There’s one country that took Andy Harless’s advice

As you know, I have relentlessly argued that the Fed made a huge mistake in mid-2008 by not targeting NGDP at about a 5% growth trajectory, level targeting.  If they had done so, NGDP almost certainly would not have fallen last year, and the recession would have been far milder.  But 5% NGDP growth, which implies about 2% trend inflation, almost certainly is not the optimal monetary target in the long run.  I picked it because the Fed had been implicitly targeting NGDP at around 5% for several decades, and since all sorts of wage and debt contracts in 2008 had been negotiated under the reasonable assumption that we would continue to have roughly 5% NGDP growth, it didn’t seem like a good idea to enact a highly deflationary policy in the midst of a financial crisis.  But I’m not running the Fed.

In fact, the optimal inflation rate is probably either lower or higher than 2%.  If we were to assume the Fed adopted NGDP forecast targeting, level targeting, then we would not have to worry about “liquidity traps,” i.e. the zero-rate bound on conventional monetary policy.  In that case we’d be better off with a lower inflation rate.  Neither Bill Woolsey or George Selgin advocate inflation targeting; their proposals are somewhat closer to my NGDP idea, but Woolsey’s plan would likely lead to near-zero inflation in the long run, and Selgin’s plan would probably lead to slight deflation on average.  These are sensible ideas if we have sound monetary policy, as inflation is a tax on capital, and lowers the rate of economic growth.

On the other hand if we don’t have a sensible monetary policy regime, then low inflation makes an economy more susceptible to bumping against the zero-rate bound.  Nick Rowe compares the problem to balancing a tall pole in one hand.  If you want to make the top of the pole go left, you move your hand to the right.  If the Fed wants inflation to rise, it lowers the fed funds rate.  But suppose while balancing the pole you bump up against a wall, then you can’t move your hand further to the right, and thus can’t move the top of the pole to the left.  That’s a liquidity trap.  Of course both Nick and I realize that you aren’t really stuck, you can climb a ladder and directly pull the top of the pole in whatever direction you like.  But many central bankers are afraid of heights. 

So let’s suppose you have a central bank full of meek, timid souls.  What sort of inflation rate is optimal?  I’ve mentioned that you’d probably be better off with an inflation rate even higher than 2%.  But I never really developed the idea, as I didn’t want people to associate my 5% NGDP rule with a policy of printing money to get out from under our debt burden.  I am not an “inflationist” or a monetary policy ”dove.”  Still, I should have done a post and let the chips fall where they would. Fortunately, Andy Harless has done so, and much more elegantly than I could have. 

In the 1980s we brought inflation down from double-digits to about 4%.  Should we have declared victory and stayed at that level?  In retrospect, we probably should have.  We did get inflation down to about 3% in the 1990s, and only 1.8% in terms of the GDP deflator from mid-2000 to mid-2008.  At the time I thought this was good, because it lowers the real tax rate on capital.  But in retrospect it was a big mistake, as the cost of the liquidity trap we stumbled into in late 2008 will vastly exceed the gains from 1% or 2% lower inflation.  Indeed one of the costs will be a massive increase in our national debt, which will almost certainly lead to much higher tax rates on saving and investment.

Interestingly, I know of only one country that stayed away from the ever lower inflation obsession of the major central banks.  The Bank of Australia.  Australia had about 4% inflation in their GDP deflator and 7.4% NGDP growth between 2000:2 and 2008:2.  With a much higher inflation and NGDP trend rate going into the crisis, they we able to avoid the zero interest rate bound.  And by the way, for those who think nominal shocks don’t explain real events like the recent recession, Australia was the only major developed economy to avoid a recession last year.  Indeed they haven’t had one since 1991.  They are called ‘the lucky country,” but I have argued that their culture lacks our puritanical obsession with inflation.  Perhaps each member of our FOMC should drink a 6-pack of Fosters before their policy meetings.

PS.  Matt Yglesias quoted Harless and then asked:

I would like to see more commentary on this matter from smart and informed people before I say I’m taking this account to the bank. But it seems to me to be an obvious enough question to ask especially since there are a variety of other reasons to think that something like a 3-4 percent inflation rate would be more desirable than a 2 percent inflation rate.

I don’t know if I am smart, but I think I am reasonably well-informed, so I’ll take a stab at the question.  If we ever get to NGDP targeting, a lower than 2% rate would be optimal.  Under our current far from perfect system, I’d say Yglesias and Harless are about right.

PPS.  Economic development is a much more important issue than monetary policy.  About the time he switched from money to development, Robert Lucas said that “once you start thinking about economic growth, it is hard to think about anything else.”  I sometimes feel guilty talking about these comparatively minor issues at a time when there is such a horrible tragedy in Haiti.  But I really don’t know enough about that issue to provide any useful ideas, and other bloggers like Tyler Cowen are covering the topic far better than I could.


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57 Responses to “There’s one country that took Andy Harless’s advice”

  1. Gravatar of Duke Duke
    18. January 2010 at 09:58

    Interesting take, but I have one major qualm with your analysis:

    Aussies are not big consumers of Fosters! Fosters is considered the same quality as something like Natty light or Milwaukee’s Best… Try a sixer of Carlton Draught!

  2. Gravatar of FuManchu FuManchu
    18. January 2010 at 10:16

    “Australia was the only major developed economy to avoid a recession last year. Indeed they haven’t had one since 1991.”

