Working Papers

2005 10

Dear Ms. Burrow

The IMF replies to ACTU President, Sharan Burrow:

Overall, the benefits of economic reforms in Australia, including improvements in the functioning of the labor market, have been substantial, and this gives a sound basis for expecting positive results from further labor market reforms. Hence, I can not accept the statement in your letter that the staff report’s support for labor market reforms reflects poorly on the professionalism of the IMF review team.

posted on 31 October 2005 by skirchner

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More Housing ‘Bubble’ Myth Busting

IMF research points to the role of mortgage securitisation in reducing deviations in house prices from fundamentals:

With funding conditions now determined in a national market, trends in real activity and prices have become less cyclical and converged across all regions of the United States. As a result, a model of housing prices based on economic fundamentals finds that pricing errors—the deviations of actual prices from those estimated in the model—have fallen by half. Moreover, a change in homebuilders’ behavior—in particular, a move away from speculative starts and a reduction of levels of inventories of new homes—has reduced the risk of a sharp decline in housing prices, although some indicators suggest speculative pressures in a number of metropolitan areas. This stabilization of housing activity may have made an important contribution to the reduction of the volatility of GDP growth over the same period.

posted on 31 October 2005 by skirchner in Economics

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True Confessions of Bill Gross

PIMCO boss Bill Gross tells it like it is:

I am no expert…all I know is what I read in the newspapers.

posted on 31 October 2005 by skirchner in Economics

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Inflation Targeting and Fed Governance

Greg Mankiw echoes some of this blog’s arguments for reform of Fed governance:

Some recent news reports have suggested that inflation targeting would mean a big change in policy from the Greenspan era. That is not right. Starting where we are today, a switch to inflation targeting is not so much a change in monetary policy as it is a change in the way the Fed communicates about monetary policy. To a large extent, Mr. Greenspan’s policy can be described as “covert inflation targeting.” He has never announced a target inflation rate, but there is little doubt about his goals. As former Fed governor Laurence Meyer pointed out, anyone who doesn’t know that Mr. Greenspan is aiming for a measured inflation rate of about 1% to 2% is just not paying attention…

Alan Greenspan is a rock star, at least by the standards of the American Economic Association… The most negative assessment I have ever heard about Ben Bernanke, from one of my colleagues, is that he is “a bit boring.” For an economist, boring is an occupational hazard. For a central banker, however, it is just the ticket. The central bank’s job is to create stability, not excitement. Ben Bernanke would do well to increase public confidence in the institution of the Federal Reserve: The institution matters more than the individual who happens to be leading it at the moment. It would be ideal if, after a long, successful tenure, Mr. Bernanke’s retirement as Fed chairman were a less momentous event than his arrival.

UPDATE:  Free version here.

posted on 28 October 2005 by skirchner in Economics

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RBNZ Governor Bollard Has Lost the Plot

Former RBNZ Governor (now National Party leader) Don Brash got a lot of bad press for his conduct of monetary policy, most of it undeserved.  But his successor as Governor, Alan Bollard, deserves criticism following today’s decision to raise the official cash rate to a record 7%.  The problem is not the rate increase as such.  A case can be made for further tightening, even if this partly reflects Bollard’s mistake in lowering the cash rate in 2003.  Rather, the problem is Bollard’s rationalisation for the latest tightening, which is contradictory to say the least.  According to Bollard:

The most serious risk to medium term inflation is the continuing strength of household spending, supported by a relentless housing market and rapid growth in mortgage lending.  Significant dis-saving by the household sector is showing through in a worsening current account deficit, now 8 per cent of GDP. Borrowers and lenders alike need to recognise that the current rate of debt accumulation is unsustainable. The correction of these imbalances and associated inflation pressures will require a slowdown in housing, credit growth and domestic spending. We also expect a significantly lower exchange rate. The longer these adjustments in behaviour and asset prices are deferred, the more disruptive they are likely to be.

This is not only a mischaracterisation of the risks to inflation, it is also contradictory.  Raising the official cash rate will only attract further capital inflow, already very strong, putting further upward pressure on the exchange rate and making the current account deficit even worse.  This is exactly the policy mistake the RBA made in the late 1980s, when it sought to target the current account deficit with tighter monetary policy, resulting in a recession in the early 1990s.  Both Governor Bollard and the Finance Minister have been trying to talk the NZD lower, yet monetary policy has been driving it higher.  This can only cause credibility problems for the Bank.  If anything, Bollard should be talking up the exchange rate. 

