krugman's views on optimal monetary policy in small countries. The zero bound isn't a factor, as they can always depreciate their currencies without limit. Does Krugman say fiscal stimulus never makes sense in small countries? Or can it be optimal if there are international (real) AD shocks impacting the small country

Some comments there suggest NZ had no fiscal boost over the period; that's not quite true. Rather, what fiscal boost we've had has been more permanent spending increases than temporary spending jolts. Labour implemented Working For Families (EITC) in its last term in office; National cut taxes very slightly in its first budget (by much less than they'd promised). And, National's brought forward some infrastructure projects; that spending couldn't really be brought forward enough to have any substantial effect during the worst of the recession. On NZ's stimulus spending, see NZIER, discussion at TVHE which eventually concludes that OECD overestimated the extent of NZ fiscal stimulus; TVHE later wonders whether we really had any substantial discretionary spending increases..

We're now in rather large deficit, mostly due to the permanent spending programs inherited from Labour rather than because of any stimulus push in the current administration. We might expect that National will cut those back a bit after the recession fades, but such expectations don't really make the current spending levels temporary.

I'll punt on the rest for now and see what Seamus has to say on the dark arts of macro....

Watson on White

William Watson highlights William R. White's critiques of modern central banking:

The argument he provides is explicitly Austrian, which will commend it to many readers of this page. He quotes Hayek in two places and relies heavily on the fundamental proposition of Austrian economics that: “It is not self evident that policies are desirable when they are effective only at the expense of creating even bigger problems in the future.”

That’s a jab at Greenspanian monetary policy, which White sees as having imparted an inflationary bias to U.S. monetary policy and sown the seeds of future disaster even as it fought against recessionary tendencies in 1987, 1998 and 2001. If the Fed rushes in with buckets of liquidity every time a financial market experiences stress, the market learns that stress is not such a fearful thing. As a result, monetary policy becomes less effective. As White writes: “The degree of monetary easing required to kick start the United States economy seems to have been rising through successive downturns as the ‘headwinds’ of debt have become stronger.” Much of the debt in question was spawned by monetary policy itself: Credit begets collateral, which begets further credit, an evolution the Fed has fostered over the last 25 years.

We may have had unusual stability in the real economy in the Greenspan-era but, White argues, we had growing “instrument instability.” Consider balancing a ping-pong ball on a ping-pong racquet. To keep the ball stable, you move the racquet. If there are shocks to either ball or racquet, you have to move the racquet more and more to keep the ball where it is. The ball never moves much but eventually the required racquet movements are too big, the system collapses and you drop the ball. White argues that’s what’s happened to monetary policy.

Watson never links to the paper, but it's almost certainly this one.

Upshot: interest rates in the boom should be higher than would be dictated by inflation targeting alone, banks should watch against "unusually rapid credit and monetary growth rates, unusually low interest rates, unusually high asset prices, unusual spending patters (say very low household saving or unusually high investment levels)" to try to resist procyclicality in the financial system.

I wonder how or whether this could be operationalised. I'd want something other than "pick a central banker with the right utility function and let him be independent" and more like our current policy targets agreement. Not sure that it can be done in a way that wouldn't wind up being worse than simple inflation targeting: it's awfully hard to distinguish a monetary asset bubble in, say, housing prices from structural problems like the combination of IRD being too lenient on LAQCs and tight zoning/RMA restrictions on new housing supply.

What did I miss?

A week ago, the RBNZ worried a lot that the banks were shafting customers by not passing along the Reserve Bank's interest rate cuts. Of course, banks do have to compete for deposit funds; it's not like they can underwrite mortgages based on overnight borrowing at the RBNZ.

This week, the RBNZ instead is worried that recovery in the New Zealand housing sector may presage a return to our old "borrow and spend" ways: in other words, we need to do something to encourage more saving and less borrowing. What is it that affects that...ah, right. The interest rate. So a week ago the RBNZ berated banks for interest rates being too high; today, Bollard berates consumers for responding to interest rates being too low. Which is it? I suppose that new information could have come into the system in the interval about housing sector recovery, but it would suggest that perhaps folks oughtn't have been so quick to criticize the banks in the first place.

Quote of the day: Krugman edition

Over the last few months I have had a chance to closely examine many of Krugman’s recent and past writings on fiscal and monetary policy. One thing that I notice is that Krugman is very skilled at making an argument. He can use the same basic model to make either monetary or fiscal policy seem like the only reasonable option. All that is required is that one tweak the assumptions in such a way that the less favored policy seems either undesirable or infeasible. So my message is this—don’t let anyone (including me) bully you into thinking that your policy instincts are wrong, until you have closely examined the assumptions that underlie each side of the debate. All this drivel in the blogoshere about velocity, multipliers, liquidity traps, Ricardian equivilence, budget constraints, etc, etc, are merely verbal tools that can be wielded to achieve any desired outcome. It’s an insiders game. The real battle is elsewhere.

Scott Sumner on Krugman