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Euro Crisis Vindicates Friedman’s Big Idea

I have an op-ed in today’s Business Spectator arguing that the euro crisis should be viewed primarily as a vindication of Milton Friedman’s pioneering 1953 essay, ‘The Case for Flexible Exchange Rates.’

Not mentioned in the op-ed, but Friedman’s essay had its origins in a 1950 memo he wrote as a consultant to the Office of Special Representative for Europe, United States Economic Cooperation Administration. The essay references many of the problems with exchange rate regimes in Europe at that time.

posted on 21 May 2012 by skirchner in Economics, Financial Markets, Monetary Policy

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Good and Bad Reasons for a Budget Surplus

The government’s stated motivation for returning the budget to surplus next financial year is to give the Reserve Bank ‘maximum room to move’ on interest rates. Yet a fiscal contraction is no more effective in restraining the economy than a fiscal expansion is effective in stimulating it. In an open economy with a floating exchange rate and an inflation-targeting central bank, changes in fiscal policy do not have significant macroeconomic implications. That is why the reaction of financial markets to budget statements is so negligible. The Reserve Bank’s statements also make clear that fiscal policy is a very minor consideration in its decision-making.

During the financial crisis, the government tried to have it both ways, arguing that its fiscal stimulus saved us from recession, but had no implications for interest rates. The second part of the argument was correct, but not the first. If the first part had any truth, then monetary policy must have been much tighter during the financial crisis as a result of the government’s stimulus spending.

The government should have no concern over the macroeconomic implications of changes in the budget balance, so long as it is balancing its budget over time and conducting fiscal policy in a sustainable manner. This should free the government to focus on what fiscal policy can do effectively, namely, changing microeconomic incentives to work, save and invest.

The government and opposition’s mistaken belief in a trade-off between fiscal and monetary policy is dangerous, because it leads to fiscal policy decisions that are more about window-dressing the budget balance and claiming credit for reductions in official interest rates that would have happened anyway, rather than improving incentives. For example, the mistaken belief that tax cuts stimulate demand and lead to higher interest rates can prevent sensible tax reform that has positive implications for the supply-side of the economy. Similarly, the fiscal stimulus of 2008-09 was bad primarily because it misallocated resources. Take away the macroeconomic rationale and the stimulus measures look indefensible on microeconomic grounds, even if the spending had been administered perfectly (which it was not).

A budget surplus target can be defended as a fiscal rule designed to impose additional discipline on government decision-making that might otherwise be absent. But there is no reason to subordinate fiscal policy to monetary policy and fiscal targets should not be pursued at the expense of the microeconomic incentives that are the ultimate source of both economic growth and long-term fiscal sustainability.

posted on 09 May 2012 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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Give Bernie 50 and He Will Want 100

Some of us have long memories:

‘No Risk In 1% Rate Cut, Says Fraser’,  PAUL CHAMBERLIN, 4 December 1996, The Age:

The former governor of the Reserve Bank, Mr Bernie Fraser, said last night he believed November’s cut in official interest rates should have been doubled. As an overheated dollar retreated in markets yesterday, amid concern about its effect on exports, Mr Fraser said he thought the 0.5 per cent reduction announced last month by the central bank could have been 1 per cent.

“I thought at the time with inflation pretty well under control, very much under control really, and the economy being a bit sluggish in some sectors, that we could have accommodated a 1 per cent cut without any risks,” he said on the ABC’s The 7.30 Report.

Bernie’s comments in December 1996 tanked AUD so hard, the RBA did not cut at that month’s regularly scheduled Board meeting. The RBA waited until 14 December while markets recovered from Bernie’s open mouth operations. So monetary policy ended-up being marginally tighter for longer thanks to Bernie. During his time as Governor, Bernie gave us an average cash rate of 8.7% and an average inflation rate of 3.6%.

posted on 01 May 2012 by skirchner in Economics, Financial Markets, Monetary Policy

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Give Austerity a Chance

Robert Carling and I have an op-ed in today’s AFR making the case for fiscal austerity. Drawing on the work of Alberto Alesina and his co-authors, we note that austerity may work politically as well as economically:

Interestingly enough, Alesina and his co-authors also show that fiscal consolidations do not generally reduce the popularity of governments or make it more likely they will lose elections.

Indeed, they go so far as to say that “it is impossible to find systematic evidence of predictable political losses following fiscal adjustments”.

This is entirely consistent with their finding that fiscal consolidations need not have adverse implications for economic growth and may even support growth. Electorates seem to recognise this, even if politicians do not.

posted on 08 February 2012 by skirchner in Economics, Fiscal Policy, Monetary Policy

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EMU and International Conflict

Martin Feldstein writing in Foreign Affairs in 1997, demonstrating that the euro crisis was entirely foreseeable:

If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe and confrontations with the United States.

