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Matt Nolan takes issue with Bernard Hickey's conclusions when applying a speech by British FSA boss Adair Turner to a NZ context

Posted in Opinion
Do the views of a British regulator have any relevance for NZ? Matt Nolan thinks Bernard Hickey has drawn the wrong conclusions.

By Matt Nolan*

Via Bernard Hickey I saw this speech by Adair Turner about monetary policy in the UK.

Let us give it some context – the UK has had their cash rate at virtually zero for some time, and many analysts over there have been screaming hyperinflation and showing that they do not understand the purpose of credibility, independence, and expectations management for a central bank in the slightest.

With these concerns in mind, Turner has come out to try and open up debate a little more, and make it a bit more intelligent.

This is good.

However, I think that Bernard Hickey is misinterpreting these points when he comes back to looking at NZ.

However, as I agree with him that we should discuss these issues I am going to briefly point out here how I can:

   1. agree with Adair Turner

   2. disagree with the inferences Bernard Hickey seems to be aiming at.

Let’s go.

1)  So we start with a point that you’d be surprised to hear that no-one in the economics profession would disagree with:

And still only slowly gaining better understanding of the factors which got us there and which constrain our recovery. We must think fundamentally about what went wrong and be adequately radical in the redesign of financial regulation and of macro-prudential policy to ensure that it doesn’t happen again. But we must also think creatively about the combination of macroeconomic (monetary and fiscal) and macro-prudential policies needed to navigate against the deflationary headwinds created by post-crisis deleveraging.

This was an accepted point as soon as the crisis occurred.

There was something descriptively missing from our understanding of what was going on – and that appears to have been the large unregulated shadow banking system, which thought it had an implicit backstop, but didn’t.

Given that, central banks didn’t understand the scale of the crisis before it was too late – they didn’t respond sufficiently – and in the ECB’s case they took years to respond appropriately.  There are lessons here for policy makers – but let’s not get too far ahead of ourselves.

2, 3, 4)  Next Hickey comes to the following “2. And then he thinks the unthinkable and says the unsayable.” – where he is talking about helicopter drops (printing money, giving it to people).

Pro-tip, this is far from unthinkable. It is taught in university. It is even taught at undergraduate level.

Bernanke, the current Fed governor, was called “helicopter Ben” for a reason – he was one of the guys that pushed the idea that if we even face a crisis like the Great Depression, where the “natural” interest rate is very negative (so that savings and borrowing are only balanced at a negative rate) we can deal with this by printing dem dollars and dropping them from a helicopter.

Now there was a problem here – this is essentially a form of fiscal policy as well as monetary policy.

As a result, you need a democratic mandate (or permission) to do it. Central banks didn’t have that – and as a result even if they wanted to do it there were problems.

This is an area where policy needed to be tied down in practical terms prior to the crisis.

Let us bring it back to New Zealand. Were we ever at a case where the “natural” interest rate was negative?  No.

In that environment, if we have the OCR at the right level and THEN we print a bunch of money and throw it around it IS inflationary.  This is why I was saying QE doesn’t make sense here, let alone direct monetization!

5, 6, 7)  Friedman says abolish fractional reserve banking

Ok ok ok ok ok – Friedman 1948-1960 was very different from later on.

Yes, originally many economists were against fractional reserve banking, as it seems intuitive to be against it.

Having the funds on hand to pay back the depositors just seems natural.

Remember, Friedman suggested many things, and as data improved and his experiences widened he updated these views – he was a master economist, his mind was open and sharp.

The thing is that it misses the investment side of things. Financial institutions are an intermediary, savings and investment are always equal (with any gap captured by the capital/current account), and that demand for investment is in a large part based on an expected rate of return.

By allowing banks to lend out to meet loans, this process gave regulated agents in the economy the ability to screen and provide this intermediary service.

Remember, banks still set assets equal to liabilities – the big thing that differs between assets and liabilities is their time profile!

There are concerns around whether expected returns on investment are adequately screened, or that there is some systemic risk, or “black swan” events – and that these require a central bank or central government to offer implicit insurance.

However, goes a step further and has the central bank directly set the money supply – given that this supply is set exogenously at a point in time, and shifts in investment demand would lead to swings in the price level and interest rates.

