Working Papers

Not a Currency War

Just normal currency markets responding to events, argues Jim O’Neill:

through the ebb and flow of foreign exchange movements, our system of floating rates will demonstrate its utility. It will ultimately deliver much more sense than many of those who currently opine about it.


posted on 24 November 2010 by skirchner in Economics, Financial Markets

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The Downside of China’s Managed Exchange Rate

Inflation and price controls.  As we have often noted, China’s managed exchange rate is a much bigger problem for them than it is for the rest of the world. Former RBA Governor Ian Macfarlane told the Chinese as much in 2005, when he compared China to Australia in the 1970s:

surpluses may be more difficult to sustain in the long run than deficits are for some other countries. I speak from experience here as Australia faced this problem in the early 1970s and did not handle it successfully. At that time, Australia briefly experienced a current account surplus and also became a favourable destination for capital flows. As the money poured in from both these sources it had to be sterilised or it would flow directly into the banking system and through that into money and credit aggregates, with obvious inflationary results.

The problem we found was that in order to sell the official paper in sufficient volumes to soak up the inflow, interest rates had to be raised, and this induced further inflow. In the end, the monetary aggregates grew too quickly and inflation soon rose to an unacceptable rate. We came to the conclusion then that it was not possible to restrain an over-exuberant and inflation-prone economy only by domestic tightening. Exchange rate adjustment was required in order to take away the ‘one way bet’ aspect of the exchange rate. We eventually did this, but we were too slow and the inflation had already become entrenched.

So far, China has made a much better job of handling this situation than we in Australia did 30 years ago. And, of course, it is made easier by the fact that it is occurring in a world environment of low and stable inflation rather than the rising inflation of 30 years ago. But, ultimately, I think the point will be reached where domestic restraint has to be augmented by action on the exchange rate.

Five years on, Macfarlane’s speech remains highly relevant. He could usefully give the same speech in Washington today.


posted on 22 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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One More Time, for the Dummies

RBA Deputy Governor Ric Battellino says it again for the hard of hearing:

“People feel there is, or there should be, a rule that says banks can’t actually set any rates more than the official interest rates set by the Reserve Bank,” Mr Battellino said.

“That rule doesn’t exist, it has never existed, and it would be quite risky for the financial system to have such a rule.”...

Mr Battellino said bank margins had not changed in six years, remaining between 2.25 per cent and 2.5 per cent.


posted on 19 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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Don’t Blame Ben

Charlie Gasparino defends Ben Bernanke:

what’s happening to Bernanke now isn’t accountability, it’s a feeding frenzy. And for the good of the country, it should stop.

Classical liberal and conservative critics of Bernanke would do well to read this speech, in which Bernanke pays tribute to Milton Friedman:

Friedman’s monetary framework has been so influential that, in its broad outlines at least, it has nearly become identical with modern monetary theory and practice.

posted on 18 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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The G20 and ‘Balanced’ Trade

I have a column at the ABC’s Drum Unleashed arguing that the G20 is doing more harm than good:

The G20 is still saddled with the same mercantilist thinking that underpinned these earlier episodes of international policy coordination. That thinking mistakenly blames the global financial crisis on cross-border capital flows, rather than the role of America’s government-sponsored enterprises in misdirecting these capital flows. The Obama administration’s call for the G20 to set numerical targets for trade ‘imbalances’ would do more to threaten free trade and global economic growth than to sustain it.

Since the early 1990s, Australian policymakers have embraced the ‘capitalist acts between consenting adults’ view of current account imbalances, not least because Australia’s economic success has been built on the global trade in saving and investment that the Obama administration now wants to constrain through the G20.

More recently, however, Treasury has seemingly re-embraced mercantilist notions of ‘balanced’ trade. Treasurer Swan called the Obama administration’s proposal “constructive”. Yet the 4 per cent limit on current account imbalances proposed by US treasury secretary Geithner would condemn Australia to permanently slower economic growth and lower living standards.


posted on 16 November 2010 by skirchner in Economics, Financial Markets

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Maybe the Banks Just Don’t Want Your Business

The big four banks have now set their post-November RBA tightening mortgage interest rates. Amid the shameful public vilification of the banks by politicians and others who should know better, almost no one has considered the possibility that, at least at the margin, the banks probably don’t want our business. People in the banking industry tell me that Westpac and CBA in particular have full mortgage books and don’t want to take on additional exposure to housing. Not surprisingly, they have the highest mortgage rates on offer. Notice too how ANZ and NAB are much more aggressive in their advertising? In any other business, using price signals to manage excess demand would be viewed as completely unexceptional.