The immediate effects of EMU would be to replace the individual national currencies of the participating countries in 2002 with a single currency, the euro, and to shift responsibility for monetary policy from the national central banks to a new European Central Bank (ECB). But the more fundamental long-term effect of adopting a single currency would be the creation of a political union, a European federal state with responsibility for a Europe-wide foreign and security policy as well as for what are now domestic economic and social policies. While the individual governments and key political figures differ in their reasons for wanting a political union, there is no doubt that the real rationale for EMU is political and not economic. Indeed, the adverse economic effects of a single currency on unemployment and inflation would outweigh any gains from facilitating trade and capital flows among the EMU members.

posted on 13 December 2011 by skirchner in Economics, Financial Markets, Monetary Policy

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The Irrefutable Logic of Quantitative Easing

A useful thought experiment from Robert Hetzel:

The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

posted on 13 December 2011 by skirchner in Economics, Financial Markets, Monetary Policy

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Not that 70s Show: Why This Boom is Different

Treasury’s David Gruen highlights the role of Australia’s macroeconomic policy framework in sustaining the boom:

The Federal Governments of the 1970s were in direct control of all arms of macroeconomic policy, including the value of the exchange rate. When commodity prices were rising strongly, generating boom conditions in parts of the economy, it proved extremely difficult for governments of either political persuasion to impose sufficient restraint on other parts to deliver an appropriate outcome for the economy overall.

By contrast, the current macroeconomic framework has several elements that together represent a crucial improvement on the framework of the 1970s. These elements are: a market-determined exchange rate, a medium-term inflation target implemented by the Reserve Bank, a medium-term fiscal framework implemented by the Federal Government, and largely decentralised wage-setting arrangements.

A consequence of the current framework is that when commodity prices are high, the floating exchange rate is likely to have appreciated sharply, acting as a shock absorber, and reducing the expansionary effects of the terms of trade rise on the overall economy. As a consequence, there is a smaller role for ‘activist’ macroeconomic management - simply because much of the necessary restraint is imposed by the exchange rate.

The exchange rate plays its shock-absorber role primarily by imposing significant restraint on those parts of the traded sector, including parts of the manufacturing sector, which are not experiencing strongly rising prices for their output or are not directly exposed to the booming sectors of the economy…

In the longer term, the increasing numbers of people in the Asian middle classes, with disposable incomes to match, will generate rising demand for a range of Australian goods and services - whether they be a range of foodstuffs, Australian tourist destinations, or educational, financial and other professional services in which Australia has a proven track record. Indeed, this process is well underway.

posted on 29 November 2011 by skirchner in Commodity Prices, Economics, Monetary Policy

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Was there Anything Ian Macfarlane Couldn’t Do?

A strange line from Paul Kelly’s The March of the Patriots:

Macfarlane’s skill at smoothing the growth curve helped to transform Sydney’s skyline…

Move over Harry Seidler! Then there is this:

Bank independence was Costello’s triumph over Hewson.

In this op-ed, I argue that it was Hewson’s triumph over the Bank.

posted on 09 October 2011 by skirchner in Economics, Monetary Policy

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How to Fix a Conflicted RBA Board

I have an op-ed in today’s AFR arguing for monetary policy decision-making to separated from the Reserve Bank Board. Full text below the fold (may differ slightly from edited AFR text).

continue reading

posted on 06 September 2011 by skirchner in Economics, Financial Markets, Monetary Policy

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The Shadow RBA Board

The Centre for Applied Macroeconomic Analysis at the ANU has put together a Shadow RBA Board:

Made up of senior Australian economists, the shadow board was set up as a research project by The Australian National University to look at interest rate setting by monetary policymakers.Director of the Centre for Applied Macroeconomic Analysis at ANU Professor Shaun Vahey said board members were asked to rank their preferred target interest rate, and to give the probability that each interest rate is appropriate.“Each economist gave a percentage value for how much they preferred each interest rate using an electronic voting system,” he said.

“The board members are not forecasting actual RBA board behavior, but are considering what they believe is the appropriate rate.”

Of course, what you believe to be the appropriate rate should be the same as your prediction for the actual interest rate outcome, unless you think the RBA Board is behaving inappropriately! Not surprisingly, at the August meeting, every member of the Shadow Board except Shaun assigned the single highest weight to the current official cash rate setting, endorsing the current stance of monetary policy.

This highlights a major point of difference between the Shadow RBA Board and its overseas namesakes. The US Shadow Open Market Committee and the UK’s Shadow Monetary Policy Committee were established specifically to critique current policy from a monetarist perspective, as well as advocating reform of existing monetary institutions. The members of the Shadow RBA Board for the most part share with the RBA the standard New Keynesian framework for monetary policy, which is unlikely to lead Shadow Board members to adopt a radically different policy stance, even in a probabilistic setting. This is not to say that the New Keynesian model is an inappropriate framework. As Ed Nelson has shown, the basic features of the New Keynesian model can be derived explicitly from quantity theory identities.

