Working Papers

Greenspan, Monetary Policy and Asset Prices

The SMH has been running extracts from Peter Hartcher’s forthcoming book Bubble Man: Alan Greenspan & the Missing 7 Trillion Dollars.  I will post a full review in due course, but the extracts highlight numerous problems with Hartcher’s argument.  Hartcher notes:

And the research by the Fed’s own economists is also at odds with the chairman’s contention. By demonstrating that surprise changes in official interest rates have a “multiplier” effect on stock prices of between three and six times, their work simply affirms what market strategists already knew - the Fed can make a powerful difference. And a tightening would certainly introduce an element of risk for speculators and interrupt the one-way bet that generates speculative momentum.

This is very selective, ignoring an extensive body of Federal Reserve Board and other research which suggests that targeting asset prices with monetary policy would be a disaster.

Hartcher’s conclusion is almost pure hyperbole:

We are left with the conclusion that, because of acts of omission as well as acts of commission, Alan Greenspan was not prepared to contain or manage in any way one of the most deluded and dangerous market manias in four centuries of financial capitalism until it had assumed such vast proportions that recession was inevitable.

This is a good illustration of how careless talk about ‘bubbles’ promotes the belief that asset prices can be centrally planned by monetary policy.  It is the asset market equivalent of the socialist calculation debate of the 1930s.  If you think the tech stock boom and bust was manic, wait and see what markets look like when central banks start second-guessing the market on asset prices.  If monetary policy is as powerful as Hartcher would have us believe, and the Fed Chairman as prone to error as Hartcher suggests, then surely this is a strong argument against activist monetary policy, particularly where asset prices are concerned.

posted on 20 June 2005 by skirchner in Economics

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More Housing ‘Bubble’ Scepticism

In case you haven’t noticed, James Hamilton is now blogging.  He suggests some simple fundamentals underpinning gains in house prices:

This simple calculation helps us to understand that if a community experiences a change in its growth rate, property values can increase a great deal over a short time. For the above example, going from 2% to 3% growth would cause the property values to double overnight. It’s noteworthy that over the last 5 years, the three states with the highest population growth rates as reported by the Census Bureau—Nevada, Arizona, and Florida—have also been among the locations that saw the biggest increase in home prices. Forces such as these, rather than a random distribution of irrational exuberance, seem a more natural explanation for why some communities got bubbled and others didn’t.

posted on 19 June 2005 by skirchner in Economics

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Tagged by Soon

It was only a matter of time before I would be tagged in relation to my reading habits.  I have listed the five books that have been the most influential on my own thinking and that are likely to be of most interest to readers of this blog.

continue reading

posted on 19 June 2005 by skirchner in Misc

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The Current Account, Foreign Exchange and Interest Rate Risk

Alan Wood highlights some widely underappreciated facts about Australia’s lack of exposure to foreign exchange and interest rate risk in relation to its foreign borrowings:

In 2001 [the RBA] asked the Australian Bureau of Statistics to do a survey on the issue. It found that once the banks’ off balance sheet activities in derivatives were taken into account, their foreign exchange exposure was negligible - their borrowings were all effectively in Australian dollars.

This is still the case, so a fall in the dollar won’t lead to a banking crisis. And it is not just the banking system. The ABS found that Australia as a whole was long on foreign currencies - assets exceeded liabilities.

This means that Australia as a whole is not vulnerable to changes in currency valuations caused by even large falls in the exchange rate. A fall in the dollar would actually be a financial gain, not a loss. This is also still true.

And then there is refunding risk. What if foreign investors become worried about our current account deficits and high debt levels? They will push down the exchange rate and push up interest rates, making it too expensive for banks to go on funding offshore.

When they come back onshore to borrow it will push up interest rates, won’t it? Only marginally, according to the RBA. Banks borrow mainly at the short end of the yield curve, where it sets the rates, and it is not going to respond to a fall in the dollar by pushing up official rates.

posted on 18 June 2005 by skirchner in Economics

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The Biggest Bubble in History?

House prices feature on the cover of The Economist.  With its usual hyperbole, the Economist claims that house prices are now ‘the biggest bubble in history.’  Its benchmark for this claim is the percentage change in the capitalisation of the housing stock relative to GDP.  Apart from the dubious stock versus flow comparison, the Economist would have us believe that this is all pure asset price inflation: 

the biggest increase in wealth in history was largely an illusion.

