Working Papers

2007 06

Bong Hits 4 Bollard

The RBNZ has issued an op-ed style article designed to explain its intervention in foreign exchange markets.  The article signals a departure from the RBNZ’s usual standards of openness and transparency, stating that:

Foreign exchange intervention is an ongoing process and the Bank will not be commenting publicly on its specific intervention activities.

Instead, analysts will have to rely on the RBNZ’s financial accounts to infer the scale of intervention.  This lack of transparency from the RBNZ is counter-productive, since the Bank is denying itself the benefit of an announcement effect when it intervenes.  Since the first intervention on June 11, market participants have only been guessing at whether the RBNZ is in the market.  For example, the RBNZ was rumoured to be selling in New York trade last Friday, although you would be hard pressed to discern this from the price action in NZD.

The statement argues that:

Intervention operates at the margin, affecting the balance of demand and supply for the New Zealand dollar. It can have an immediate downward impact on the exchange rate as it did on 11 June. That can help to moderate the ‘peaks’ in the exchange and the length of time we spend at peak levels. It does not attempt to defend a particular level of the exchange rate. Rather it sends a signal that, in the Bank’s view, the exchange rate is out of alignment with the economic fundamentals. Those speculating in the New Zealand dollar need to be aware that the exchange rate is not a one-way bet; they need to be cautious.

The statement neglects to mention that both NZD-USD and the NZD TWI are now significantly higher than they were when the RBNZ first intervened on June 11.  The ‘immediate downside impact’ is proving very short-lived.  Adding another seller to what is a reasonably deep and liquid market does not significantly change the price dynamics for the NZD.  Most traders see RBNZ intervention as an opportunity to get set at better levels rather than a significant downside risk to the currency.

The RBNZ is correct in noting that RBNZ intervention is not constrained by its ability to supply New Zealand dollars, contrary to media reports that erroneously suggested that the RBNZ’s foreign exchange reserves are a constraint.  But RBNZ intervention is effectively constrained by the current stance of monetary policy.  The RBNZ has sought to argue that intervention is both independent from, but complementary with, monetary policy.  But it should be obvious that the RBNZ’s intervention to sell the NZD is at cross purposes with the current stance of monetary policy.

Walter Bagehot once said in relation to capital inflows that ‘eight percent will bring gold from the moon.’  With an official cash rate of 8.00% and threatening to go higher, the RBNZ will face an uphill battle containing further NZD appreciation through intervention.

posted on 27 June 2007 by skirchner in Economics, Financial Markets

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Austrianism or Agnosticism at the BIS?

The WSJ’s Greg Ip claims that:

Although the concluding chapter of the BIS’s latest annual report, released Sunday, never mentions the Austrian school, it is suffused with its influence.

My own reading of it would suggest that it is studiously agnostic on most issues.  We have previously had occasion to ridicule the notion of the BIS as a home of Austrian School thinking.  Greg Ip says that:

The BIS’s leading “Austrian” is a Canadian, William White, the head of the bank’s monetary and economic department and sometimes-rumored successor to retiring Bank of Canada governor David Dodge.  In a 2006 paper Mr. White wrote that under Austrian theory, “credit creation need not lead to overt inflation. Rather…. the financial system … create[s] credit which encourages investments that, in the end, fail to prove profitable.” This leads to an “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it [because] the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.” He argued that in recent decades, “financial liberalisation has increased the likelihood of boom-bust cycles of the Austrian sort.”

As we noted when it was released, White’s paper was little more than Bretton Woods revivalism dressed-up in Austrian clothes.  The notion that Austrian business cycle theory provides a basis for a revival of Bretton Woods institutions and central bank targeting of asset prices is absurd, but it is not hard to understand why these conclusions might appeal to a central banker.

There is little evidence to support Austrian business cycle theory as even a stylised account of business cycle and financial market dynamics, at least under current central bank operating procedures in the major industrialised countries, which have been dominated by interest rate and inflation targeting for at least the last 10 years. 

The Taylor rule and related literature shows that it is much easier to explain monetary policy with reference to the economy than it is to explain the economy with reference to monetary policy.  This is just another way of saying that monetary policy for the most part responds endogenously to economic developments and the exogenous component of monetary policy is very small.  Anyone who has tried to motivate a role for official interest rates in standard economic models (the sort of empirical work that few would-be Austrians are prepared to undertake) knows what a problematic exercise this can be.  Growth in money and credit aggregates can be given a similar endogenous interpretation.

