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Monetary versus Fiscal Stimulus

Tony Makin, on the relative effectiveness of monetary and fiscal stimulus:

dramatically easier monetary policy has probably done more for the Australian economy than fiscal policy. A less modest, or perhaps more independent, Reserve Bank would take more credit for this.

Tony makes an important point.  The RBA’s very low public profile relative to the very noisy fiscal stimulus efforts of politicians is skewing perceptions of the relative importance of these two arms of macro policy.

It was not that long ago that many economic commentators were talking of a direct trade-off between fiscal and monetary policy.  Tax cuts and smaller budget surpluses, we were told, would lead to higher inflation and interest rates.  This argument never had much merit, not least because the actual (as opposed to the forecast) fiscal impulse was simply too small to matter very much for the economy.  The former government put in place some of the tightest fiscal policy settings since the early 1970s. 

By contrast, the current government has put in place an unprecedented fiscal easing of 4.4% of GDP in a single financial year.  The RBA’s statements on monetary policy suggest that it believes that fiscal stimulus is supporting economic activity (in sharp contrast to previous years, in which fiscal policy was rarely even mentioned).  This would argue against reductions in interest rates at the margin, even if it is based on an exaggerated view of the effectiveness of fiscal policy.  The proponents of discretionary fiscal policy can’t have it both ways.  If activist fiscal policy is thought to be effective, there is less work for monetary policy to do in supporting activity and official interest rates will be higher than in the absence of a discretionary fiscal easing.

posted on 14 July 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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Too Much Hand Wringing, Not Enough Hand Raising

The Australian’s FoI desk has another stab at the decision-making processes of the RBA Board, this time seeking voting records, but comes up empty-handed:

“There are no records as the board seeks to achieve a consensus without the need for formal voting,” the board’s secretary, David Emanuel, wrote in response to The Australian’s request.

“The board now seeks to make decisions by consensus and only the consensus decisions are recorded.”

This remarkable unanimity implies that the RBA Board is little more than a rubber stamp for decisions made by the RBA’s senior officers.  Now that the RBA and Treasury effectively control the appointments process to the Board, there is little chance that this bureaucratic monopoly over monetary policy decision-making will ever be effectively challenged.  I make the case for an alternative model of RBA governance in this article.

 

posted on 07 July 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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When Interventions Collide

Christopher Joye notes how the government’s bank guarantees have undermined its $8 billion intervention in the market for residential mortgage-backed securities:

while the $8 billion has directly helped out the lenders who have benefited from the capital, it has had no effect at all on the overall cost of RMBS funding (or the so-called ‘spreads’) because it is being undermined by the government guarantees of bank debt, which have massively increased the supply of AAA-rated securities and created two-tiers of investment – those AAA assets with and without a government guarantee (RMBS and CMBS obviously fall into the latter category). Indeed, as the RBA (in its Statement of Monetary Policy) and the Treasury’s David Gruen have recently observed with some bewilderment, RMBS spreads have actually increased markedly to more than 200 basis points over the swap rate since the AOFM started investing its money notwithstanding their incredibly low default rates (again because of the dysfunction indirectly introduced by the government guarantees of bank debt). In the ten years prior to the advent of the GFC, Aussie RMBS spreads averaged 20-30 basis points over. And today, the 90 day mortgage default rate sits at about 15 per cent and 25 per cent of US and UK levels, respectively, or roughly 0.6 per cent.

As I argue in this paper, the idea that government intervention in the RMBS market can engineer an exogenous easing in credit conditions is mistaken, because the RBA fully discounts these conditions in its conduct of monetary policy.  Even if such an easing were possible, it would be capitalised into house prices, with no benefit to home borrowers.

posted on 02 July 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Greenspan on the Political Allocation of Capital

Alan Greenspan, on the quantitative channel for crowding-out:

Even absent the inflation threat, there is another potential danger inherent in current US fiscal policy: a major increase in the funding of the US economy through public sector debt. Such a course for fiscal policy is a recipe for the political allocation of capital and an undermining of the process of “creative destruction” – the private sector market competition that is essential to rising standards of living. This paradigm’s reputation has been badly tarnished by recent events. Improvements in financial regulation and supervision, especially in areas of capital adequacy, are necessary. However, for the best chance for worldwide economic growth we must continue to rely on private market forces to allocate capital and other resources. The alternative of political allocation of resources has been tried; and it failed.

posted on 26 June 2009 by skirchner in Economics, Fiscal Policy, Monetary Policy

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More Anti-‘Bubble’ Popping

BoE chief economist Spencer Dale, on the evils of ‘bubble’ popping:

Short-term interest rates are a blunt instrument best deployed maintaining a broad balance between nominal demand and supply. They are not well suited to the task of managing asset price bubbles and economic imbalances. They may be wholly ineffective in addressing some types of imbalances, particularly those with an international dimension. And, even for domestic imbalances, short-term interest rates would probably need to be held substantially higher for a persistent period in order to suppress rapid rises in asset prices or growing imbalances. Such policy actions could generate significant economic costs. 