The many real factors that might be contributing to an increased capitalisation of the housing stock are all irrelevant apparently.  With all the authority of a hellfire preacher, The Economist claims to have seen it all coming and proclaims ‘the day of reckoning is closer at hand.’  It is all just so shriekingly obvious to The Economist.  It’s everyone else that must be stupid:

The rapid house-price inflation of recent years is clearly unsustainable, yet most economists in most countries (even in Britain and Australia, where prices are already falling) still cling to the hope that house prices will flatten rather than collapse.

I would suggest that what economists are clinging to is the intellectual modesty The Economist magazine surrendered a long time ago. 

The great Max Corden once said that worrying about something that is ‘unsustainable’ is like worrying about the growth rate of a teenager.  Australia’s experience both historically and with the current moderation in house prices certainly points to the ‘flatten’ rather than the ‘collapse’ scenario.  The fact that falling house prices have made the cover of The Economist, notorious as a contrarian indicator, is perhaps the most reassuring sign yet.

posted on 17 June 2005 by skirchner in Economics

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Current Account Sustainability

Tony Makin argues against the 5% of GDP rule of thumb on current account sustainability:

an internationally recognised rule of thumb has developed that says an external deficit is excessive if it reaches 5 per cent of GDP. Australia has not been below that for quite some time.  Yet this 5 per cent limit, popular with the IMF, has never been justified analytically and seems arbitrary…

an economy’s productive investment opportunities alone set a feasible upper limit for the current account deficit…judging external account and foreign debt sustainability with reference to the nation’s saving pool would seem to improve on the arbitrary 5 per cent of GDP rule.

On this basis, and given the sizeable fiscal surplus at present, Australia’s current account deficit is easily sustainable, although its feasible limit gets closer as private and public consumption spending rises too quickly.

In the meantime, the high current account deficit remains the best measure of the extent to which foreigners are expressing confidence in the Australian economy. It will persist as long as that confidence is warranted.

It is also worth recalling that the existing record current account deficit was preceded just a few years ago by a record narrowing of the deficit.  Current account balances cycle and this cycle is becoming more pronounced in Australia’s case.  It is no accident that the record narrowing in the deficit followed the AUD making record lows in 2001.  As Makin argues, floating exchange rates provide an adjustment mechanism to external imbalances.

posted on 16 June 2005 by skirchner in Economics

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Beazley Economics

If the Labor Party wants to restore its credibility on economic policy, it will have to do much better than this:

“Our country is at a crossroads; every day we sink further and further into unsustainable debt,” Beazley told the conference. “On average, foreign debt has gone up by more than $2.5 billion in every single month of the Howard-Costello Government.

“My deep worry for Australia is this: I believe John Howard and Peter Costello are taking us to the edge of the debt cliff. I fear Australia’s credit card is nearly maxed out.”

Net foreign debt increases under every government, for the very good reason that we need to borrow abroad to make good the shortfall between domestic saving and investment that drives the current account deficit.  If Beazley is seriously proposing to reduce foreign debt, then he is arguing for some combination of increased national saving or reduced investment.  We can maintain higher levels of both consumption and investment by borrowing abroad than would otherwise be possible.  Beazley is effectively proposing to cut our standard of living for the sake of a lower current account deficit, a self-defeating policy prescription.  It is the capital markets equivalent of an import substitution policy.  The gains from trade in goods markets are equally applicable to capital markets.  Australia’s debt servicing ratio is in very respectable bounds and the foreign currency risk is fully hedged, so Australia’s foreign liabilities are well below the level that would give rise to any concern.

Beazley’s populist rhetoric on foreign debt is of course no different from that the government used when it was in opposition, but it doesn’t do much for his credibility.

posted on 14 June 2005 by skirchner in Economics

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Ben Bernanke and the Fever Swamp Austrians

Bryan Caplan defends Ben Bernanke against the attack of the fever swamp Austrians.  Those who refer derisively to ‘printing press Ben’ would do well to actually read some of Bernanke’s academic work.  Bernanke has done much to revive pre-rational expectations, old school monetarism and once again give it respectability in academic and policy circles after decades of neglect (his 2004 Brookings paper with Reinhart and Sack being a good example).  Even John Taylor, the pre-eminent exponent of interest rate targeting, has spoken of the need to resort to quantitative approaches to monetary policy when low inflation puts a floor under the real rate. 

