World’s Most Expensive Narrative
Vince Reinhart, on the high cost of bad narratives:
The most expensive stage of a financial crisis is not the initiating economic loss—in our case, an unsustainable boom in residential construction that left too many houses and a mountain of debt. Nor are the largest losses racked up as investors withdraw from risk, markets freeze, and balance sheets implode. Policy missteps, including the continuing confusion of solvency problems for liquidity ones, no doubt add to the tab. These costs, while they may be big, pale to insignificance compared to what follows.
The most expensive stage of a financial crisis occurs when society tries to explain to itself what just happened. The resulting narrative is not the product of one person or institution. Rather, it gets written in the tell-all “tick-tocks” of major newspapers, the inside accounts in bestsellers, the speeches of leading officials, and the punch lines of late-night comedians. The narrative determines our attitudes toward the actors and events of the crisis. It also identifies the structural problems thought suitable for legislative and regulatory remedy.
posted on 03 June 2009 by skirchner in Economics, Financial Markets
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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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Bankruptcy and the Rule of Law in the US
James Glassman on the decline of the rule of law in the United States:
I head a nonprofit group that encourages developing nations to adopt policies that will lead to prosperity — starting with transparency and the rule of law — and hold up America as a model. Yet in its high-handed dealings with Chrysler and G.M., the Obama administration reminds me of an irresponsible third-world regime, skirting the law and handing economic prizes to political cronies…
What lesson does federal favoritism toward Chrysler and G.M. teach other businesses that play by the rules? How will our trade negotiators keep a straight face when complaining about subsidies to Airbus or Chinese steel makers? The government should have stepped aside earlier and allowed a normal bankruptcy that would have treated the union and the debt-holders fairly.
As P J O’Rourke notes, bankruptcy is the norm rather than the exception for the US car industry:
American cars have been manufactured mostly by romantic fools. David Buick, Ransom E. Olds, Louis Chevrolet, Robert and Louis Hupp of the Hupmobile, the Dodge brothers, the Studebaker brothers, the Packard brothers, the Duesenberg brothers, Charles W. Nash, E. L. Cord, John North Willys, Preston Tucker and William H. Murphy, whose Cadillac cars were designed by the young Henry Ford, all went broke making cars. The man who founded General Motors in 1908, William Crapo (really) Durant, went broke twice. Henry Ford, of course, did not go broke, nor was he a romantic, but judging by his opinions he certainly was a fool.
posted on 01 June 2009 by skirchner in Economics
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The Quiggin-Caplan Wager: I’m with Quiggin
Bryan Caplan and John Quiggin take a 10-year bet on the average of the US-EU15 unemployment rate differential. On this bet, I have to say I’m with Quiggin. The reason: the US is thinking more and more like Quiggin and less like Caplan. Public policy in the EU is not appreciably worse than it has been in the past, but the rate of deterioration in the US implies that their respective structural unemployment rates should converge via a faster rate of deterioration in the US. The capital allocation process in the US is now so deeply compromised by political intervention that there is little reason to believe in the continued structural outperformance of the US economy. Differences in labour market institutions won’t matter much in this context. Caplan himself puts his chances of winning at only 60%.
David Goldman put it well in perhaps the most disturbing metaphor for the crowding-out effect on US economy:
The moment the zombie pulls on his chain, rates rise, consumption falls, and the zombie gets less oxygen.
posted on 29 May 2009 by skirchner in Economics, Financial Markets
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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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Convenience Shopping for Gold Bugs
Gold vending machines.
posted on 29 May 2009 by skirchner in Economics, Financial Markets, Gold
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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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Steve Keen, They Hardly Knew You: Consumer House Price Expectations
The most recent Westpac-MI Consumer Sentiment survey included a question on expectations for house prices over the next 12 months. Expectations were close to balanced nationally, with those expecting declines slightly outnumbering those expecting falls. However, there was considerable sub-national variation. Most pessimistic are the resource states of Queensland and WA, while the south-eastern states are relatively upbeat. No change was the single most common expectation in every state, except NSW, where the single most common expectation was for a rise of 0-10%.
posted on 27 May 2009 by skirchner in Economics, House Prices
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Boondoggle Nation
RBA Board member Warwick McKibbin, on the effectiveness of activist fiscal policy:
“Most fiscal policy doesn’t do anything except switch spending from one period to another,” the RBA director said.
“When you change fiscal policy, all you do is stimulate the economy today out of future possible growth.”
Stimulus spending had to be paid for either with higher future taxes or reduced opportunities for the private sector so that the public sector could be financed.