Turner goes on to point out the real argument he is making here – there may be a reason why the socially desirable reserve ratio differs from the one banks independently come to.  Full reserve banking sets the RR at 100%, banks will set it at a lower level, what level allows market participants to have an efficient time meeting funding for investment and desire for invest while also dealing with any perceived “collateral damage” in the case of crisis?  This is an old and widely accepted point among economists, and something that there has been a lot of work on especially over the last decade (so prior to the crisis!).

8)  Need to reconsider inflation targeting

This one is easy – he is saying that “strict inflation targeting” doesn’t seem to make sense.  Conveniently the only central bank that tried to follow this is the ECB, not NZ.

Blanchard's higher inflation target, current Fed policy, Woodford, and Mark Carney‘s discussion on NGDP are ALL consistent with flexible inflation targeting.

In fact, the last three have made a point of saying flexible inflation targeting is THE BEST framework out there – and that we can use the gains from it to switch to level targeting if we are at the ZERO LOWER BOUND.

Again, NZ isn’t at the zero lower bound, and already does flexible inflation targeting!

9, 10)  Monetary policy isn’t necessarily hyperinflationary

This is targeting squarely at the UK media and analysts – who are talking a lot of nonsense at the moment. In New Zealand, the central bank knows this, and from what I can tell most analysts do as well.

Finishing remark

As I’ve said before, the policy debate in NZ is going in a strange direction. Compared to a lot of countries our monetary policy is very good – and the debate we are having needs to be reframed to look at the real issues that are hitting New Zealand.

Why are the real exchange rate and real interest rates persistently so high?

Why is our current account deficit persistently so large?

These are not issues about monetary policy – they involve taking a harder look at government, competition policy, and institutions in New Zealand ... as well as more carefully looking at NZ data (after all, our debt profile is a different one!).

-------------------------------------------------------------------------

Matt Nolan is a senior economist at Infometrics. This piece was originally published on TVHE and is used here with permission.

Bernard defended himself on TVHE. And Matt followed up there with further points.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment in the box on the right or click on the "'Register" link at the bottom of the comments.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current Comment policy is here.

27 Comments

Matt, "However, goes a step

Matt,
"However, goes a step further and has the central bank directly set the money supply..."
Whom goes further?
This is not the only basic mistake. So many points off for poor prose that you lose your argument before it is adequately invoked.
Recall you are arguing, in English not Econese, with a journalist.
Revise and edit Matt.
Regards,

This was a personal blog post

This was a personal blog post that I scrawled up, and Bernard Hickey was interested - as it was involved with our dialogue.  This wasn't an article written for anyone or anything - and interest.co.nz just wanted to borrow it.

This however is relative and

This however is relative and not absolute which Matt N I think you are ignoring or at least not making clear..
"In that environment, if we have the OCR at the right level and THEN we print a bunch of money and throw it around it IS inflationary"
That was pre-peak oil btw.  Now I do think we should be dropping the OCR first, at least 1% ie we are looking at dis-inflation with CPI at 0.9%,  we desperately need to turn around....before we go negative.
So lets say inflation is 4% and the OCR is say 6%, printing in that situation provided it gets to ppls pockets is inflationary...
However there are so many ifs and buts that qualify where we are today and not the above simplistic model its not true.
Printing for instance where it doesnt make it to ppls pockets.
High un-employment and over-capacity
So lack of demand in a way...
High energy prices and commodity prices removing profit (margins)
So really lets move on from the text book and out into the real world.
 
regards
 
 
 

That was pre-peak oil btw. 

That was pre-peak oil btw.  Now I do think we should be dropping the OCR first, at least 1% ie we are looking at dis-inflation with CPI at 0.9%,  we desperately need to turn around....before we go negative.
 
I firmly believe you misunderstand the relationship between lower interest rates and deflation -  read article
 
Moreover,
 
The financial media and economists want us to believe that the Fed printing is "stimulus" when in fact it is part of the "liquidation" of Fed member banks' balance sheets of bad assets. Read article

If you want to go with what

If you want to go with what they (Austrians) think is happening fair enough....Personally I think fekete is a nut job and zerohedge as well.  So its not a question of mis-understanding at all as far as I am concerned.
But thanks for putting your posts in a very clear context.
regards

If you want to go with what

If you want to go with what they (Austrians) think is happening fair enough
 
I just go along with that which makes money over the long run.

Stephen, that was Stevens

Stephen, that was Stevens answer when he does not know what to say....now that you have mentioned making money in the long run you have given him the opportunity to get off the hook..I sense the energy argument stirring again...