The credibility problem is made worse by the fact that the RBNZ recently sought an increase in its capitalisation to facilitate intervention in foreign exchange markets, yet it seems unwilling to back its exchange rate overvaluation rhetoric with actual intervention.  This is just as well, because we would then have a situation in which interest rate and exchange rate policy were at cross purposes, but it highlights the contradiction between what the RBNZ and the government say about the exchange rate and what the RBNZ is actually doing with monetary policy.

Before the current government watered down the RBNZ’s inflation targeting regime, the current rate of inflation might have already seen the RBNZ Board meet to decide whether to recommend dismissal of the Governor to the Minister, although the contribution to inflation from higher oil prices would fall under the caveats to the Policy Targets Agreement.  This is now much harder to do, because the inflation target has been re-defined in such a way as to accommodate a much wider range of outcomes.  By the Bank’s own admission, there is little scope for inflation to return to the target range before 2007.

posted on 27 October 2005 by skirchner in Economics

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Blog Capitalisation

Who said blogging doesn’t pay?

My blog is worth $28,227.00.
How much is your blog worth?

(via Barry Ritholtz)

posted on 27 October 2005 by skirchner in Economics

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The Dark Side of the Confirmation Process

Some of the charming search terms that are showing in my site stats: ‘bernanke cannabis,’ ‘dirt on bernanke,’ ‘bernanke family origins’ etc. 

This is more stupid than sinister.  Do these people honestly think the background checks conducted for the White House would miss something on the internet?

posted on 26 October 2005 by skirchner in Economics

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The Real Ben Bernanke

The market reaction to Ben Bernanke’s nomination as Fed Chair has been disappointing.  The implication that Bernanke is somehow more inflation friendly than Greenspan reveals profound ignorance about Bernanke’s thinking.  This view largely stems from two speeches given during the 2002-2003 deflation scare, in which Bernanke canvassed various quantitative approaches to monetary policy that might be used as an alternative to the Fed funds rate should the zero bound become a binding constraint.  Bernanke’s willingness to canvass unconventional approaches to monetary policy should if anything be welcomed.  I suspect very few of the people who derisively refer to ‘printing press Ben’ have bothered to even read these speeches, much less understood their significance or context.  It is interesting that Bernanke’s nomination has attracted endorsement from libertarian economists like Tyler Cowen, Bryan Caplan and even qualified support from an arch free banker like Larry White.  Those on the libertarian right who have criticised Bernanke do so largely out of ignorance, but it seems these silly prejudices against Bernanke have wider currency given the market reaction to his nomination.

The negative market reaction to Bernanke’s nomination is also disappointing in the sense that it shows that the credibility of the Fed resides largely in the position of Chairman, not the institution itself.  This is the unfortunate legacy of Greenspan’s highly discretionary approach to Fed policy and hostility to inflation targeting.  I suspect that reform of Fed governance is high on Bernanke’s agenda.  Bernanke’s interest in inflation targeting is particularly promising in this regard.  The WSJ’s reference to a ‘Bernanke Standard’ misses an important point: Bernanke may well end up presiding over the de-personalisation of US monetary policy, elevating process above personality.

Finally, it should be noted that Bernanke’s nomination is another event the prediction markets got ‘right,’ in the sense that the Bernanke contract was consistently the highest priced contract for next Fed Chair on Intrade.

posted on 25 October 2005 by skirchner in Economics

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Misguided Monetarism: Tim Congdon’s Money and Asset Prices in Boom and Bust

My review of Tim Congdon’s (2005) Money and Asset Prices in Boom and Bust, London: Institute of Economic Affairs.