“The only exceptions are infrastructure and similar spending, which raises the return to private activities,” Professor McKibbin said.
“The most sustainable way of reducing a fiscal deficit is through strong productivity growth in the private sector.”
He said that in mature economies, it was hard to engineer productivity growth.
Whether public infrastructure spending increases private sector productivity is a case-by-case judgement. As the rest of the story makes clear, much of the government’s stimulus spending consists of little more than electoral boondoggles such as swimming pools and sports stands.
posted on 26 May 2009 by skirchner in Economics, Fiscal Policy
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The Monthly Labour Force Lottery
Centrebet is now running a book on the unemployment rate, as published in the monthly ABS Labour Force release. A rate of 5.6%-5.7% is currently favoured for May following 5.4% in April.
The quoted range begs the question as to whether they would pay on a rounded estimate published at 5.6% or 5.7% that was actually outside this range on an unrounded basis.
posted on 25 May 2009 by skirchner in Economics, Financial Markets
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Crowding-Out Gets Crowded-Out
I have an op-ed in today’s Age, noting that it is the crowding-out effect and not the short-run multipliers that will determine the long-run economic effects of the government’s discretionary fiscal policy actions:
In the 366 pages of Budget Paper No. 1, where the Government outlines its fiscal strategy, crowding out isn’t mentioned once.
It wasn’t always this way. The budget papers released in the second half of the 1990s were full of references to the contribution federal budget surpluses were making to national saving and investment. One of the advantages of budget surpluses, Treasury informed us, was that the government would no longer make a net call on capital markets. Instead of crowding out private capital and investment spending, budget surpluses would crowd them back in.
All this was said when the economy was still well short of full employment.
Treasury Secretary Ken Henry’s “secret” speech to Treasury officers in March 2007 drew heavily on the idea of crowding out to explain why government intervention in an economy at full employment was counter-productive, resulting in a misallocation of resources and reduced output. Only by augmenting the supply side of the economy, he noted, could Australia increase national income.
When the public sector saves less, all else being equal, national saving is also reduced, reducing future growth in national income. This crowding-out effect can occur even if there is no change in interest rates and the economy is below its full employment level of output.
posted on 22 May 2009 by skirchner in Economics, Financial Markets, Fiscal 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 Ken Henry Speech that Time Forgot
Treasury Secretary Ken Henry, speaking to the Sydney Institute in 2005:
By the 1990s, however, a consensus had emerged, in Australia and elsewhere, that fiscal activism had to be limited. Fiscal policy had to be given a medium-term anchor. At the same time, a view emerged that macro stabilisation should be primarily the responsibility of monetary policy. But monetary policy, too, had to have a medium-term anchor….
The last of these observations is particularly striking for a student of post-war economic history: one has to wonder whether the policy debate in this country is not the sort of thing that one might have hoped to see in a ‘classical’ economy of the sort that economists thought existed before the Great Depression and the ensuing Keynesian revolution; a debate about the factors that influence our productive capacity rather than the factors that influence our demand for it…
It might be worth asking the question whether, because of the reform efforts of the past, we should not now consider ourselves to be most often in a ‘classical’ world in which the economy naturally trends toward, and in fact spends most of its time quite close to, its productive capacity, or supply potential, without the need of continuous macro policy stimulus.
Answering this question in the affirmative would not imply a view that we have eliminated the business cycle. There will be future economic downturns. And when we see evidence of one we should not be afraid of responding with activist expansionary macroeconomic policy. Rather, an affirmative answer implies some conditioning of the exercise of macro policy activism – an acceptance that large swings in macro instruments are to be implemented (only) in extremis…
let me say something about the emerging pressure for increased infrastructure spending. This pressure is mostly well-intentioned – more spending on infrastructure will indeed tend to increase the productive potential of the economy. And, with long-term interest rates and therefore the cost of capital at a cyclical low at the moment, both the public and private sectors are in a relatively strong position to undertake additional spending.
But without appropriate price signals, quality investment decisions will not be made. And present price signals are far from appropriate. The risks of making large infrastructure investment decisions in such an information-poor environment are very great.
posted on 20 May 2009 by skirchner in Economics, Fiscal Policy
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Wisdom of Crowds: Budget Edition
Only 30% of Newspoll respondents believe the federal budget will be back in surplus within six years. There is a sharp partisan divide on this issue, although surplus skepticism increases with age and income. It is interesting that the most well received federal budget since 1993 was also the Howard government’s last.
posted on 19 May 2009 by skirchner in Economics, Fiscal Policy, Politics
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