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The Financial System Inquiry and Macro-Pru

I have an op-ed in Business Spectator endorsing the sceptical approach to macro-prudential regulation taken in the Murray inquiry’s interim report:

Macro-prudential policies are seen as providing policymakers with a more targeted set of policy instruments that might complement or even substitute for changes in official interest rates. However, these instruments also implicate policymakers in making much finer judgements about risks to financial stability as well as the more traditional concern of monetary policy with price stability.

A blunt instrument like monetary policy encourages caution in making such judgements. By contrast, more targeted counter-cyclical quantitative controls are a standing invitation to micro-manage credit allocation, but do not in themselves improve the ability of policymakers to make appropriate judgements about the implications of such policies. It can also create a false impression that a central bank’s price stability mandate has been subordinated to other objectives, such as house price inflation.

Macro-prudential policies are also more politically fraught than traditional monetary policy. Quantitative controls designed to be selective in impact are more likely to provoke opposition. In Britain, macro-prudential policies are at cross-purposes with the government’s ‘Help to Buy’ mortgage guarantee scheme. Macro-prudential regulation is often a second-best approach to dealing with the inflationary implications of supply-side rigidities in housing markets. It may also push borrowing and lending activities outside the regulatory perimeter altogether.

posted on 25 July 2014 by skirchner in Economics, Financial Markets

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Rent or Buy: Does it Matter?

A RBA Research Discussion Paper on whether Australian housing is over-valued attracted considerable media attention. The (unsurprising) bottom-line was that Australian housing is currently fairly valued based on the user-cost approach, but that the average household might be better off renting now if, ‘as many observers have suggested,’ future real house price growth is less than the historical annual average rate of around 2.5% since 1955.

As it turns out, the ‘many observers’ actually referenced in the paper are the RBA itself, which makes one wonder whether the RDP’s conclusion is part of the RBA’s broader jaw-boning effort directed at expectations for future house price appreciation.

In fact, the RBA’s RDP makes an excellent case for the view that we should be indifferent between renting or buying ex ante. The user costs of owner-occupation and renting are subject to a long-run equilibrium relationship. The RBA’s RDP shows how close this relationship has been historically using matched data on house prices and rents, despite some short-run volatility. In principle, one could use deviations from this equilibrium relationship to profitably arbitrage the user cost of owner-occupation and renting, but it is likely that these deviations reflect the transaction costs associated with buying/selling and moving. The deviations arise precisely because this arbitrage is difficult in practice.

So don’t sweat on the rent-buy decision.

posted on 17 July 2014 by skirchner in Economics, House Prices

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Eight Housing Affordability Myths

Eight Housing Affordability Myths, Issue Analysis 146, Centre for Independent Studies, Sydney, July 2014.

posted on 09 July 2014 by skirchner

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Eight Housing Affordability Myths

I have published a new Issue Analysis with the Centre for Independent Studies, Eight Housing Affordability Myths. In the paper, I show how a number of highly persistent myths about the nature of housing markets, the dynamics of house prices and the drivers of housing affordability condition public policy to focus on excessively on housing demand at the expense of housing supply.

posted on 09 July 2014 by skirchner in Centre for Independent Studies, Economics, Foreign Investment, House Prices

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Is John Edwards a Ricardian?

John Edwards’ ‘Beyond the Boom’ is a welcome follow-up to his 2006 ‘Quiet Boom’, which I reviewed at the time in conjunction with Ian Macfarlane’s Boyer Lectures.

I agree with the argument that economic reform should not be sold on the basis of a faux crisis or economic failure narrative. If proposed reforms are worth doing they are worth doing regardless of where we sit in relation to the business cycle or the budget outlook.

John notes that households saved the Howard government’s tax cuts and that household saving would have been lower in their absence. This is an important observation, because it demonstrates the private saving offset to changes in public saving. Possibly to spare his readers the jargon, John didn’t mention this as an example of Ricardian equivalence, but it is clearly relevant here. I made much the same argument at the time.