Leland Yeager once said ‘I sometimes get the impression that Austrians recite their favourite cycle theory as a kind of elaborate password for mutual recognition and encouragement.’  Yeager has shown that acceptance of the importance of monetary disequilibrium actually argues against much Austrian business cycle theory.

Bernanke is currently front runner on the Intrade contracts to replace Greenspan, although the market is very thin.  My guess is that his lack of extensive experience in government relative to some of the other candidates will count against him, but he would make a fine Fed Chairman.

posted on 12 June 2005 by skirchner in Economics

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RBA Transparency: Right Up There With Motherhood

A survey has found a high level of public support for the proposition that the RBA should be required to release the minutes of its deliberations:

The Hawker Britton survey of 500 people found 80 per cent thought it was time the Reserve was forced into releasing its minutes, with just 16 per cent supporting the current closed book.

The Reserve at present does not reveal its monthly meeting minutes.  Only when it changes interest rates does it release a statement, outlining its reasons for moving rates.

But there has been pressure from business groups, economists and others for the Reserve Bank to follow the lead of other central banks by releasing its minutes.

The minutes would give some insight into what the bank’s board members are thinking about the economy, and the prospect of further interest rate changes.

Hawker Britton managing director Bruce Hawker said it was time for the Reserve Bank to be more open.

“The Bank of England and the United States Federal Reserve both release minutes of their board meetings, but not the Reserve Bank of Australia,” he said in a statement.

Of course, transparency is a bit like motherhood and so the high level of support is not really surprising.  Moreover, if the respondents were told about the practices of other central banks, this frames the question in a way likely to elicit a positive response.  Still, it is encouraging to see this issue being actively canvassed.

posted on 09 June 2005 by skirchner in Economics

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Investment and the Current Account

There has been scepticism in comments about my claim that Australia has experienced a non-dwelling investment boom and that this is the main driver of the deterioration in the current account balance.  The following chart shows the dwelling and private business investment share of GDP, although leaves out some investment components such as public investment.  Total investment has been at record levels as a share of GDP, yet the dwelling investment share has remained relatively stable.


posted on 08 June 2005 by skirchner in Economics

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Economists for Legalising Weed

The sort of applied economics we like to see:

Replacing marijuana prohibition with a system of legal regulation would save approximately $7.7 billion in government expenditures on prohibition enforcement-$2.4 billion at the federal level and $5.3 billion at the state and local levels.

Revenue from taxation of marijuana sales would range from $2.4 billion per year if marijuana were taxed like ordinary consumer goods to $6.2 billion if it were taxed like alcohol or tobacco.

If you are an academic economist, you can add your name to a list of over 500 economists supporting legalization here.

(via Mahalanobis)

posted on 08 June 2005 by skirchner in Economics

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The AEI Disgraces Itself Yet Again

Why is it that the right-wing American Enterprise Institute is channelling John Quiggin and Ross Gittins?

The Economist  
Publication Date: June 2, 2005

Sir—You waxed lyrical about Australia’s 15 years of continuous economic growth. However, you gloss over the fact that Australia’s external imbalances have never been larger, even at a time when international commodity prices are booming and China is expanding rapidly. You also failed to note that Australia’s housing bubble and consumer over-indebtedness make the United States look like a paragon of frugality. A more balanced view might have asked what happens to Australia when commodity prices ebb and when China’s investment bubble bursts?

Desmond Lachman is a resident fellow at AEI.

Since the Australian economy powered through the global collapse in commodity prices in 1998 after the Asian crisis with a real annual growth rate of 6%, I think we already know the answer to that question Des!