There are I think enough

There are I think enough comments that arguing with extremists/fanatics like Liberatarians/Austrians over and over again is simply a waste of time.  I mean when that side at 0.01% accuse the 99.99% of being brianwashed by the nanny state you just know there isnt much point in arguing in depth, with logic, reason and evidence.  Besides which I have a lot more interesting things to do than comment against that piece...
Energy, well the long run comment is interesting...because the "long run"  was the last 50-70 years, which is now passing....the next 50 years will be vastly different and not pretty.  I think as Hugh Hendry says (paraphrase) right now its about losing the least money....and that is the mind set yet to sink in.
Kind of like your comment that there is plenty of ammo in LA....reality in the industry world wide says no....but then there's a business opportunity for you, buy it all up in LA and ship it....
I think PK this morning sums it up well enough,
http://krugman.blogs.nytimes.com/2013/02/13/marco-rubio-has-learned-noth...
regards

Steven maybe this info will

Steven maybe this info will help you understand.  Just check out what is beng spent on Social Security and Welfare then look at how much is generated in revenue from income tax. 
Core Crown Expenses 2012/2013 = $73.7b
Social Security and Welfare.............$23.2b
Health...............................................$14.7b
Education..........................................$12.4b
Law and Order..................................$3.6b
Transport and Communications.......$2.2b
Core Government Service.................$6.5b
Finance Costs...................................$3.8b
Other................................................$7.3b
 
 
Core Crown Revenue 2012/2013 =$ 64.2b
 
Individuals Tax...................................$25.5b
Corporate Tax.....................................$9.0b
GST.....................................................$15.7b
Other direct Taxes .............................$2.1b
Other Indirect Taxes...........................$5.6b
Interest Revenue and Dividends.........$2.4b
Other Revenue...................................$3.5b
 

ergo pension funds go bye

ergo pension funds go bye bye....and thats before we even consider energy.
regards

Totally different

Totally different context......
The discusion started on different or differing schools of economics and not a spot look at Govn finances.
Ive commented before that the tax take level should be neutral across booms and busts and the difference saved in the booms used to pay for the above deficits in busts.  Further instead of using the OCR as a tool which hammers savers one minute and debtors the next vary the tax rat instead.
regards

Stephen - thanks for

Stephen - thanks for links......alway like what Fekete has to say.
 
There are quite a few articles floating around on the "liquidation" not "stimulus" view. 

These two comments by the

These two comments by the writer are of real concern and suggest a real lack of understanding as to what banks actually do.
Having the funds on hand to pay back the depositors just seems natural.
Financial institutions are an intermediary, savings and investment are always equal (with any gap captured by the capital/current account)

Financial institutions are an

Financial institutions are an intermediary, savings and investment are always equal (with any gap captured by the capital/current account)
this is the part I don't understand.....   If Banks were just intermediaries...and if savings and investment are always equal....   Then....
How does money supply Grow..?????
Answer that one Matt....  
For Money supply to GROW.... Banks have to be able to "create" credit...
This is what distinguishes Banks from, for example, small Finance companies...( which truely are intermediaries,...where savings equals investment )
look forward to ur answer..
Cheers  Roelof

Savings and investment are

Savings and investment are always equal - it is an identity. 
However, neither of them is fixed, they are both a function of demand and supply factors - and the interest rate combined with expectations of inflation is the price.  Savings and investment are jointly determined by a set of factors ... one doesn't cause the other.

Banks are intermediaries ... but "only" is a strange term to use here.  Saying a bank is an intermediary only involves admiting that they are matching and screening the activities of borrowers and savers - it does not change the point that banks can "create credit" at the given price, and given the inherent capital ratios set by the central bank.

Also, banks assets and liabilities do equal - this is a factual statement as well.