One possibly unintended consequence of the Shadow RBA Board will be to hold it members accountable for their policy prescriptions. Having confidently announced in a press release that ‘the current interest rate is at the correct level,’ it will now be more difficult for members of the Shadow RBA Board to retrospectively criticise the stance of monetary policy. Unlike the US and UK shadow policymaking bodies, the Shadow RBA Board may find themselves locked-in to defend the official policy position.

posted on 29 August 2011 by skirchner in Economics, Monetary Policy

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Why Raising the US Debt Ceiling Was a Mistake

I have an article at The Conversation arguing that failure to raise the US debt ceiling need not have led to sovereign debt default:

It was the failure of US politicians to acknowledge the policy implications of long-run budget sustainability that decided the recent ratings action by Standard & Poor’s. Failing to raise the debt ceiling would not have led to debt default if US politicians had taken the necessary decisions to put the budget on a sustainable footing. Raising the debt ceiling kicks the problem down the road and creates the risk of a far more serious fiscal crisis in future.

A fiscally responsible US president would have joined with responsible members of Congress in refusing to sign a further increase in the debt ceiling. The Obama administration could have used the unthinkable prospect of debt default to force spendthrift members of Congress to reduce government spending and stabilise expectations for the future path of net debt that are currently weighing on economic growth.

Congress and the Administration know that if they lead the US to default on its obligations, the American people will sweep them from office. For politicians, incentives don’t come much stronger than that.

My CIS colleague Adam Creighton has been making similar points in Crikey, although I’m far better disposed towards quantitative easing than he is.

See also Jonah Goldberg, Wake Up and Smell the Tea.

posted on 10 August 2011 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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In Defence of Fractional Reserve Banking

George Selgin defends fractional reserve banking against the fever swamp Austrians:

Free bankers have tried responding to this argument by noting how fractional reserve banking has prevailed under every sort of bank regulatory regime, from the earliest beginnings of banking, not excepting regimes that involved very little regulation, like those of Scotland, Canada, and Sweden, and that lacked even a trace of government guarantees or other sorts of artificial support.  But since some 100-percenters seem unmoved by this approach, I here take a different tack, which consists of pointing out that every significant 100-percent bank known to history was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions. Yet despite the special support they enjoyed, and their solemn commitments to refrain from lending coin deposited with them, they all eventually came a cropper. What’s more, it was these government-sponsored full-reserve banks, rather than their private-market fractional reserve counterparts, that were the progenitors of later central banks, starting with the Bank of England.

posted on 01 June 2011 by skirchner in Economics, Monetary Policy

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What Would Friedman Do IV?

Yes, Friedman would do QE. A new paper from Ed Nelson:

This paper views the policy response to the recent financial crisis from the perspective of Milton Friedman’s monetary economics. Five major aspects of the policy response are: 1) discount window lending has been provided broadly to the financial system, at rates low relative to the market rates prevailing pre-crisis; 2) the Federal Reserve’s holdings of government securities have been adjusted with the aim of putting downward pressure on the path of several important interest rates relative to the path of short-term rates; 3) deposit insurance has been extended, helping to insulate the money stock from credit market disruption; 4) the commercial banking system has received assistance via a recapitalization program, while existing equity holders have borne losses; and 5) an interest-on-reserves system has been introduced. These five elements of the policy response are in keeping with those that would arise from Friedman’s framework, while a number of the five depart appreciably from other prominent benchmarks (such as the Bagehot-Thornton prescription for discount rate policy, and New Keynesian approaches to stabilization policy). One notable part of the policy response, the TALF initiative, draws largely on frameworks other than Friedman’s. But, in important respects, the overall monetary and financial policy response to the crisis can be viewed as Friedman’s monetary economics in practice.

posted on 30 May 2011 by skirchner in Economics, Monetary Policy

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Fed Glasnost: Australia’s Media Shouldn’t Settle for Less

If it’s good enough for Ben Bernanke, it’s good enough for Glenn Stevens:

Next Wednesday, Federal Reserve Chairman Ben Bernanke will do something no Fed chief has done before: Stand before a room full of journalists after officials conclude a policy meeting and answer questions about the central bank’s decisions…

Fed officials have been preparing carefully, according to people familiar with the process. Mr. Bernanke spent a recent weekend watching videos of European Central Bank President Jean-Claude Trichet and Bank of England chief Mervyn King, parrying reporters’ questions at their regular press conferences.

In February, on the sidelines of a meeting of financial officials in Paris, Mr. Bernanke quizzed Mr. Trichet and other European central bankers on how they manage their press conferences. He’ll do dress rehearsals, with staffers peppering him with questions, as the briefing nears.

Mr. Bernanke’s staff, meanwhile, has spent weeks scripting the mechanics of how the press conference will work.

He will hold his briefing in a big top-floor conference room at the Fed’s Martin building, opposite the central bank’s main cafeteria, where Mr. Bernanke can sometimes be found wandering, tray in hand, to chat with staffers…

In the past month alone, 16 different Fed policy makers have given more than 40 formal addresses, in addition to television, newspaper and newswire interviews. They espouse different views, not only on when to reverse the Fed’s easy-money policies, but how.

As I noted in this op-ed, post-Board meeting and post-CPI press conferences by the RBA Governor would change for the better the media dynamics around inflation and interest rates in Australia.

posted on 21 April 2011 by skirchner in Economics, Monetary Policy

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What Caused the Housing Boom of the 2000s?

Not monetary policy.

posted on 13 April 2011 by skirchner in Economics, House Prices, Monetary Policy

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