It is perhaps worth noting that John was rather more sympathetic to tax cuts in ‘Quiet Boom,’ where he says that:

It may well be worthwhile to reduce the top marginal income tax rate, or to encourage more workforce participation by older Australians or to increase the incentives to move from social security support to paid employment.

Those arguments remain valid, regardless of the state of the budget. While balancing the budget over time is important, this should not come at the cost of reducing incentives for labour market participation.

John also notes that during the financial crisis, the increase in private sector saving more than offset the decrease in public sector saving from the fiscal stimulus. He doesn’t mention that this is at odds with the dominant narrative around the stimulus, which is that it worked because we ‘went early, went large and went households.’ If the stimulus worked, John’s analysis implies that it was not through household consumption spending. I would like to have seen John spell out these implications in more detail (my take is here).

John maintains we should limit the current account deficit to 3.3% of GDP to contain growth in external liabilities. This is close to the average since 1960 and so is certainly achievable based on historical experience. However, in ‘Quiet Boom’ John shows how conditioning macro policy on a view about the appropriate size of the current account deficit got us into a lot of trouble. Tim Geithner’s attempt to get the G20 to sign up to a 4% of GDP limit on current account imbalances was similarly mistaken in my view. We cannot know in advance the appropriate rates of saving and investment, from which it follows that the appropriate current account deficit is also unknown.

John maintains that the government has a revenue rather than a spending problem, but this is necessarily a joint problem. The normative issue is to define what government should be doing and raise revenue accordingly.  In that sense, the expenditure side is analytically prior to the revenue side, regardless of what is driving changes in the budget balance over any given period. The test both revenue and expenditure measures need to pass is whether they improve incentives to work, save and invest. Higher average tax rates do not pass that test and would be at odds with the aims of the tax reform process and raising labour force participation. Balancing the budget is important, but should not come at the expense of microeconomic incentives. Balancing the budget and stabilising net debt as a share of GDP will be a somewhat hollow achievement if it comes at the expense of a smaller economy that yields less revenue for government in absolute terms.

John is spot on in arguing that Australia’s economic future lies in integration with Asia through trade in services. I would add that there are even larger gains to be had through increased trade in capital and labour. Regional free trade agreements will be important in defining the parameters of our engagement and deserve close attention from policymakers. The G20 would do well to focus on the successful conclusion of regional and multilateral trade deals.

Alex Tabarrok says the Reserve Bank deserves a lot of credit, but I do not think we can attribute Australia’s relative economic outperformance to the conduct of monetary policy. Australia adopted inflation targeting along with the rest of the world. Australia’s senior central bankers largely trained in north America and think much like Ben Bernanke. It cannot be said Australia followed a different intellectual approach or that we know something foreign central bankers do not.

At the onset of the crisis, CPI inflation was running at an annual rate of 5%, nominal GDP at 11% and inflation expectations were coming unhinged. In the absence of a global downturn, the RBA would probably have needed to engineer a severe domestic slowdown to bring inflation back to target. In that sense, the downturn in the world economy did the RBA a favour. Monetary policy is neutral in the long-run, so I don’t think we can give the central bank too much credit for a 23 year expansion.

posted on 03 July 2014 by skirchner in Economics, Monetary Policy

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The 2014 Budget and Monetary Offset

The 2014 Budget is notable for its explicit rejection of monetary offset. According to the government’s fiscal strategy, ‘the pace of fiscal consolidation balances the need for structural fiscal repair with the shorter term impact on the economy.’ Yes, the government still thinks it is in the business of aggregate demand management.

As I have argued in more detail here, this misunderstands the role of fiscal policy in the economy. With an inflation targeting central bank and a floating exchange rate, fiscal policy need not concern itself with demand management. Interest rates and the exchange rates can carry most of the required adjustment to reduced government spending.