Tim Congdon is perhaps best know for his former role as head of Lombard Street Research and his membership of the IEA’s Shadow Monetary Policy Committee, which is loosely modelled on the monetarist Shadow Open Market Committee in the US.  Money and Asset Prices seeks to motivate a role for broad measures of the money supply in the determination of asset prices.  Congdon subscribes to the ‘active money’ paradigm, which is at odds with the mainstream academic view that money plays an essentially passive role in an economy because it is endogenous to the determination of official interest rates and money demand.  The ‘active’ money view is, however, probably closer to popular conceptions of how monetary policy works.  Popular commentary on monetary policy is often framed in terms of some vaguely defined notion of ‘liquidity,’ even though monetary aggregates play only an incidental role in the determination of official interest rates.

continue reading

posted on 24 October 2005 by skirchner in Economics

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Serious Tax Reform

Finance Minister Nick Minchin on tax reform:

“Serious, sustainable and responsible income tax reductions can only be delivered by reducing government expenditures,” the minister told the Liberal Party’s South Australian state council last night.

“Those who want further substantial income tax cuts should tell us all where they think the Government can and should reduce its expenditure to pay for their cuts.”

If Minchin isn’t willing to volunteer these cuts himself, doesn’t it follow that he is not interested in ‘serious, sustainable and responsible’ tax reform?

posted on 22 October 2005 by skirchner in Economics

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Housing Equity and Consumption: Myth Busted

The RBA has released the results of its survey on housing equity withdrawal.  As we predicted when the survey was first announced, the results effectively demolish one of the most pernicious myths about the Australian economy in recent years: that strong economic growth was largely driven by a housing equity fuelled consumption boom:

Around two-thirds of equity withdrawn in 2004 was invested in other assets or used to pay down other loans. In contrast, only a relatively small proportion of equity withdrawn was used to fund consumption. This implies that swings in housing equity withdrawal in recent years are likely to have had a smaller impact on aggregate household consumption than the raw figures on aggregate net household equity withdrawal would suggest…

the results suggest that swings in recent years in the amount of equity withdrawn or injected by the household sector probably did not result in swings of a corresponding magnitude in consumption growth. To a significant extent, the changes in the amounts withdrawn or injected are likely to have been the result of changes in turnover in the property market and the longer-term growth in prices. The results of the survey indicate that withdrawals of equity through transactions were not typically used for consumption but were instead used to accumulate other assets.

posted on 21 October 2005 by skirchner in Economics

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Brad Setser (Almost) Gets It

In the wake of the August TIC data showing strong net foreign inflows into US assets, Brad Setser shows signs of capitulating to the consenting adults view of current account deficits:

Why not run a bigger trade deficit?  After all, the market seems willing to finance one!

As we have argued previously, the financing of the US current account deficit is essentially pre-determined for given US and foreign saving-investment imbalances.  Only the asset composition of this financing and prices at which assets change hands is actually in question, yet many analysts persist in analysing this data as though it were some incredible surprise that foreigners are still buying US assets.  Setser nonetheless persists in his view that:

it would be a mistake, I think, to conclude from the TIC data that the US is no longer dependent on foreign central bank support.

As this research suggests, even in the very unlikely event that foreign official sector purchases disappeared entirely, the implications for US interest rates would be small.  In other words, there is no such US ‘dependence.’  Furthermore, as Setser notes, US accounts were net sellers of foreign assets, suggesting that there are not many net buyers of the doomsday cult trade.  With the USD index testing its highs for the year, those who ignored the purveyors of doomsday cultism have been appropriately rewarded.

posted on 19 October 2005 by skirchner in Economics

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How Important Are Foreign Official Reserve Asset Purchases?

Federal Reserve Board research examines the implications of foreign purchases for yields on US debt securities:

foreign official purchases of U.S. Treasury bonds skyrocketed in 2003 and 2004, but these were only a small subset of foreign flows into all types of U.S. bonds—Treasury, corporate, and agency bonds. At their peak in the summer of 2004, foreign official inflows amounted to 2.5 percent of GDP, far below the overall foreign purchases of U.S. bonds of 7 percent…

if foreigners did not accumulate U.S. bonds over the twelve months ending May 2005, our model suggests that the 10-year Treasury yield would currently be 150 basis points higher.  But even if the United States experienced only average inflows of 2 percent of GDP, our point estimate suggests that U.S. rates would be 95 basis points higher… had foreign official flows been zero over the last twelve months, long rates would currently be 60 basis points higher.

While 60 bps is not trivial, it is very small relative to the enormous importance many commentators have attached to foreign official sector asset purchases by East Asian central banks as drivers of US interest rates.  Since foreign official sector demand is largely determined by managed exchange rate regimes, this demand is not discretionary under current exchange rate regimes. 

