Overhyping nothing: The NZ context for the UK FSA speech

By Matt Nolan 13/02/2013


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 suprised 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 occured.  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 govenor, 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 depositers 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 adequetely 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 targetin

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.

Blanchards 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 nonsence 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 is 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!).