The Abbott government proposes a four percentage point turnaround in the budget balance over 10 years.

By way of comparison, the Hawke government’s ‘trilogy’ of fiscal rules led to a fiscal consolidation of similar magnitude in five years during the mid- to late-1980s. The combined efforts of the Keating and Howard governments turned a deficit of 4% of GDP in 1993-94 into a balanced budget by 1997-98 (using today’s measures). These turnarounds were as much cyclical as discretionary, but this only serves to demonstrate that the economy is more important for the budget than the budget is for the economy.

The US has seen a sharp turnaround in its budget deficit from 10% to 4% of GDP over four years, including the sharpest decrease in federal spending since World War Two, without inducing an economic slowdown, because of accommodative monetary policy. As Scott Sumner has argued, it is hard to conceive a better test of monetary offset.

The Abbott government has thus conditioned its fiscal strategy on the same mistaken understanding of the role fiscal policy in the economy that informed the Rudd government’s fiscal stimulus of 2008-09.

posted on 14 May 2014 by skirchner

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ECB to Adopt QE in H2 2014

I have an op-ed in Business Spectator arguing that the ECB will likely resort to QE in the second half of this year. This will be a vindication of the long-standing criticisms of ECB monetary policy made by the new market monetarists. Inflation outcomes, nominal GDP and the euro exchange rate are all consistent with monetary policy having been too tight rather than too easy. The emerging divergence between ECB/BoJ and Fed monetary policy should set the stage for broad-based USD outperformance.

posted on 11 April 2014 by skirchner in Economics, Financial Markets, Monetary Policy

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Do Financial Markets Care About the G20?

An ECB Working Paper looks at the impact of G20 meetings on financial markets:

In this paper we run an event study to test whether G20 meetings at ministerial and Leaders level have had an impact on global financial markets. We focus on the period from 2007 to 2013, looking at equity returns, bond yields and measures of market risk such as implied volatility, skewness and kurtosis. Our main finding is that G20 summits have not had a strong, consistent and durable effect on any of the markets that we consider, suggesting that the information and decision content of G20 summits is of limited relevance for market participants.

That won’t stop the Australian federal government spending $500 million on a process markets have deemed an irrelevance.

posted on 05 April 2014 by skirchner in Economics, Financial Markets

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Bob Shiller, Ex-Ante and Ex-Post

Scott Sumner has a nice comparison of Robert Shiller’s investment advice with that from one of my favourite supply-side economists, Alan Reynolds. Loyal readers of this blog will not be surprised to see that Scott’s post has my name all over it.

Scott asks, ‘Can people find me the dates where Shiller recommended people buy stocks?’

Sure. In his 2009 book with George Ackerlof, Shiller wrote: ‘there has been one way, at least in the past, in which almost everyone could become at least moderately rich … Invest it for the long term in the stock market, where the rate of return after adjustment for inflation has been 7% per year’ (p. 117).

Unfortunately, Shiller’s ex-post observations on stock market returns in 2009 do not sit well with his ex-ante prediction in 1996: ‘long run investors should stay out of the market for the next decade.’

posted on 25 March 2014 by skirchner in Economics, Financial Markets

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Scapegoating Foreigners for Domestic Policy Failures in Housing

I have an op-ed in the SMH on foreign direct investment in the Australian housing market noting that foreigners are being used as scapegoats for what are really domestic policy failures. The House Economics Committee will now inquire into the issue:

According to committee chair Kelly O’Dwyer, the inquiry will consider whether the current restrictions on foreign investment in residential real estate serve to increase supply, as is their stated intention, or raise prices.

This is rather like asking whether foreign tourists increase the production of goods and services or raise consumer prices. The answer depends on how flexibly Australian producers can accommodate changes in foreign as well as local demand through increased output.

It is pointless blaming foreigners for inflexible elements on the supply-side of the Australian economy. For that, we should blame local politicians.