This makes the claim that, but for the supposed monetary policy errors of central banks, the amplitude of business and asset price cycles would be greatly reduced extremely implausible, at least under contemporary interest rate/inflation targeting regimes.  Indeed, we know that under the gold standard, the preferred monetary regime for many Austrians, volatility was more pronounced, with inflexibility in prices and exchange rates simply forcing any adjustment on to the real side of the economy.

The increased prominence of Austrian business cycle theory in popular discourse actually has profoundly anti-market implications, because it leads people to believe that there is something wrong with macroeconomic and financial market outcomes that are in fact largely market-determined and have very little to do with either monetary policy or asset price ‘bubbles.’

posted on 26 June 2007 by skirchner in Economics, Financial Markets

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Depression Era Exchange Rate Regimes

Amity Shlaes, on exchange rate policy under Roosevelt:

At some points Roosevelt seemed to understand the need to counter deflation. But his method for doing so generated a whole new set of uncertainties. Roosevelt personally experimented with the currency—one day, in bed, he raised the gold price by 21 cents. When Henry Morgenthau, who would shortly become Treasury Secretary, asked him why, Roosevelt said that “it’s a lucky number, because it’s three times seven.” Morgenthau wrote later: “If anybody ever knew how we set the gold price through a combination of lucky numbers, etc., I think they would be frightened.”

You can hear Amity talk about her new book, The Forgotten Man: A New History of the Great Depression, in this podcast.


posted on 25 June 2007 by skirchner in Economics

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Gordon Brown Wants You for the BoE MPC

Outgoing Chancellor of the Exchequer Gordon Brown wants to advertise for new members for the Bank of England’s Monetary Policy Committee:

Gordon Brown yesterday bowed to pressure to reduce the secrecy surrounding appointments to the Bank of England’s rate-setting body by pledging to advertise the positions.

Making his final appearance before the Treasury select committee as chancellor, the prime minister-elect said he would invite “expressions of interest’’ from economists and other experts for the four outside appointments to the nine-member monetary policy committee.

The advertisements would be more specific about the criteria and skills the Treasury was looking for than under current rules, he said, amid fears that under-qualified people might be appointed.

Last year, four former MPC members raised concerns that Mr Brown might have received advice to appoint a non-economist to replace Stephen Nickell, an economics professor who now heads Nuffield College, Oxford.

The House of Lords’ economic affairs committee last year described the appointments process as one which was “shrouded in mystery and may not always recommend the most suitable candidates”.

Mr Brown also pledged to lay out a timetable for appointments. Mervyn King, Bank governor, has criticised the Treasury for a “very informal” approach resulting in appointments being made “very much at the last minute” instead of in a “timely” fashion.

In Australia, we know all about timely appointments of qualified persons to the Board of the Reserve Bank.

posted on 18 June 2007 by skirchner in Economics, Financial Markets

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How to Beat Warren Buffett

It’s as easy as investing in Australian banks:

Research from global consulting firm Stern Stewart, commissioned by The Australian, shows the banks beat Buffett in terms of total shareholder return (share price growth plus dividends) over one, three, five, 10 and 15 years.

posted on 16 June 2007 by skirchner in Economics, Financial Markets

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Never Mind the Incandescent Light Bulbs

From RBA Governor Glenn Stevens’ speech in Brisbane today:

One recent study suggests that, based on the experience of most other countries which have made that transition, the number of motor vehicles owned in China would be expected to rise from 20 million in 2002 to almost 400 million by 2030. That would be equivalent to nearly 50 per cent of the vehicles in the world today.


posted on 14 June 2007 by skirchner in Economics

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Fertility and the Exchange Rate

Fertility has been a long-standing preoccupation of the authorities in Singapore, so it is perhaps not surprising that the Monetary Authority of Singapore should examine the links between fertility and the exchange rate:

We use a quinquennial data set covering 87 countries between 1975 and 2005 to investigate the relationship between fertility and the real effective exchange rate.  Theoretically a country experiencing a decline in its fertility rate can be expected to have higher savings, lower investment, a current account surplus, and accordingly a real depreciation.  We test and confirm this hypothesis, controlling for a host of potential determinants such as PPP deviations and the Balassa-Samuelson effect.  We find a statistically significant and robust link between fertility and the exchange rate.  Our point-estimate is that a decline in the fertility rate of one child per woman is associated with a depreciation of approximately .15% in the real effective exchange rate.

