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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.

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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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Is the RBA Still Agnostic on Bubble Popping?

In contrast to the cautious agnosticism of his boss on the question of bubble-popping, RBA Assistant Governor Guy Debelle is remarkably clear on the issue:

the current episode vindicates the position that monetary policy, narrowly defined as the setting of the policy interest rate, should be confined to targeting inflation. Set interest rates primarily to achieve the inflation goal as that, in itself, contributes to sizeable social gains. A departure from that runs the risk of losing the nominal anchor that the inflation target provides.

But other tools, most notably the much-touted (although not clearly defined) macro-prudential instruments, should be used to address asset price and credit imbalances. I do not think that a slightly tighter setting of interest rates would have prevented the development of the imbalances that have led to the current financial crisis. When human psychology is such that optimism about asset price rises is at the fore, then an excessively stringent setting of interest rates would be required to suppress the optimism. The Australian and Scandinavian experience in the late 1980s shows the sort of interest rate settings required to achieve such an outcome. In that example, a credit boom and bubble-like asset price dynamics took hold and only a very high setting of real interest rates ultimately curtailed that, but at the cost of a historically high level of unemployment.

I do not think it would be socially acceptable or desirable to endure the level of unemployment that would come with the high interest rates necessary to pop the bubble. It is asking too much of the single monetary policy instrument, namely, the targeted short-term interest rate to target both financial excesses and inflation.

Nor do I believe there is much to be achieved by ‘leaning against the wind’. The wind that is blowing in most episodes of credit booms is generally at least gale force. Setting interest rates a bit higher in such circumstances is likely to be close to futile when such credit dynamics take hold. Again, what would be the point of undershooting the CPI inflation target and enduring a higher than desirable level of unemployment with little to be gained. How would such actions be explained to the public?

 

posted on 21 May 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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The Myth of an Independent Treasury

My CIS colleague and former Treasury official Robert Carling has an op-ed on page 21 of today’s Australian (no link, but see text below the fold) noting that neither Treasury nor the Budget papers are independent of the federal government. 

The claim that Treasury is an institution independent of government fundamentally misconstrues the relationship between the federal government and the Commonwealth public service.  While it is not surprising to see politicians fail Economics 101, it is more surprising to see them also failing Political Science 101. The government now routinely hides behind Treasury and RBA independence and the federal opposition is increasingly accommodating this behaviour through their unwillingness to challenge official sector views.

While the RBA is more independent than Treasury, this independence is limited in scope.  At its most basic, RBA independence means that it is free to set interest rates without the approval of the Treasurer, what is often called ‘operational independence.’  This independence in no sense precludes the government or opposition from taking a different view on monetary policy to the RBA or being publicly critical of central bank policy actions, statements and forecasts.  The RBA has been made progressively more independent of government precisely in order to facilitate differences of opinion with government.  Under the Reserve Bank Amendment (Enhanced Independence) Bill, it is almost impossible to remove the RBA Governor, so public criticism could hardly be viewed as a threat to the Governor’s position.  By the same token, the RBA would not be compromising its independence by speaking out on issues relating to its statutory responsibilities, provided it does so in a non-partisan fashion.

Mistaken notions of Treasury and RBA independence are being used to suppress public debate over economic policy, not least by the current government.  That the federal opposition and media are accommodating this behaviour on the part of the government can only undermine the robustness of public debate and democratic accountability. 

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posted on 16 May 2009 by skirchner in Economics, Fiscal Policy, Media, Monetary Policy, Politics

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Should We Use Monetary Policy to Regulate Human Nature?

Writing in the letters page of today’s AFR (no link), Des Moore says:

Whether or not a targeting of asset prices warrants more attention, any review of policy surely needs to address the difficult issue of changes over time in human nature…

There is a long history of swings in attitudes from optimism to pessimism, often “inspired” by governments, that result in changes in risk behaviour: our most recent swing of optimism was reflected in the boom in investment in commodity production. 

If monetary policy does not pay sufficient regard to such swings, it is very likely that we will end up with a “bust” - and high unemployment. That is what happened in the 1980s and what is happening now…

The idea that human nature is variable at business cycle frequencies is highly questionable, as is the assumption that the monetary authorities are somehow immune to these ‘swings of attitude’.  Des falls into the classic trap identified by public choice theorists of assuming that human nature changes when we relocate people from the private to the public sector. 

In arguing that the recent boom in commodity investment was a ‘reflection’ of ‘our most recent swing in optimism’, Des Moore identifies himself with behavioralists like Robert Shiller, who maintain that sentiment drives economic activity, rather than the other way around.  But as I argue in Bubble Poppers, the more asset prices are thought to be disconnected from the real economy, the weaker the case for using monetary policy to regulate asset prices via the real economy.

posted on 06 April 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Bubble Wrap

Reactions to my Bubble Poppers monograph, here and here.

posted on 31 March 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Bubble Poppers: Monetary Policy and the Myth of ‘Bubbles’ in Asset Prices

CIS has released my Policy Monograph, Bubble Poppers: Monetary Policy and the Myth of ‘Bubbles’ in Asset Prices.  The text was finalised before Greenspan published a defence of his record in the WSJ, but takes a similar position to the former Fed Chair.

The monograph is partly devoted to debunking the concept of a ‘bubble’ in asset prices.  It argues that if the idea of ‘bubbles’ in asset prices cannot be given analytical or empirical substance, then monetary policy should not attempt to actively manage asset price cycles.

There is a shorter version in the latest issue of Policy and an even shorter version in today’s Age.

posted on 19 March 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Greenspan versus Taylor

Former Federal Reserve Chairman Alan Greenspan defends the Fed’s record against criticism from John Taylor:

However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his “Taylor Rule,” “it would have prevented this housing boom and bust. “This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover, while I believe the “Taylor Rule” is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble. All things considered, I personally prefer Milton Friedman’s performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”

Proving that great minds think alike, I will shortly be releasing a CIS policy monograph making much the same argument in the context of a broader discussion of the relationship between monetary policy and asset prices. I discussed the issue with John Taylor at the New York MPS meeting, but could not bring him around to my point of view.

 

posted on 12 March 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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The Greenspan Counter-Factual

Alan Greenspan on the counter-factual to the Fed’s 2001-2004 easing cycle:

“If we tried to suppress the expansion of the subprime market, do you think that would have gone over very well with the Congress?” Mr. Greenspan said. “When it looked as though we were dealing with a major increase in home ownership, which is of unquestioned value to this society — would we have been able to do that? I doubt it.”

Mr. Greenspan said that if he had taken steps to prevent the crisis, the outcome would have been painful.

“We could have basically clamped down on the American economy, generated a 10 percent unemployment rate,” he said. “And I will guarantee we would not have had a housing boom, a stock market boom or indeed a particularly good economy either.”

posted on 13 February 2009 by skirchner in Economics, Monetary Policy

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