Ironically, the inquiry could result in a bringing forward of foreign demand in anticipation of increased controls on FDI in residential real estate. The inquiry should recommend the abolition of the existing controls on FDI in real estate. My guess is the Committee will instead recommend extra conditions be attached to FIRB approvals, along with some additional quantitative controls.

I am also quoted in this story in today’s AFR on anti-dumping measures on imported tomatoes.

posted on 20 March 2014 by skirchner in Economics, Foreign Investment, Free Trade & Protectionism

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Regulating Foreign Direct Investment in Australia

Regulating Foreign Direct Investment in Australia: Discussion Paper, Financial Services Institute of Australia (FINSIA), February 2014.

posted on 02 March 2014 by skirchner

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Finsia Industry Lunch Forum on FDI Regulation

I will be speaking at a Finsia Industry Lunch Forum on the regulation of foreign direct investment on 28 February. Other speakers include Ian Harper, Anthony Latimer and Tony Mahar. Details and registration here.

UPDATE 28 February: A write up of my presentation by David Uren. Finsia discussion paper here.

posted on 14 February 2014 by skirchner in Foreign Investment

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‘Australian of the Year’ as Contrarian Sell Signal

In January 2010, The Australian named then Prime Minister Kevin Rudd as ‘Australian of the Year’ ‘because of the way he dealt with the global financial crisis’. From affiliate EWI’s 2014 State of the Global Markets Report:

We correctly called the award a sell signal for Australian stocks - the All Ords would make no net progress for the next three-and-a-half years.

posted on 30 January 2014 by skirchner in Financial Markets

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Nina Munk on Jeff Sachs

Nina Munk’s summation in her Econtalk interview is not at all surprising, but no less devastating for that:

they were now really living in a kind of squalor that I hadn’t seen on my first visit. Their huts were jammed together; they were patched with those horrible polyurethane bags that one sees all over Africa, covered in sort of burlap bags and sort of plastic tarps from the UN refugee service. There were streams of slop that were going down between these tightly packed huts. And the latrines had overflowed or were clogged. And no one was able to agree on whose job it was to maintain them. And there were ditches piled high with garbage. And it was just—it made my heart just sink. And I thought to myself: You know what, Jeffrey Sachs? You came to this village once. That’s not true. I think he came a second time in a helicopter the second time. He’s been to that village twice. And on both times he was received like a welcoming monarchy. All the people come out to greet him, and the local officials come out in their best Sunday suit. And everyone’s out there giving grand speeches on a microphone, and they sing songs and they dance for him and they thank him and they praise him and they pray for him. But you know, when you leave and you go back home to your townhouse on the upper west side of Manhattan and you return back to your comforts, you know, these people are left really with nothing. With nothing. And arguably they are left with something that is more dismal and worse than it was before he tried to impose his ideas of progress on them.

posted on 30 January 2014 by skirchner in Economics

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House Prices Up, Time to Blame Negative Gearing

I have an op-ed in today’s Australian beating the housing supply drum at the expense of the anti-negative gearing brigade. In particular, I address the argument that demand for investment property is largely met through existing rather than newly built dwellings:

This reflects the fact that the flow of new houses is small relative to the existing dwelling stock. But it is about as relevant as noting that investors in the stockmarket mostly buy already held rather than newly issued shares. It is only supply-side constraints that prevent demand for existing dwellings from inducing new construction.

Negative gearing is first and foremost a tax policy issue and should be addressed as such as part of a broader tax reform effort. I could live with the Henry review’s proposed discount for income derived from saving, although ideally it would be much larger than his suggested 40%.

posted on 22 January 2014 by skirchner in Economics, House Prices

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De-Risking the RBA

I had an op-ed in the AFR over the break on the federal government’s injection of funds into the RBA’s Reserve Fund. The article notes that the public policy issue is not the subtraction from the budget bottom line from the injection, but whether the benefits of holding foreign exchange reserves are worth the risk of potential valuation losses and forgone income on higher yielding domestic assets. Foreign exchange reserves are not necessary for the effective conduct of monetary and exchange rate policy in Australia. An alternative policy approach is to hold smaller reserves. Full text below the fold (may differ slightly from published AFR text).