Far from being greedy, the banks are being prudent, while the government tries to induce them into taking on additional risk. Of course, we could always go back to the days of regulated interest rates and non-price credit rationing, when getting money from the bank was a beauty contest that saw housing credit go only to the rich.

posted on 12 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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A Daily CPI

Never mind a monthly CPI. How about a daily one:

Economists Roberto Rigobon and Alberto Cavallo at the Massachusetts Institute of Technology’s Sloan School of Management have come up with a method to scour the Internet for online prices on millions of items and then use them to calculate inflation statistics for a dozen countries on a daily basis. The two have been collecting data for the project for more than three years, but only made their results public this week…

Two days after the September 2008 collapse of Lehman Brothers, for example, the economists’ price index for the U.S. started to fall, and by the end of the month it was down a full percentage point, as desperate companies slashed prices amid slowing sales. It wasn’t until mid-November—when the Labor Department released its average monthly consumer price figures for October—that government data began to catch up.

posted on 11 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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How to Shut Down Freddie and Fannie

Withhold approval for new debt issuance:

the Treasury doesn’t need Congress or an academic assessment in order to tackle the most important reform goal: eliminating the GSEs and moving their activities to the private sector. Mr. Geithner himself can immediately reshape the mortgage markets—by withholding his approval of new debt issuances by the GSEs. That’s the best way to begin curtailing the GSEs, and it can be done unilaterally.

Congress chartered the GSEs and in their charters required that the Treasury secretary approve all of their new debt. For decades, the Treasury exercised this duty, and the GSEs submitted each new debt issuance to the department for prior approval.

But the Clinton administration found this process cumbersome and a strain on Treasury staff. It established a new process that weakened the administrative approval process for GSE securities offerings. This hands-off approach represented an abdication of Treasury’s essential oversight powers.

The bloating and strategic drift of the GSEs began soon thereafter.

posted on 11 November 2010 by skirchner in Economics, Financial Markets

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What the Critics Don’t Get About Modern Macro

Tom Sargent defends modern macro in a very good interview for the Minneapolis Fed:

The criticism of real business cycle models and their close cousins, the so-called New Keynesian models, is misdirected and reflects a misunderstanding of the purpose for which those models were devised. These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.

By the way, participants within both the real business cycle and new Keynesian traditions have been stern and constructive critics of their own works and have done valuable creative work pushing forward the ability of these models to match important properties of aggregate fluctuations. The authors of papers in this literature usually have made it clear what the models are designed to do and what they are not. Again, they are not designed to be theories of financial crises.

it is just wrong to say that this financial crisis caught modern macroeconomists by surprise. That statement does a disservice to an important body of research to which responsible economists ought to be directing public attention. Researchers have systematically organized empirical evidence about past financial and exchange crises in the United States and abroad. Enlightened by those data, researchers have constructed first-rate dynamic models of the causes of financial crises and government policies that can arrest them or ignite them. The evidence and some of the models are well summarized and extended, for example, in Franklin Allen and Douglas Gale’s 2007 book Understanding Financial Crises. Please note that this work was available well before the U.S. financial crisis that began in 2007.

(HT: Falkenblog)

posted on 11 November 2010 by skirchner in Economics, Financial Markets

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What Would Friedman Do II?

Allan Meltzer claims Friedman would not support QE, but undermines his argument when he says:

Friedman made an exception to his rule about steady-state monetary policy in case of deflation. When prices fell, as they had during the Great Depression or in Japan in the 1990s, he urged the central bank to increase money growth. I served as one of two honorary advisers to the Bank of Japan in the 1990s. With short-term rates close to zero, I gave the same advice, urging the bank several times to buy long-term bonds or foreign exchange to increase money growth until deflation ended.

All this is not relevant now, since there is no sign of deflation in the United States. The Fed’s claim that there is a risk of deflation should embarrass it.

That last paragraph is unavoidably a judgement call. Meltzer may be right in his judgement, but he has all but conceded the point that if deflation is a significant risk, then QE is the right response. Here are my reasons for thinking that it is.


posted on 04 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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Political Thuggery and the Banks

Saul Eslake notes the long history of ministerial thuggery directed at the banks, not to mention bureaucratic intimidation by the ACCC. As Saul reminds us:

the whole debate about whether the banks have some obligation to tie the timing and magnitude of movements in their lending rates to changes in the RBA’s cash rate entirely misses the crucial point that the RBA is now targeting the interest rates that borrowers actually pay when it sets the cash rate, and thus takes into account any change in the spread between the cash rate and the rates that borrowers pay.

If banks raised lending rates by an average of, say, 50 basis points, following yesterday’s 25-basis point rise in the cash rate, the RBA would remove one of the series of further 25-basis point increases in the cash rate it is clearly contemplating between now and the peak of the current mining boom.

