Working Papers

The Wizards of Oz: Behind the Curtain

The always interesting Scott Sumner (who is right on most things) falls into the grass-is-always-greener trap that seems to afflict many Americans when it comes to monetary policy:

Earlier I said Australia is very similar to the US.  The main difference is that the wizards who run monetary policy in Australia don’t listen to Puritans who insist we must suffer high unemployment for our sins. 

Scott is impressed with Australia’s high rates of nominal GDP growth, which he attributes to superior monetary policy.  But as Scott himself notes, Australia has had a high average growth rate for nearly 20 years.  Real growth has also averaged at or near the top of the OECD.  In other words, this outperformance is structural rather than cyclical and has little to do with short-run demand management.  The fact that Australia has continued to outperform in the context of a global economic downturn lends further weight to the view that this outperformance has been structural rather than cyclical.

Scott fails to consider the downside of this high rate of nominal GDP growth: a high rate of inflation.  While Australia’s headline inflation rate has moderated recently, the statistical core series that capture the persistent component of inflation are still running well above the upper bound of the RBA’s 2-3% target range, even after a nearly two percentage point increase in the unemployment rate.  Australia consequently also has some of the highest nominal interest rates of any developed country.  As Friedman noted, high nominal rates are often indicative of monetary policy that is too loose due to a high inflation premium. 

The RBA’s inflation target range has a mid-point above the 2% widely considered to be consistent with price stability in the rest of the world.  Australia has thus institutionalised a relatively high rate inflation.  If the central bank’s primary responsibility is long-run inflation and price stability rather than nominal income growth, then Australia’s monetary policy performance does not compare favourably to the US.  What is considered to be an acceptable inflation rate in Australia would be considered a policy failure in the US.

posted on 10 August 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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It’s Not Easy Being a Supply-Sider

From RBA Governor Glenn Stevens’ speech yesterday:

A very real challenge in the near term is the following: how to ensure that the ready availability and low cost of housing finance is translated into more dwellings, not just higher prices. Given the circumstances – the economy moving to a position of less than full employment, with labour shortages lessening and reduced pressure on prices for raw material inputs – this ought to be the time when we can add to the dwelling stock without a major run up in prices. If we fail to do that – if all we end up with is higher prices and not many more dwellings – then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over leverage and asset price deflation down the track.

Much of the commentary on Stevens’ speech suggested that he was warning of a housing ‘bubble’, but the text makes clear that his real concern was the supply-side rigidities that amplify asset price cycles.  Stevens’ speech is the lead story in much of today’s media, but Google News finds only three stories that directly quoted ‘serious supply-side impediments’.  It is indicative of how difficult it is to interest the media in structural as opposed to cyclical stories.

posted on 29 July 2009 by skirchner in Economics, Financial Markets, House Prices, Monetary Policy

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Central Bank Transparency and Accountability in Action

Federal Reserve Chairman Ben Bernanke’s appearance at a town hall meeting at the Federal Reserve Bank of Kansas City can be seen here (transcript here). 

As I lamented in an AFR op-ed last week, this kind of public scrutiny is notably absent in Australia.

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

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No Time for a Media-Shy Central Banker

I have an op-ed in today’s Australian Financial Review, comparing the level of media scrutiny applied to central bankers in Australia and the rest of the world.  Full text below the fold (may differ slightly from edited AFR text).

continue reading

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

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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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