The practical difficulty of implementing a policy of “leaning against the wind”, where the main policy instrument is short-term interest rates, should not be underestimated. If, as policymakers, we were successful in preventing a bubble from inflating, it might appear as if we were responding to phantom concerns. The bubble or imbalance would be nowhere to be seen, but interest rates would be higher, inflation would undershoot the inflation target and we would appear to have inflicted unnecessary economic hardship. That could undermine public faith and support in both the inflation target and the MPC.

posted on 24 June 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Fiscal Stimulus, Interest Rates and Crowding-Out

I have an article in the Weekend Australian arguing that the government’s discretionary fiscal stimulus measures will undermine Australia’s long-run growth prospects, citing the Australian edition of a widely used undergraduate textbook:

“When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.” So says Joshua Gans in his Principles of Macroeconomics text. Yet Gans was also one of the 21 economists who recently signed a letter defending the government’s deficit spending.

An increase in the stock of government debt reduces the amount of capital available for private investment, although this crowding-out effect may be offset by increased private saving and foreign capital inflows. In a small and open economy such as Australia, crowding out occurs not so much because interest rates rise, but because it induces foreign capital inflows that put upward pressure on the exchange rate, lowering net exports and reducing aggregate demand, which offsets the increase in government spending.

I also have an article in Business Spectator, noting that recent market-led increases in retail borrowing rates are just a taste of things to come:

Whatever the cause of rising global bond yields, these increases in interest rates will inevitably be passed on to Australian borrowers. It would be a sign of political maturity if Australian politicians were to acknowledge this reality, rather than taking refuge in the shameless populism of bank-bashing.

UPDATE: Joshua complains about ‘selective extracting’ and an ‘unwillingness to deal with economic complexity’ in my Weekend Australian piece.  The point of highlighting the very good discussion of these issues in Joshua’s textbook was precisely to show that the 21 economists were being selective and incomplete in their analysis, by not acknowledging the many arguments against discretionary fiscal stimulus.  I would certainly encourage people to read Principles of Macroeconomics in coming to a considered view of the merits of discretionary fiscal policy.

posted on 21 June 2009 by skirchner in Economics, Fiscal Policy, Monetary Policy

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‘Bubble’ Popping at Treasury and the BoE

The Australian Treasury’s David Gruen on monetary policy and asset prices:

Some have suggested that, rather than simply being a contributing factor, expansionary US monetary policy in the early 2000s was the main cause of the crisis.

Expansionary US monetary policy undoubtedly contributed to rising US asset prices, including house prices, at the time. Indeed, that is the point of the policy – rising asset prices constitute one of the ways that expansionary monetary policy works.

But I have less sympathy with the argument that monetary policy should explicitly ‘lean against the wind’ of a suspected inflating asset price bubble, which is implicit in the criticism of US monetary policy at that time.

In my view, to lean against the wind and do more good than harm requires a level of understanding about the likely future path of a suspected asset bubble that is simply unrealistic. Without that understanding, attempting to use monetary policy to lean against the wind is as likely to be destabilising for the wider economy as it is to be stabilising.

It is good to see that Adam Posen, author of one of the better social democratic critiques of ‘bubble’ popping, has just been appointed to the BoE’s MPC.

posted on 17 June 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Australia and the World Economy

I have a column in the Business Spectator, arguing that the transmission mechanism from the world to the Australian economy is mainly via financial markets rather than cross-border trade in goods and services:

While it may seem surprising that export volumes are holding up in the context of a global economic downturn, it highlights the fact that the transmission mechanism from the world to the Australian economy is somewhat different to the one many people assume.

There has been a much closer relationship between the world and Australian economy since the early 1980s, as lower trade barriers have resulted in closer ties with world markets and a larger traded goods sector. However, it is difficult to account for the strength of this relationship based purely on trade linkages.

A more important transmission mechanism from the world to the Australian economy comes from our increased integration with global financial markets following financial market liberalisation and deregulation in the early 1980s. Changes in global interest rates and other asset prices are transmitted directly to the Australian economy via global financial markets.