Preventing banks raising their rates by more than the cash rate would not result in borrowers paying lower interest rates. All it would do is alter the distribution of the stream of interest payments made by borrowers between bank shareholders, bank depositors, and other sources of bank funds. And why that should be the subject of government intervention - especially by those who generally favour less rather than more government intervention in business decision-making - continues to elude me.

What eludes me is why the banks make donations to political parties that are actively seeking to damage their franchise (see, eg, CBA’s donations). These donations are clearly not buying the banks much in terms of influence. Shareholders should demand that the banks stop paying political protection money, sending a message to politicians that their shameless populism has consequences.

posted on 03 November 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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US T-Bills Versus Tuna

James Hamilton on the implications of negative real interest rates:

You’re better off storing a can of tuna for a year than messing with T-bills at the moment. But there’s only so much tuna you can use, and many expenditures you might want to save for can’t really be stored in your closet for the next year. It’s perfectly plausible from the point of view of more realistic economic models that we could see negative real interest rates, at least for a while.

Even so, within those models, there’s an incentive to buy and hold those goods that are storable. And in terms of the historical experience, episodes of negative real interest rates have usually been associated with rapidly rising commodity prices.


posted on 28 October 2010 by skirchner in Commodity Prices, Economics, Financial Markets, Monetary Policy

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The Right Policy Toward China

Send them flowers and chocolates argues John Cochrane:

They put a few trillion dollars worth of stuff on boats and sent it to us in exchange for U.S. government bonds. Those bonds lost a lot of value when the dollar fell relative to the euro and other currencies. Then they put more stuff on boats and took in ever more dubious debt in exchange. We’re in the process of devaluing again. The Chinese government’s accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort. The right policy is flowers and chocolates, or at least a polite thank-you note.

Yet Mr. Geithner thinks that the Chinese somehow hurt us. There is at work here a strange marriage of Keynesianism and mercantilism—the view that U.S. consumers supported the world economy by spending beyond our means, so that other people could have the pleasure of sending things in exchange for pieces of paper.

This is all as fuzzy as it seems. Markets and exchange rates are not always right. But it is a pipe dream that busybodies at the IMF can find “imbalances,” properly diagnose “overvalued” exchange rates, then “coordinate” structural, fiscal and exchange rate policies to “facilitate an orderly rebalancing of global demand,” especially using “medium-term targets” rather than concrete actions. The German economics minister, Rainer Brüderle, called this “planned economy thinking.” He was being generous. Planners have a clearer idea of what they are doing.


posted on 26 October 2010 by skirchner in Economics, Financial Markets

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Could the G20 Get Any Dumber?

Just when you thought the consenting adults view of current account balances was accepted by Australian policymakers, Wayne Swan signs-up for this:

The Obama administration on Friday urged the world’s biggest economies to set a numerical limit on their trade imbalances, in a major new effort to broker an international consensus on how to handle festering exchange-rate tensions. Officials from Britain, Canada and Australia quickly expressed support for the idea…

The Australian treasurer, Wayne Swan, called the Geithner proposal “a constructive one.”

Germany’s economy minister is not so sure:

Rainer Brüderle told reporters that the proposal could be viewed as a reversion to “planned economy thinking.”


posted on 23 October 2010 by skirchner in Economics, Financial Markets

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Sell the Gold Stock, Burn the Gold Bugs

Ed Truman makes the case for the US Treasury to follow the IMF and offload its gold stock:

the US Treasury holds 261.5 million fine troy ounces of gold. The government has been sitting on that gold since the Great Depression, receiving no return. At the current market price of $1,300 per ounce, the US gold stock is worth $340 billion. The Treasury secretary, with the approval of the president, has the power to sell (and buy) gold on terms that the secretary considers most beneficial to the public interest. Revenues from sales must be used to reduce the national debt.

If the United States were to sell its entire gold stock at the current market price, it would reduce the gross government debt by 2.25 percent of gross domestic product. Based on the average interest cost from 2005 to 2008, this reduction in debt would trim the budget deficit by $15 billion annually. Thus, the Obama administration would be doing something about the US fiscal debt and deficit without reducing near-term support for the ailing economy.

This would of course be incredibly lazy public policy, but should nonetheless give gold bugs pause. As I have noted previously, there is a certain irony in people who fear an over-supply of money taking refuge in an asset in which governments hold substantial stocks and for which the price is arguably in a stock rather than a flow equilibrium.


posted on 22 October 2010 by skirchner in Economics, Financial Markets, Fiscal Policy, Gold, Monetary Policy

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