I have an op-ed in today’s Business Spectator arguing that the euro crisis should be viewed primarily as a vindication of Milton Friedman’s pioneering 1953 essay, ‘The Case for Flexible Exchange Rates.’
Not mentioned in the op-ed, but Friedman’s essay had its origins in a 1950 memo he wrote as a consultant to the Office of Special Representative for Europe, United States Economic Cooperation Administration. The essay references many of the problems with exchange rate regimes in Europe at that time.
The government’s stated motivation for returning the budget to surplus next financial year is to give the Reserve Bank ‘maximum room to move’ on interest rates. Yet a fiscal contraction is no more effective in restraining the economy than a fiscal expansion is effective in stimulating it. In an open economy with a floating exchange rate and an inflation-targeting central bank, changes in fiscal policy do not have significant macroeconomic implications. That is why the reaction of financial markets to budget statements is so negligible. The Reserve Bank’s statements also make clear that fiscal policy is a very minor consideration in its decision-making.
During the financial crisis, the government tried to have it both ways, arguing that its fiscal stimulus saved us from recession, but had no implications for interest rates. The second part of the argument was correct, but not the first. If the first part had any truth, then monetary policy must have been much tighter during the financial crisis as a result of the government’s stimulus spending.
The government should have no concern over the macroeconomic implications of changes in the budget balance, so long as it is balancing its budget over time and conducting fiscal policy in a sustainable manner. This should free the government to focus on what fiscal policy can do effectively, namely, changing microeconomic incentives to work, save and invest.
The government and opposition’s mistaken belief in a trade-off between fiscal and monetary policy is dangerous, because it leads to fiscal policy decisions that are more about window-dressing the budget balance and claiming credit for reductions in official interest rates that would have happened anyway, rather than improving incentives. For example, the mistaken belief that tax cuts stimulate demand and lead to higher interest rates can prevent sensible tax reform that has positive implications for the supply-side of the economy. Similarly, the fiscal stimulus of 2008-09 was bad primarily because it misallocated resources. Take away the macroeconomic rationale and the stimulus measures look indefensible on microeconomic grounds, even if the spending had been administered perfectly (which it was not).
A budget surplus target can be defended as a fiscal rule designed to impose additional discipline on government decision-making that might otherwise be absent. But there is no reason to subordinate fiscal policy to monetary policy and fiscal targets should not be pursued at the expense of the microeconomic incentives that are the ultimate source of both economic growth and long-term fiscal sustainability.
‘No Risk In 1% Rate Cut, Says Fraser’, PAUL CHAMBERLIN, 4 December 1996, The Age:
The former governor of the Reserve Bank, Mr Bernie Fraser, said last night he believed November’s cut in official interest rates should have been doubled. As an overheated dollar retreated in markets yesterday, amid concern about its effect on exports, Mr Fraser said he thought the 0.5 per cent reduction announced last month by the central bank could have been 1 per cent.
“I thought at the time with inflation pretty well under control, very much under control really, and the economy being a bit sluggish in some sectors, that we could have accommodated a 1 per cent cut without any risks,” he said on the ABC’s The 7.30 Report.
Bernie’s comments in December 1996 tanked AUD so hard, the RBA did not cut at that month’s regularly scheduled Board meeting. The RBA waited until 14 December while markets recovered from Bernie’s open mouth operations. So monetary policy ended-up being marginally tighter for longer thanks to Bernie. During his time as Governor, Bernie gave us an average cash rate of 8.7% and an average inflation rate of 3.6%.
A curious feature of this debate is the way in which the defenders of sovereign wealth funds have raised the possibility of secular stagnation in defending inter-generational wealth transfers via a SWF (Malcolm Turnbull also suggested this in a tweet). As I note in my Business Spectator piece, a SWF could at best smooth the implications of secular stagnation over time. If secular stagnation really is upon us, then it is even less likely the Future Fund will realise its targeted real rate of return of 5%.
Former Treasurer Peter Costello says that the Future Fund he created is a ‘prime sovereign wealth fund’ and ‘probably the most respected’ in the world. But that is not the conclusion of the Washington think-tank the Peterson Institute, which has compiled the most comprehensive international ranking of sovereign wealth funds (SWFs). The Peterson Institute gave the Future Fund a score of only 80 out of 100, which is below the average of 84 given to the other pension funds in its sample of 53 SWFs in 37 countries. Thirteen other sovereign wealth funds were given a higher overall score in the Peterson Institute rankings, including those in Timor-Leste and Trinidad and Tobago.
In terms of accountability and transparency, the Future Fund scored only 75 out of 100, below the 89 out of 100 given to the State Oil Fund of Azerbaijan. On governance, the Fund scored 86, a little below the average of 87 for other pension funds in the sample. By contrast, New Zealand’s Superannuation Fund ranks third overall with a score of 94 and a perfect score of 100 for governance as well as accountability and transparency.
The Future Fund’s fractious board and the controversy surrounding the process for appointing the new Future Fund chairman only serves to underscore the Peterson Institute’s finding that the Future Fund falls well short of world’s best practice.
A Sovereign Wealth Fund is Not the Same as Fiscal Responsibility
Treasury Secretary Martin Parkinson addressed the issue of a sovereign wealth fund in a speech to the Australia-Israel Chamber of Commerce. Parkinson said that ‘Treasury is often characterised as being opposed to an SWF – yet our comments are neither supportive nor critical.’ In fact, Treasury and the RBA are just as often characterised as supportive of a SWF when they have been studiously equivocal. Whether Australia chooses to make greater use of a SWF is ultimately a decision for politicians. It is appropriate for Treasury and the RBA to discuss the implications of this policy choice, but we should not expect them to come down explicitly in favour of one side of the argument.