Hockey Loads the RBA’s Guns

When Treasurer Joe Hockey announced an $8.8 billion injection of funds into the Reserve Bank’s Reserve Fund, he said that the RBA needed ‘all the ammunition in the guns for what’s before us.’ The purpose of the Reserve Fund is to cover potential valuation losses on the RBA’s $46 billion in foreign exchange reserves. Yet Hockey’s language could also be interpreted as priming the Reserve Bank for possible future intervention in foreign exchange markets to influence the value of the Australian dollar.

The government’s Mid-Year Economic and Fiscal Outlook stated that the injection ‘will enhance the Reserve Bank’s capacity to conduct its monetary policy and foreign exchange operations.’

The public policy issue is not the subtraction from the budget bottom line. The Reserve Bank is part of the public sector and pays dividends to the government based on its underlying earnings and realised gains or losses on its portfolio of assets, less its expenses.

The Reserve Bank’s conduct of monetary policy and portfolio management have implications for the size of the RBA dividend from one year to the next, but these are very much secondary to the objectives of monetary policy and the Reserve Bank’s other functions.

The issue for public policy is the extent to which the risks associated with holding foreign exchange reserves are necessary for the effective conduct of monetary and exchange rate policy.

An alternative policy approach to dealing with potential valuation losses arising from swings in the value of foreign exchange reserves is to re-risk the RBA’s balance sheet by holding smaller reserves.

A central bank’s solvency is not generally an issue, not least because its balance sheet is denominated in its own (ultimately irredeemable) monetary liabilities and taxpayers stand behind any losses.

The balance sheet is not a constraint on its ability to conduct monetary policy. Indeed, central bank balance sheet expansion has been a vital tool underpinning the ability of monetary policy in other countries to respond to the deflationary shock emanating from the global financial crisis.

While excessive balance sheet expansion could be inflationary, the bigger problem in the context of the global financial crisis has been the reluctance of foreign central banks to make even greater use of the quantitative policy instruments available to them.

Although a severe global deflation was averted, inflation in the advanced economies generally remains very low in the wake of the crisis. This implies that monetary policy has not been especially expansionary, either in Australia or abroad, despite frequent commentary to the contrary.

The RBA’s foreign exchange reserves are a constraint on its ability to hold the exchange rate above its market-clearing value, but this is not a problem for a country with a floating exchange rate. While the RBA occasionally intervenes to support the Australian dollar, it would not do so in the expectation of being able to hold the exchange rate significantly above it market-clearing level for any length of time. This would be an open invitation for a speculative attack on the RBA’s finite foreign exchange reserves. The most the RBA could hope for is to temporarily introduce two-way risk into the market when it might otherwise be absent.

By contrast, there is no in-principle limit on the ability of a central bank to weaken the exchange rate, although it needs to be mindful of the inflationary implications. Foreign exchange reserves are not necessary to weaken the exchange rate, although the accumulation of these reserves may be a by-product of such a policy.

The question for taxpayers is whether the capacity to intervene in foreign exchange markets is worth the risks associated with taking on significant exposures to foreign currency assets. Apart from potential valuations losses on these assets, the Reserve Bank forgoes the higher rate of return generally available on Australian dollar-denominated assets. Foreign exchange reserves are effectively a loan to foreign governments.

Reserve Bank Governor Glenn Stevens has recently argued that the costs of intervention to weaken the Australia dollar are greater than the potential benefits. By all accounts, the effects of intervention are modest and not very persistent because foreign exchange reserves are small relative to the depth and liquidity of foreign exchange markets.