Maybe Quiggin and Brad DeLong were right after all:

“Back in the late 1970s, the American Enterprise Institute ranked close to the Brookings Institution as a think tank you could trust not to deliberately lie to you. Now it has fallen very deeply into the pit indeed”.

posted on 07 June 2005 by skirchner in Economics

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More Housing Nonsense from Gittins

Ross Gittins’ column today is almost a perfect summary statement of all the nonsense written about housing in recent years.  In particular, Gittins claims:

What many people don’t realise, I suspect, is that the housing boom effectively crowded out external demand (“net exports”). You can see this from two perspectives. The first is that, on the one hand, the housing boom added to consumption and so reduced saving while, on the other, it added to investment (in the housing stock). So, by reducing national saving and increasing national investment, the housing boom caused a widening of the current account deficit.

The problem with this argument is that it is simply not supported by the data.  As we have pointed out on previous occasions, consumption and national saving as a share of GDP have been remarkably steady.  Investment has boomed, of which housing makes up only a part.

The widely held perception to the contrary stems in part from the fact that the ABS does not highlight the national saving data in the national accounts release, for the simple reason that these data are so boring.  They do report the household saving ratio, because it shows more colour and movement, but if you read the fine print, you will see that the ABS doesn’t believe its own numbers.  In particular, they warn that the data are potentially subject to significant revisions which ‘can cause changes in the apparent direction of the trend.’

In fact, one can argue that it is the increased purchasing power of domestic production from improvements in the terms of trade that is driving income growth that is in turn driving consumption and house prices.  In other words, consumption and house prices are jointly driven by strong growth in national income, not the other way around.  Strong growth in the terms of trade is also driving the growth subtraction from net exports, as we substitute cheap imports for domestic production.  This makes us better off in welfare terms, but you won’t see this looking at the domestic product account. In fact, the peak in annual growth in house prices coincides quite nicely with the growth peak in real gross domestic income.

Gittins goes on to argue:

The second way to think of it is that, thanks to the economic growth emanating from the housing boom, the unemployment rate fell steadily to a 28-year low of 5 per cent.

The Reserve Bank would not have wanted to see the economy growing any faster than it did. In its management of demand along the path it took, the Reserve kept the official interest rate higher than otherwise, which probably kept the exchange rate higher than otherwise, thereby crowding out net exports.

I trust Gittins is not seriously arguing that we should have a slower rate of economic growth and a higher unemployment rate, just so we can have lower interest rates, a weaker dollar and a better current account balance, but that is the clear implication of what he is saying.  That is exactly the formula which brought us the early 1990s recession.

posted on 06 June 2005 by skirchner in Economics

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The Euro:  Too Crappy, Even for the Italians

One of the great attractions of the euro was that it offered instant monetary credibility to countries with less than stellar inflation records like Italy.  For these countries, the euro was a free lunch.  They could import monetary policy credibility, without having to make difficult monetary and fiscal policy decisions over and above satisfying the convergence criteria.

Italian politicians are now seeking support for a referendum to pull Italy out of the euro:

Roberto Maroni, Mr Berlusconi’s social security minister and a joint acting leader of the Northern League, said his party would start collecting signatures for a referendum on the issue later this month. He also appealed for the process of ratifying the EU constitution to be halted.

Days after it was reported that senior German ministers had discussed the disintegration of the single currency, Mr Maroni pledged to start collecting signatures for a referendum later this month. He branded the euro a “disaster” which was product of a “European model whose failure we are witnessing with concern”...

Mr Maroni held up Britain as a model to be copied. “It is growing [and] developing while keeping its own currency,” he said.

(via Alex Singleton)

posted on 05 June 2005 by skirchner in Economics

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From Nostradamus to Krugman: 450 Years of Economic Doom-Mongering

Mark Mahorney has compiled an inventory of published economic doom-mongering, showing the remarkable persistence of the genre.  I’m sure there is a great behavioural finance paper to be written about our willingness to believe that the economic end is nigh, which is generally belied by the actual personal financial decision-making of most people.  I can think of at least one prominent market forecaster who must have a lot of canned food stocked in his basement if he takes his forecasts for the S&P 500 at all seriously!

The widespread adoption of general equilibrium theorising by the economics profession has actually encouraged the belief that any observed cycle must somehow be indicative of an irrational, and potentially ruinous, boom and bust.  The great contribution of Austrian economics is to show that disequilibrium is in fact the norm, not the exception.  It is a tragedy that much popular Austrian economics is these days so heavily implicated in doom-mongering, inspired by a gross misreading of its own tradition.

posted on 04 June 2005 by skirchner in Economics

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