Even the 150 bps attributable to overall foreign purchases needs to be placed in context:

with U.S. bonds comprising roughly half the global bond market, other international investors—be they speculators or institutions such as pension funds—are not likely to completely abandon the U.S. market. Indeed, zero net inflows into U.S. bonds over a sustained period has not occurred in at least 20 years. Even during the 1990-1991 recession, when the U.S. current account was temporarily balanced (and thus net capital inflows were not required), annual foreign purchases of U.S. bonds still totaled about one percent of GDP (compared to the current record annual bond inflows of roughly 6 percent of GDP). This is not to say that a retreat could not occur, just that a complete and sustained retreat is unlikely.

posted on 14 October 2005 by skirchner in Economics

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The Flat Tax Costello Rejects

The 30% flat tax plan Treasurer Peter Costello rejected:

WHEN Treasurer Peter Costello left Canberra for his Christmas break last year, he had before him modelling for the most radical reform to income tax in 60 years.

The ambitious plan, prepared for the 2005 budget, would have replaced all the existing tax scales with a single flat rate of tax of 30 per cent…

The plan was clearly affordable without pushing the budget into deficit, with the cost rising from $7.7 billion in 2005-06 to $10.1 billion in 2008-09…

Only those privy to the Treasurer’s thinking know why the plan was dropped, but it may have been because of an analysis Treasury prepared on who would be the winners. Although nobody would be worse off as a result of the changes, only 20 per cent of taxpayers would be better off.

A more plausible explanation is that Costello is rationing tax cuts to fit with his leadership timetable.

posted on 14 October 2005 by skirchner in Economics

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An Australian Congressional Budget Office?

Simon Banks, formerly of the Chifley Research Centre, argues for an independent fiscal policy institute to improve the quality of public debate about fiscal policy.  This is an excellent proposal and ties in with earlier work by the CRC on fiscal policy rules by Ric Simes.  The current arrangements under the Charter of Budget Honesty are inadequate, with the process still dominated by partisan political considerations and ministerial direction.  Costings done privately by hired guns like Access Economics do not carry much authority, since the client is assumed to get what they pay for, and it is very simple for Treasury to pick holes in these analyses, distracting attention from the substance of the policy proposal. 

Unfortunately, while oppositions get very excited about reforming fiscal and monetary policy rules, they quickly lose interest in the subject when in government.  When I worked for the federal opposition in the early 1990s, there was a determination on the part of the Coalition to reform both the RBA Act and institute fiscal responsibility legislation that would prevent what we saw as abuses of process by the then Labor Government.  What subsequently emerged in government fell well short of what many of us would like to have seen implemented.  We can only hope that the Labor Party doesn’t forget what it was like to be in opposition quite as quickly as the Coalition did.

posted on 13 October 2005 by skirchner in Economics

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Johan Norberg in Sydney

The Centre for Independent Studies has been playing host to Johan Norberg this week.  I attended the launch of the Australasian edition of his book In Defence of Global Capitalism on Monday and his John Bonython Lecture last night, an op-ed rendition of which can be found here.  Norberg’s theme of the cognitive biases that motivate anti-globalisation sentiment is remarkably consistent with some of the arguments run on this blog in relation to financial markets and asset prices. 

Norberg’s book is perhaps the most accessible and persuasive defence of globalisation in print.  The book is much more faithful to the classical liberal tradition than the books on globalisation by Jagdish Bhagwati and Martin Wolf.  Both Bhagwati and Wolf concede way too much to globalisation’s critics and have probably done the cause more harm than good, particularly in the case of Bhagwati’s hostility to international capital mobility.

posted on 12 October 2005 by skirchner in Economics

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When Costello Attacks

Treasury costings of Liberal MHR Malcolm Turnbull’s tax reform proposals purport to show a greater cost than allowed for in Turnbull’s discussion paper.  This analysis somewhat misses the point that meaningful tax reform should come at a cost to revenue.  That these costs might be greater than assumed by Turnbull is not in itself an argument against the proposed reforms.  Analysis by the Melbourne Institute shows an expected increase in labour force participation from the tax reform proposals of both Turnbull and Labor MHR Craig Emerson.  Increased labour force participation is meant to be a key objective of government economic policy and yet the Treasurer shows no interest in tax reforms that might be helpful in realising this goal. Hiding behind Treasury costings does not conceal the fact that Treasurer Costello remains a policy-free zone when it comes to tax.