  Matt: Let us bring it back

 
Matt:
Let us bring it back to New Zealand. Were we ever at a case where the “natural” interest rate was negative?  No.
In that environment, if we have the OCR at the right level and THEN we print a bunch of money and throw it around it IS inflationary.  This is why I was saying QE doesn’t make sense here, let alone direct monetization!
What if we have the OCR at the right level, but instead of the government borrowing money from offshore to fund its deficit, it prints that money instead? How is that inflationary? (That is I believe the Green's proposal more or less).
If the inflationary impact is through a lowering of the exchange rate, then in my view that would instantly help solve the competitiveness issue you rightly wish to address. And if it does not affect the exchange rate, how has that not saved us the billions in principal and interest not borrowed?
Seems to me there are many chicken and egg situations here:
The first principles to me start with our loss of wealth through excess national spending vs production (imports over exports simplistically); leading to very high national indebtedness and/or loss of assets. This also means we are favouring foreign producers over domestic production; affecting our producers, and their employees.
The price signals of a high exchange rate encourage this behaviour. They also encourage for many reasons investment in property rather than production.
If we keep borrowing/selling to pay for this process, there is a vicious cycle effect, that needs to be broken. The extra borrowing lifts the exchange rate, further encouraging more buying of foreign vs domestic goods and services. The most obvious way to break the cycle is to fund directly whatever proportion of the government deficit is required to achieve reasonable outcomes of GDP, employment, and services and indeed, inflation. You rightly say it is the government's role to determine fiscal policy; but surely the RB has a role in determining how that is funded as part of monetary policy.
Turner states over and over in his paper that the objectives of a Central Bank should almost certainly be broader than just an inflation measure; and that the tools they have to manage to their objectives should be wider than the OCR, and should where appropriate include printing to fund deficits. By the by, if our exchange rate were more aligned with fundamentals, you would expect higher production, higher employment, higher profits, higher tax revenues (with no higher rates) and lower welfare. So a lower fiscal deficit as well, a virtuous rather than vicious cycle.
You seem to contradict the proposition that the RBNZ's singular monetary policy focus is inflation; that is news to me. What are there other targets? Clearly most other central banks are now operating a mix of objectives including inflation, but overtly or not, also including nominal GDP, unemployment, and exchange rates and their current accounts.
We seem an outlier, and there in my view, is the key answer to your end questions:
Why are the real exchange rate and real interest rates persistently so high?
Why is our current account deficit persistently so large?

Hows that Venezuelan

Hows that Venezuelan devaluation working out?

How is Chinese devaluation

How is Chinese devaluation worked out?
And some other countries previously.

Might be a good place to

Might be a good place to repost this:
Charlie Munger on monetary policy    https://www.youtube.com/watch?v=DwuNlqin4I4
 
Max Keiser on cargo cult Keysnians  https://www.youtube.com/watch?v=_ZbhcGs0Fio

Matt nails it.   (1) Why are

Matt nails it.   (1) Why are the real exchange rate and real interest rates persistently so high?  (2)Why is our current account deficit persistently so large?
Government institutions and competition policy  are where we need to look.  New Zealanders are being boiled like frogs with a deteriorating jobs market, and price gouging on a massive scale.  (see electricity)  And massive non productivity.  Individuals and small business owned by New Zealanders are being massively screwed.  Not that that is important any more apparently.
 

Well said, though I'd add a

Well said, though I'd add a few like Steve Keen got it right, however their views have been steadfastly ignored for 4~5 years.
Ergo the clueless such as this one actually dont want to get clued up.
regards

Matt I have also read the

Matt I have also read the Turner article.  But reading your summary I wonder if we both read the same article.  You summarise nothing about the role of banks using fractional reserve banking to create their own money (i.e. not central bank created).  You don't convey the important point by Turner that monetary or fiscal measures (or combinations)  might have an inflation effect or a growth effect or some combination of both depending on the specific circumstances.  
It isn't as black and white.
The economics profession (especially the neo-classicals)are more culpable that you try to convey.
 
 

"You summarise nothing about

"You summarise nothing about the role of banks using fractional reserve banking to create their own money (i.e. not central bank created).  You don't convey the important point by Turner that monetary or fiscal measures (or combinations)  might have an inflation effect or a growth effect or some combination of both depending on the specific circumstances. "

As mainstream economics assumes that credit creation is endogenous, and that monetary and fiscal policy "shocks" can effect output in the short run - in exactly the same way he discusses.  If we didn't think this, we wouldn't have a flexible inflation targeting central bank who uses the short-term interest rates (and not the quantity of high powered money) as an instrument!
Think of it this way.  If you set the short term price, shifts in say demand for credit will be met, which in turn will lead to inflationary pressures - which leads the central bank to change the price.  If we were to set the short term "stock" by not using fractional reserve banking, then instead demand changes would be met by shifts in the interest rate ... which the central bank would then decide whether to incorporate or not.