By contrast, the Reserve Bank’s official cash rate remains a relatively powerful instrument that works in part by changing the appeal of Australian dollar-denominated assets to foreign investors. While not the only factor influencing the exchange rate, the intense focus on monetary policy decisions by foreign exchange traders shows that it is an important one.

Before Treasurer Hockey next considers loading the RBA’s guns, he might also consider whether there are cheaper and less risky weapons at the Bank’s disposal for managing monetary and exchange rate policy.

Dr Stephen Kirchner is a Research Fellow at the Centre for Independent Studies.

posted on 12 January 2014 by skirchner in Economics, Financial Markets, Monetary Policy

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Op-eds - 2014

‘Australia mustn’t jump the gun on macro-prudential policy’, Business Spectator, 25 July 2014.

‘Scapegoating investors won’t slow up house prices’, The Australian Financial Review, 10 July 2014.

‘Europe holds its breath for ECB action’, Business Spectator, 11 April 2011.

‘Official statistics need culture change’, Business Spectator, 27 March 2014.

‘Don’t blame foreigners for rising house prices’, The Sydney Morning Herald, 20 March 2014.

‘Forget trying to curb demand, build more houses’, The Australian, 23 January 2014.

‘Playing the currencies game is fraught with risk’, The Australian Financial Review, 5 January 2014.

posted on 12 January 2014 by skirchner

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Bob Shiller Still Can’t Define a ‘Bubble’

John Cochrane reviews Bob Shiller’s Nobel lecture and notes that he still can’t define the idea for which he is most well known. Moreover:

In an entire lecture, Bob did not give a single concrete example of how “listening to psychologists” produces one concrete positive step to understanding “bubbles.”

Cochrane then tries to rehabilitate Shiller by suggesting he is doing something terribly profound:

I realized just how deep and audacious Bob’s project is. He is telling us to abandon the “scientific” pretense. He wants us to adopt a literary style, where we look at the world, are inspired by psychology, and write interpretive prose as he has done.  When he says that the definition of a a bubble is a fad, he isn’t being sneaky and avoiding the argument. He means exactly what he says and wants us to think and write this way too. A bubble, to Bob, is defined as any time a time that he, writing about it, informed by psychology, and reading newspapers, thinks a “fad” is going on. And he invites us to think and write like that too. A model is, to Bob, wrapped up in one person’s judgement and not an objective machine. If I complain that this is ex-post story telling, he might say sure, stop pretending to be physics, write ex-post stories. If I complain that there are no rules and that this is no better than “the gods are angry,” he might say, no, read psychology not ancient theology, and the rules are you have to couch your story telling in their terms. He does not want us to try to construct models, either psychological or rational, that make quantitative predictions.

This is consistent with my observation that much of Shiller’s work is simply assertion rather than science. It is audacious, but not in a good way. While Cochrane means to praise Shiller, I think he effectively buries him.

posted on 19 December 2013 by skirchner in Economics, Financial Markets

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Strengthening Australia’s Fiscal Institutions

I have a new paper in the CIS Target 30 series, Strengthening Australia’s Fiscal Institutions, that re-states the case for legislated fiscal rules to be monitored and enforced by an independent statutory Fiscal Commission.

It is often argued that fiscal rules are unlikely to serve as an effective discipline on fiscal policy in the absence of political will. This is undoubtedly true, but fiscal rules can be seen as a mechanism through which the political will to tackle issues in relation to long-run fiscal sustainability can find more effective expression. If politicians are unwilling to put into law what they say they are committed to doing, then it is less likely that they will deliver on these commitments. The willingness to adopt fiscal rules can thus be seen as a test of the degree of political commitment.

Measures to strengthen Australia’s fiscal institutions should be a key recommendation of the Abbott government’s Commission of Audit.

posted on 11 December 2013 by skirchner in Economics, Fiscal Policy

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Strengthening Australia’s Fiscal Institutions

Strengthening Australia’s Fiscal Institutions, T30.06, Centre for Independent Studies, December 2013.

posted on 11 December 2013 by skirchner

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