The number of births in Australia in the year-ended December 2006 was the highest in 35 years, while the real effective exchange rate in Q4 2006 was the highest since Q1 1985.

posted on 12 June 2007 by skirchner in Economics, Financial Markets

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RBNZ Monetary Policy Now Formally at War with Itself

The Reserve Bank of New Zealand today went from the sublime to the ridiculous, intervening in foreign exchange markets to sell the NZ dollar.  On Friday, NZD-USD reached its highest level since May 1982 at 0.7640, following last week’s decision by the RBNZ to raise official interest rates to 8.00%. RBNZ Governor Bollard said that:

As stated in our June Monetary Policy Statement, we regard current levels of the exchange rate as exceptional and unjustified in terms of the economic fundamentals.  This action does not prejudge the future direction of monetary policy, which as always will remain dependent on emerging economic trends.  The action is consistent with clause 4(b) of the Policy Targets Agreement, which requires monetary policy to avoid unnecessary instability in the exchange rate.

The claim that the NZD is over-valued in the current environment only makes sense if one believes that there is a much broader misalignment in multilateral exchange rates.  The NZD’s dollar bloc peers, the Australian and Canadian dollars, are also making 18 and 30-year highs respectively.  The NZD is in fact responding to fundamentals largely of the RBNZ’s own making.  The exchange rate is “exceptional by historical standards” because the RBNZ’s official cash rate is also at record highs and threatens to go higher. 

RBNZ monetary and exchange rate policy are now formally working at cross-purposes, with the RBNZ raising interest rates on the one hand, while seeking to offset the implications of higher interest rates through intervention in foreign exchange markets on the other. 

The RBNZ has historically taken a laissez-faire approach to the exchange rate.  But after Bollard became Governor, he sought a re-capitalisation of the Bank to facilitate intervention in foreign exchange markets.  So far, the intervention has been a failure, with NZD-USD still holding above levels that prevailed before last week’s tightening.  This is despite the intervention being timed to capitalise on thin market conditions brought about by a public holiday in Australia.  While there is no technical limit on the ability of a central bank to weaken its own currency, this is only possible when monetary and exchange rate policy work together.  When monetary and exchange rate policy are at cross-purposes, it is monetary policy that invariably wins. 

Far from reducing volatility in the exchange rate, RBNZ intervention in the foreign exchange market will only serve to increase it.  In recent years, NZ monetary policy has become increasingly incoherent.  The RBNZ’s Statements on Monetary Policy, once a model for central banks around the world, increasingly have an Alice in Wonderland quality, with the RBNZ making key operating assumptions about the exchange rate and its relationship with monetary policy that simply have no credibility.

posted on 11 June 2007 by skirchner in Economics, Financial Markets

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Turnbull and Costello

The Labor Party continues its selective leaking of its internal research, which Glenn Milne seizes upon with barely disguised glee:

ONE of the finest political demographers on either side of politics has spelled out for the first time the brutal arithmetic that suggests Malcolm Turnbull is facing inevitable defeat if he stays in the seat of Wentworth—a scenario that means he will never be leader of the Liberal Party or prime minister.

It is a non-sequitur to say that defeat in Wentworth ‘means he will never be leader of the Liberal Party or prime minister.’  But it is true that Wentworth is a marginal seat, even with the effective margin of 4.5% suggested by the Labor Party’s research, which is larger than the 2.6% margin based on the 2004 federal election result and subsequent redistribution. 

Turnbull’s fate is tied in with that of the government as a whole.  Post-war experience suggests that only very large two-party preferred swings are sufficient to ensure that enough seats change hands to change the government.  Turnbull will likely retain Wentworth if the government is returned, but lose if the government loses office. 