Parkinson’s speech makes clear that greater use of a SWF is not the same thing as more responsible fiscal policy:
the creation of an SWF per se does nothing to address either Australia’s net debt position or, more broadly, the level of government or national savings over time.
If the Australian Government had financial liabilities of $10 billion and runs a $1 billion surplus, it can reduce gross liabilities to $9 billion, or it can maintain them at $10 billion and buy $1 billion of financial assets to be held in an SWF – in both cases, net financial liabilities are $9 billion.
The only way the creation of a Sovereign Wealth Fund delivers a faster improvement in net debt is if it is used to justify a tightening of fiscal policy that would not otherwise be achieved.
As such, if we are to have a sensible discussion about the merits of an SWF, the proponents of such Funds, whether at the national or sub-national level, need to be clearer about precisely what they have in mind. Absent tough fiscal decisions, an SWF does not constitute a contribution to future fiscal sustainability.
Robert Carling and I make this point in our CIS Policy Monograph, Future Funds or Future Eaters? If contributions to a SWF, like the budget surplus itself, are no more than a residual after the government is done spending and taxing, then there is no reason to believe that a SWF changes government behaviour. A SWF, like a budget surplus, is a consequence not a cause of fiscal policy decisions. The IMF found there was little impact on government spending in its study of countries making use of SWFs.
Unless a SWF is embedded in a broader framework of binding and enforceable fiscal policy rules, there is no reason to believe a SWF will induce greater fiscal responsibility. If a politician supports a SWF but does not support fiscal policy rules, you know they cannot be trusted with a SWF.
FIRB Transparency and the Colmer Doctrine Revisited
Nomura’s head of mergers and acquisitions, Grant Chamberlain, has called for greater transparency in the regulation of foreign direct investment, as reported in The Australian:
There were generally clear guidelines when it came to FIRB policy, but “but when it comes to SOEs, the picture changes”.
He said the only public information recently had been the “Colmer doctrine”, comments made by then FIRB executive director Patrick Colmer at a conference on Australia-China investment in September 2009.
Mr Colmer said the Australian government preferred that foreign investment by state-owned enterprises was kept to less than 50 per cent for greenfields projects and less than 15 per cent for major producers.
Mr Chamberlain said that it was impossible to actually get a copy of Colmer’s comments and that there was confusion about what would be considered as a “major producer”.
In fact, it is possible to get a copy of the speech here, but only due to a Freedom of Information request I made of the FIRB. The saga behind the speech and my efforts to obtain a copy are detailed in this op-ed in The Australian. Chamberlain’s speech proves the point I made in my original FOI application that releasing the speech was in the public interest.
Mortgage Interest Rate Margins in Australia and the US
A story in the WSJ about mortgage interest rate spreads in the United States perfectly parallels the debate in Australia. The story notes that:
Analysts stress it is difficult to disentangle how much of the spread is due to pricing power from banks with more control of the market, and how much might represent structurally higher costs of doing business in the U.S. mortgage market reshaped by the crisis.
However, the fact that the US and Australia are experiencing essentially the same phenomenon argues against country-specific factors as the explanation. Capital markets are global and Australia is necessarily a price-taker in these global markets, a point forever lost on our parochial media and politicians.
Martin Feldstein writing in Foreign Affairs in 1997, demonstrating that the euro crisis was entirely foreseeable:
If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe and confrontations with the United States.
The immediate effects of EMU would be to replace the individual national currencies of the participating countries in 2002 with a single currency, the euro, and to shift responsibility for monetary policy from the national central banks to a new European Central Bank (ECB). But the more fundamental long-term effect of adopting a single currency would be the creation of a political union, a European federal state with responsibility for a Europe-wide foreign and security policy as well as for what are now domestic economic and social policies. While the individual governments and key political figures differ in their reasons for wanting a political union, there is no doubt that the real rationale for EMU is political and not economic. Indeed, the adverse economic effects of a single currency on unemployment and inflation would outweigh any gains from facilitating trade and capital flows among the EMU members.
The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.
Fresh from the longest ever jailing for civil contempt in a federal white-collar case in the US, Martin Armstrong is back. You can read a much longer profile of him and others like him in The New Yorker.
I don’t have much time for cycle theories. When I worked in financial markets I met numerous advocates for various cycle theories among fund managers. Strangely, I always wound-up being the one who paid for lunch. However, his story is an interesting one. I’m always suspicious when someone gets locked-up for an incidental crime that hadn’t taken place before the prosecutors got involved and when everyone in the case seems to have copped a plea bargain. Even if I’m completely wrong in my suspicions, there are plenty of other cases like it pointing to the decline of the rule of law in the US.
The Torygraph is all over Alessio Rastani and who can blame them for wanting to stick it to the pretentious Beeb over their seeming lack of quality control. Turns out that Rastani is a ‘talker not a trader’ with somewhat limited credentials on both counts. While his now famous opinions are highly questionable, this doesn’t exactly set Rastani apart from the vastly more credentialed talking heads routinely used by the Beeb and others to fill air time.
The sad fact is that a PhD from Oxbridge or an Ivy League school and a stellar career at the IMF and/or an investment bank more often than not yields a set of opinions and insights only slightly less dubious than those of Rastani.