This has a more powerful and immediate impact on the Australian economy than international trade in goods and services and has been particularly important in the context of the recent global financial crisis.

It helps explain why domestic demand has contracted, even while external demand has proven resilient.

As I note in the column, this has important implications for the effectiveness of domestic policy interventions.

posted on 11 June 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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When Gold Bugs and Reality Meet

A Wired story on the rise and fall of E-Gold:

In a sparsely decorated office suite two floors above a neighborhood of strip malls and car dealerships, former oncologist Douglas Jackson is struggling to resuscitate a dying dream.

Jackson, 51, is the maverick founder of E-Gold, the first-of-its-kind digital currency that was once used by millions of people in more than a hundred countries. Today the currency is barely alive.

Stacks of cardboard evidence boxes in the office, marked “U.S. Secret Service,” help explain why, as does the pager-sized black box strapped to Jackson’s ankle: a tracking device that tells his probation officer whenever he leaves or enters his home.

“It’s supposed to be jail,” he says. “Only it’s self-administered.”

There are some remarkable parallels between this story and the Paypal Wars.  Contrary to the hopes of the cypherpunk and cryptoanarchist movements, on-line payments systems have not been able to effectively challenge the power of the state.  I would agree with Richard Timberlake’s assessment (quoted in the linked article) of the original intentions behind E-Gold.

 

posted on 11 June 2009 by skirchner in Economics, Financial Markets, Gold, Monetary Policy

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Velocity is Not an Independent Variable

Among certain economic commentators, it has been suggested that we should watch for a recovery in velocity (nominal GDP divided by some monetary aggregate) as an indication that economic conditions are improving.  Brian Wesbury goes so far as to argue that the US recesssion was ‘caused by a dramatic slowdown in monetary velocity’.  While an increase in velocity might be symptomatic of economic recovery, it would be wrong to think of velocity as an independent variable.  Milton Friedman is often caricatured as claiming that velocity is constant.  Rather, he claimed velocity is a stable function of other variables.

A better way to think about velocity is in terms of its inverse, or money demand.  Money demand is typically viewed as some function of nominal GDP, an interest rate (the opportunity cost of holding money balances) and financial technology.  The latter usually goes unmodelled, but conceptually at least, we can distinguish between permanent and temporary changes in financial technology.  Permanent changes in financial technology are probably the main driver of long-run trends in velocity.  Velocity trends lower in the early stages of economic development, as money facilitates a growing division of labour, before declining again as new forms of financial instrument take over some of the functions previously performed by money, giving rise to a classic U-shape. 

Short-run changes in money demand are likely to reflect temporary changes in financial technology or financial shocks, as well as cyclical variations in nominal GDP and interest rates.  From the foregoing, it should be apparent that short-term movements in velocity are unlikely to tell us anything we don’t already know about current and prospective business cycle conditions.  Against the backdrop of a shock to financial technology of unknown duration, interpretation becomes even more difficult.

posted on 09 June 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Debunking Bad Narratives on Stimulus

Henry Ergas responds to the 21 economists rounded-up by Nic Gruen to defend the federal government’s stimulus measures (as if the government were not big and ugly enough to defend itself):

The open letter 21 highly respected Australian economists published earlier this week in The Australian Financial Review strikingly illustrates the trend. Endorsing the “too much rather than too little” approach, that letter claims “there is no more effective way to stimulate the economy” than cash handouts.

In reality, the efficacy of that spending is far from established. Rather, much as economic theory would predict, the striking fact is just how smooth the path of consumption has been, despite a substantial spike in income associated with the Government’s cash splash.

Sinclair Davidson makes similar points in The Age:

It would be surprising indeed if the 21 economists were prepared to defend any of the $800 million in ‘community infrastructure’ boondoggles listed here

RBA Governor Glenn Stevens has also been out highlighting the limits of macro policy stimulus:

Macroeconomic policies have not been able to prevent an economic downturn. They rarely can, especially in the face of a global recession of this magnitude. Indeed, attempts to do so have as often as not run into trouble by stoking up bigger problems a few years down the track.

posted on 05 June 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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A Simple Test for the Effectiveness of Macro Policy Stimulus in Australia

A simple test for the effectiveness of macro policy stimulus in Australia is to model quarterly Australian GDP growth as a function of contemporaneous and lagged US GDP growth and a constant.  The model makes the reasonable assumption that causality runs from US growth to Australian growth, since Australia is too small to influence the US economy.  US stimulus measures could benefit Australian GDP based on this model, but Australian policy stimulus should not influence US GDP growth (even allowing for those stimulus cheques to ex-pats).  Domestic policy is historically correlated with US GDP growth, but presumably works in a counter-cyclical direction.  The estimated relationship implies that domestic policy can do only so much to offset the influence of US or world growth on domestic activity.