Like many others, Milne probably hasn’t given much thought to the implications of a change of government for the leadership of the federal parliamentary Liberal Party.  It is hard to imagine Peter Costello having the stomach for the job of opposition leader.  Even as Treasurer, he complains bitterly about the opportunity cost of the job and this cost will rise dramatically in opposition.  Costello could be expected to decline the leadership and leave politics shortly thereafter.  In a contest of frustrated ambition, Costello would be a clear winner.

posted on 11 June 2007 by skirchner in Politics

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Mundell’s Long View on the US Dollar

Nobel laureate Robert Mundell’s long view on the big dollar:

HONG KONG—As the audience at the Asia Society’s May gala dinner here sips their coffee, the moderator allows one more question from the audience for Nobel economics laureate Robert Mundell. A Chinese gentleman stands to ask how much longer the U.S. dollar would remain the world’s reserve currency. The query seems like the perfect set-up for the world’s foremost expert on monetary policy and a well-known “friend of China” to predict the rise to pre-eminence of China’s currency.

Instead, Mr. Mundell says that China is still far behind the U.S. in economic strength and stability. “I think the dollar era is going to last a long time . . . perhaps another hundred years.”

Nouriel Roubini’s worst nightmare.

posted on 09 June 2007 by skirchner in Economics, Financial Markets

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Deregulating Prediction Markets

Andrew Leigh and Justin Wolfers call for the deregulation of prediction markets in their Melbourne Review article:

In Australia, the legal environment has prevented prediction markets from establishing themselves in most States. In addition, there is a concern that, for major bookmakers such as Centrebet, trading on economic derivatives would bring them into conflict with the Australian Stock Exchange and the Australian Futures Exchange. Since Australian betting agencies already handle significant sums of money for elections and major sporting events, relaxation of the regulation governing such markets would bring little risk but a significant public benefit.

Unfortunately, the (now merged) ASX and SFE would probably resist the expansion of prediction markets.  Given the SFE’s failure to generate interest in many of the futures contracts it offers, it is hard to imagine it being very enthusiastic about increased competition from new prediction markets offering new products.  As in the US, incumbent exchanges and gaming interests, as well as restrictions on cross-border financial transactions, are likely to stand in the way of further development of prediction markets.

posted on 08 June 2007 by skirchner in Economics, Financial Markets

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Rudd Gets the Mackerras Kiss of Death

One of our favourite political contrarian indicators is ringing alarm bells:

FUTURE history books will note that John Howard was one of two prime ministers (the other being Ben Chifley) whose governments were defeated as a consequence of abusing Senate power, one of two (the other being Stanley Bruce) to lose his own seat at the general election defeat and one of two (the other being Robert Menzies) to serve 10 years in the top job.

Mackerras’ enthusiasm for writing history before it has actually happened is matched only by his enthusiasm for the past:

I remember 1950 as though it were yesterday.

Of course, some of us also remember 2004:

”[Mackerras] pendulum swings to Kerry landslide” (The Australian, 1 November 2004).


posted on 08 June 2007 by skirchner in Politics

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Data in the Eye of the Beholder

James Hamilton notes that everyone is playing the ‘I told you so game,’ but the one person whose view really matters stands out as being right:

It is curious that both bulls like Dave Altig and bears like Barry Ritholtz and Nouriel Roubini are pointing to the recent data to say “I told you so.” Here’s Nouriel’s take:

“a hard landing can take two forms: a growth recession (i.e. a period when growth is well below potential and ranging in the 0% to 1% range) or an outright recession (i.e. negative growth). Thus, in Q1 of this year the US entered in a growth recession, and a pretty serious one indeed.”

I find that perspective interesting, since slow growth for the start of 2007 is exactly what people like Dave and I had been expecting all along, and indeed is precisely what the Fed has been aiming for. Bernanke’s program from day one, in my opinion, has been to slow growth down sufficiently so as to contain inflation, but not go so far as to produce a recession. The latter phenomenon has a very clear and unambiguous data signature, including such features as a spike in the unemployment rate and significant declines in real GDP.

That may yet come, but let’s be clear—you can’t declare it to have started yet on the basis of the data currently in hand. If anybody wants to crow “I told you so,” in my opinion the one person who could legitimately claim that right would be Ben Bernanke.

The Hamilton emoticon indicator has yet to turn, but my associates at Action Economics remain upbeat.  You can hear Action Economics Chief Economist Mike Englund talk about the US outlook in this Bloomberg podcast.

posted on 02 June 2007 by skirchner

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