Perhaps the biggest mistake the tax reform debate has made to date has been to assume that tax cuts can only be funded out of the surplus, rather than through net reductions in government spending, particularly the welfare churn that sees many middle-income households paying no net tax.

posted on 11 October 2005 by skirchner in Economics

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The Doomsday Cult Takes a Bath, III

The WSJ weighs in and declares a winner:

For a couple of years now, we’ve been watching a debate, generally speaking, between two economic factions. The first and largest group has routinely predicted slower growth, if not recession, almost as a rite of spring and sometimes autumn too. This crowd has included the most prominent economists on Wall Street, and most of those you see quoted in the media. In this view, inflation was nowhere to be seen, and for many of them the real danger was the budget and trade deficits. The Fed could stop raising rates at any time, the sooner the better.

A second, smaller band of economists has predicted robust growth all along, especially in the wake of the 2003 tax cuts. This group includes Brian Wesbury and David Malpass, to cite two economists who often appear on these pages. Their main concern has been that the Fed underestimated the economy’s strength and kept monetary policy too easy for too long. This has let inflationary expectations build up again, perhaps leading to trouble down the road as the Fed compensates for its mistake by raising rates higher than would otherwise have been necessary.

Well, the evidence is mostly in, and the second group looks to be the winner.

posted on 10 October 2005 by skirchner in Economics

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The Doomsday Cult Takes a Bath, II

Jay Hancock on Warren Buffett as currency speculator:

Often as not recently, the world’s foremost dollar doubter has been waking up to find the greenback gaining in value, shaming its critics and costing him and his shareholders millions…

Not long after boss Buffett decided he was not just a stock-picker but an applied macroeconomist, competent to bet on global fund flows, Berkshire began lagging behind the stock market. Last month, Berkshire shares hit their lowest point in almost two years, although the drop is partly connected to anticipated costs from hurricane-insurance claims.

But from January through June of this year, Berkshire showed paper losses of nearly $1 billion on currency bets. The dollar fell a bit over the first part of summer but regained ground in September, so Buffett may show another loss for the third quarter.

Even the NYT knows a dud trade when it sees one:

Investors in funds holding bonds of intermediate and longer maturities did better; those who bought the conventional wisdom missed out.

(hat tip: Michael Covel)

posted on 08 October 2005 by skirchner in Economics

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Martin Feldstein Fed Chair Contract Volumes Spike on Intrade

As the White House confirms it is looking to make an appointment to replace Alan Greenspan as Fed Chair ‘as soon as possible,’ Intrade’s Martin Feldstein contract has seen a spike in volumes, with over 1000 contracts changing hands in a single day, taking total volume to 1,309.  This makes Feldstein the most actively traded contract, overtaking the 798 contracts that have traded hands on Ben Bernanke, still the highest priced candidate.  The Feldstein contract has fallen in price and there is greater market depth on the short side of the Feldstein market.  However, the overall Fed Chair market is still remarkably thin.

posted on 08 October 2005 by skirchner in Economics

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Gold Bug Myths

With the USD price of gold at its highest levels since the late 1980s, Stephen Jen reviews some stylised facts about gold:

1.    Stocks overwhelm flows.  What sets gold apart from other commodities, besides being ‘non-destructible’ and ‘homogeneous’, is the above-ground stocks are massive (153,000 tonnes as of 2004), relative to the annual newly mined supply (2,464 tonnes in 2004).  This means the holders, not the producers, of gold have market power.

2.    Gold has not been a good inflation hedge.  The real price of gold has declined by 50% since 1983.  To keep pace with inflation since 1983, gold should be trading at US$930 an ounce — about twice the current market price.