The model’s static forecast for Australian March quarter GDP is -0.8% q/q, with a standard error of 0.6, so we would expect March quarter GDP growth to lie in the range of -0.2% q/q to -1.4% q/q.  The median forecast of market economists is -0.2% q/q, based on Friday’s Reuters poll*, implying that the Australian economy is modestly outperforming what we might expect based solely on US growth.  Both domestic monetary and fiscal policy could thus be given some credit in offsetting the effect of the decline in world growth.  But even if we generously assume that discretionary fiscal policy measures account for most of this outperformance, it is a very small return on what has been called ‘the greatest mobilisation of resources in Australia’s peacetime history.’  The lesson is that for a small open economy like Australia, there is only so much domestic policy can do when confronted with a global economic downturn.

Model details over the fold.

* Update: Latest Reuters poll median is +0.2% q/q, following Tuesday’s release of net exports for the March quarter.

continue reading

posted on 02 June 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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Meltzer versus Battellino on Central Bank Credibility

Allan Meltzer doesn’t share Ric Battellino’s optimism that central banks will re-tighten monetary policy in a timely fashion:

Does the Federal Reserve have the technical ability to prevent inflation? Certainly! Will the Federal Reserve show the political stomach in the face of a sluggish recovery and almost certain cries of alarm from Chairman Barney Frank, the administration, the business community, the labor unions, and Krugman? Certainly not!

posted on 02 June 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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More Bubble Wrap

Alan Wood discusses the debate on the relationship between monetary policy and asset prices, referencing my CIS Policy Monograph Bubble Poppers.  Wood writes:

Central bankers have always taken asset prices into account in setting monetary policy and in Australia’s case successfully intervened in the housing market via both interest rates and jawboning by then governor Ian Macfarlane and head of Australian Prudential Regulation Authority, John Laker, a former Reserve banker, to cool off reckless lending and overheating in housing prices.

Kirchner dismisses this episode as unsuccessful, and the Howard government certainly didn’t like it. But the ratio of house prices to income fell markedly after 2003, when the RBA raised rates by 0.5 percentage points in two back-to-back hits. And Australia has so far not suffered anything like the housing price collapses in the US and Britain.

To be clear, my argument was that the RBA’s talk was not backed by policy action.  Like the rest of the world, monetary policy in Australia was accommodative in 2003 and the RBA had an explicit easing bias in June of that year.  As I noted in this op-ed, the nominal official cash rate did not reach a neutral level until 2005 and the real cash rate struggled to stay above neutral as inflation increasingly got away on the RBA.  Unfortunately, most media commentators mistake increases in the nominal cash rate for a tightening in policy, ignoring what is happening with real or expected interest rates.  It is this confusion that gave rise to the myth that the RBA presided over a successful bubble popping episode in 2002-03.

As the commodity price boom took off in 2003, population and income was sucked out of the south-eastern property markets and flowed into the resource-rich states.  As the RBA has noted, this saw renewed convergence in capital city house prices, as the heat was taken out of the south-east and shifted to the north-west.  This sub-national variation in house prices cannot be explained with reference to monetary policy, as much as the bubble poppers might like us to believe otherwise. It had a clear basis in sub-national differences in economic performance.

posted on 29 May 2009 by skirchner in Economics, Monetary Policy

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Why Monetary Easing Need Not be Inflationary

RBA Deputy Governor Ric Battellino, on why monetary easing need not be inflationary:

The other side of the debate – that the measures will result in higher inflation – implicitly assumes that the measures will be effective in stimulating the economy, since money does not miraculously transform into inflation without affecting economic and financial activity. Rather, their argument is that central banks will be too slow to reverse the various measures.

As there are no technical factors that would prevent or slow the reversal of recent measures – they can be reversed simultaneously or in any sequence – the argument must rest on central banks making incorrect policy judgments. This is always a possibility. But, the high state of awareness that currently exists about the risk of being too slow to reverse recent exceptional measures should limit the probability of such a mistake being made.

Unfortunately, a high state of awareness does not in itself guarantee timely policy action, as the RBA’s own track record would suggest.

posted on 28 May 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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