3.    Gold has a low to negative correlation with stock prices, and low general correlation with the business cycle.

The Dow/gold ratio, or the number of ounces of gold required to buy the DJIA, has been trending higher for over a century (putting aside the 1979-80 episode), yet gold bugs typically view this as indicative of overvaluation in stocks rather than an argument against holding gold. 

posted on 08 October 2005 by skirchner in Economics

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Peter Costello and the Attack of the Stone, Episode IV

Former Treasury Secretary John Stone, doing what he does best - taunting Treasurer Costello:

In his latest essay to establish statesman’s credentials, federal Treasurer Peter Costello has crassly criticised (in an interview with The Australian Financial Review) the tax-cutting policies of President George W. Bush…

Costello’s remarks are all the more extraordinary for having been made a few days after a truly excellent speech by the governor of our Reserve Bank, Ian Macfarlane. His closely argued and analytically compelling address demonstrated to anyone willing to read it with a mind not poisoned by anti-Americanism that, so far from being a threat to world financial and economic stability, the US deficits (budgetary and current account) are the response we might hope for in a world the rest of which (Japan, China, other parts of East Asia, Middle East oil producers) is running a huge surplus of savings over investment.

Had Costello not read the governor’s speech before unburdening himself of his second-hand musings to the AFR? Or had he read it but simply not understood it?

With momentum building for genuine tax reform (including significant tax cuts) in next year’s budget, Costello runs the risk of being the only senior Liberal still convinced that the Government knows better how to spend our money than we do ourselves. With any luck, though, by then he won’t be making the decisions.

Costello must be truly thankful for Ken Henry.

posted on 07 October 2005 by skirchner in Economics

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The Doomsday Cult Takes a Bath

Market pricing has been particularly unkind in recent days to those who have participated in what one fund manager has called a ‘doomsday cult,’ the perverse tendency of many commentators to forecast a massive current account-related shake out in the USD and USD-denominated asset markets.  The cult has some surprising members, not least the Chairman of the Australian Stock Exchange, who at last week’s ASX shareholder AGM had this to say:

America has long been living on borrowed money and its economy is on borrowed time. Unprecedented fiscal and monetary stimulus has provided the sunshine, but all the while costs have been steadily mounting. The balance of payments deficits have been climbing and unsustainable budget deficits have been scarcely contained…In the process the United States has become the world’s largest deficit country and debtor.  We are in uncharted waters, so it is difficult to know how this situation will play out. However, at some time in the foreseeable future it would seem some form of global rebalancing is inevitable.

The Chairman is partly just talking his book, trying to promote Australian equities to investors, but his comments show how pervasive the cult has become. 

What sets cult members apart is their conviction that this ‘rebalancing’ process must be disorderly rather than smooth.  Those who think this process must be disorderly face the burden of explaining why markets are not already adequately pricing these risks.  It is not enough simply to claim that markets are irrational.  Some account of market inefficiency is required to explain this mispricing, particularly if these risks are as obvious as many claim.

Instead of relying on the standard cop out that markets are irrational, some cult members invoke the risk of an adverse shock that brings about a disorderly adjustment, including a flight of capital to countries with strong net international investment positions.  Such adverse shocks are always possible, but it seems strange to predicate a forecast on such an asymmetric view of the distribution of these shocks.  Positive shocks are just as likely, or at least, shocks that may be negative for non-USD asset markets.

Perhaps the biggest assumption of cult members is that a significant rebalancing of international investment flows is even necessary.  RBA Governor Macfarlane’s recent speech on the subject (see below) poses some interesting challenges to that view.

posted on 04 October 2005 by skirchner in Economics

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‘Why I’m Not an Austrian Economist’

I sometimes get labelled an Austrian School economist, but regular readers will be aware that I’m also very critical of ham-fisted attempts at applying Austrian theories of the business cycle to current economic and financial conditions, not least because they ignore important facts about central bank operating procedures.  Surprisingly, a lot of economic commentary is explicitly organised around a very similar interpretation of the business cycle as being driven by some vaguely defined notion of liquidity that is assumed to be an entirely exogenous function of monetary policy decisions, rather than an endogenous and largely market-driven response to economic conditions.

The main contribution of Austrian economics is in understanding the role and functioning of markets, something that mainstream economics and finance has lost sight of.  Important as these insights are, they only get you so far.  Jack Strocchi has pointed me in the direction of Bryan Caplan’s ‘Why I’m Not an Austrian Economist,’ which neatly summarises some of my reservations about Austrian economics in practice.  Caplan hits the nail on the head when he notes:

Yet all too large a fraction of Austrian research has not been in economics at all, but rather in meta-economics: philosophy, methodology, and history of thought…Neoclassical economists go too far by purging meta-economics almost entirely, but there is certainly a reason to be suspicious of scholars who talk about economics without ever doing it.

posted on 03 October 2005 by skirchner in Economics

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