    From here in China, the people I’ve spoken with all attributed this to China’s demand for Australian commodities. Their real estate “bubble” also never collapsed. (Interestingly, their real estate prices have mirrored China’s since it began recovering in 2003 — all the anti-EMH folk should be doubling down on their shorts there)

    I don’t think these alone could make that big of a difference. Do you think these circumstances alone could have changed the effects of their policies?

  3. Gravatar of David Pearson David Pearson
    18. January 2010 at 10:35

    Scott,

    I know you don’t focus on nominal policy rates, but the RBA raised rates in lock-step with the Fed — to 7.25% in March of ’08 from 4.25% in 2002. Real policy rates, however, were much higher than the Fed’s (by 2007 they were at least 3%). The RBA has a formal 2-3% inflation target, so it was natural for them to be “tighter” than the Fed when Australian inflation was hitting 4.7% in the summer of 2008. Lastly, their rhetoric on trying to cool down the housing market was leagues different than the Fed’s.

    It appears that your view of monetary policy is post-facto. Did the RBA know it was “loose” in 2008 while the Fed was “tight”. How? The inflation indicators were flashing the same signals. Yet you argue that the RBA did a better job of managing NGDP expectations and therefore avoiding a recession. After the fact, this is unarguable. Before the fact, would you have predicted the superior performance? How?

    By the way, Australia’s performance in 2009 has everything to do with the fact that, by fiat, China threw two-thirds of GDP into bank lending (on an annualized basis) during the first half of 2009. This was simply unprecedented on a global or historical basis. If you want to credit anyone for the performance of Australian GDP, it should be the PBOC. However, I would suggest that the jury is still out on the PBOC’s actions, given that they are certain to produce massive loan losses in the years to come.

  4. Gravatar of Marcus Nunes Marcus Nunes
    18. January 2010 at 10:46

    Instead of “provoking” readers and “correlating” tax breaks and increase and unemployment,Krugman could have straight away shown how the steep fall in NGDP growth in 81/82 and strong rise after that go a long way in expalaining the observed rise and fall in unemployment.

    Australia compares well even with it´s “smaller” brother New Zealand, a big anti inflation hawk (at least it was)

  5. Gravatar of Marcus Nunes Marcus Nunes
    18. January 2010 at 10:46

    The Krugman link:
    http://krugman.blogs.nytimes.com/2010/01/18/reagan-taxes-jobs/

  6. Gravatar of David Pearson David Pearson
    18. January 2010 at 10:57

    I call attention to an excerpt from the March, 2008 RBA policy statement:

    “There is tentative evidence that some moderation in household demand is beginning to occur, with business and consumer sentiment softer recently, and household credit demand slowing somewhat. The extent of that moderation is uncertain, however. As the Board noted last month, a significant slowing in demand from its pace of last year is likely to be necessary to reduce inflation over time.”

    So yes, nominal rates don’t tell the whole story. However, from the above statement we know, for a fact, that the RBA thought NGDP had to slow more in 2008 in order to contain inflation. As a result, they raised rates at a time when the Fed was cutting. Anyone at the time would have concluded that the RBA was “tighter” than the Fed, which was making no such conclusions about NGDP at that time.

    http://www.rba.gov.au/media-releases/2008/mr-08-03.html

  7. Gravatar of StatsGuy StatsGuy
    18. January 2010 at 11:41

    With regard to <2% vs. 3-4%, you are likely right technically, but I think you continue to underestimate the political economy factors associated with the acceptability of lowering the rate vs. direct purchases of assets by the Fed. Moreoover, the existence of that barrier creates expectations that the Fed may fail to follow through with a target (which in fact happened), which makes it more likely they will _need_ to follow through.

  8. Gravatar of StatsGuy StatsGuy
    18. January 2010 at 11:43

    Marcus:

    “Australia compares well even with it´s “smaller” brother New Zealand, a big anti inflation hawk (at least it was)”

    While true, this ignores the fact that the Australian economy is much more dependent on commodity exports (largely to east asia). Thus, it’s at least partly true that Australian “luck” was due to Chinese monetary policy as much as Australia’s own.

  9. Gravatar of ssumner ssumner
    18. January 2010 at 11:51

    Duke, I stand corrected.

    FuManchu, Both good points, but:

    1. Commodity prices plunged very sharply during the late 2008 crash. That should have hurt the Australian economy quite badly.

    2. The lack of a housing crash supports my theory. I say much of the US crash was caused by the fall in our NGDP. Most others (like The Economist) say a big crash was inevitable, produced by excessive speculation. Australia provides a perfect test, and I think my theory came out ahead.

    David Pearson, The higher rates in Australia would have given me more confidence that a liquidity trap could be avoided. Of course if rates are raised because of tight money, that hurts the economy, but if there are raised because of 10% NGDP growth, that reflects a strong economy. In the US we were already flirting with a liquidity trap in the spring of 2008, when T-bill yields fell very low. The Fed needed to be extra careful, whereas the BOA had lots of room. In general, I did not expect a liquidity trap in either country, but given a choice in mid-2008, I would have said the US was far more likely to experience that sort of problem. Knowing that Australia was far from a liquidity trap, there was no reason for investors in Australia to fear a sharp fall in NGDP, as that is very unlikely to occur unless a central bank is constrained by the zero rate bound.

    And yes, nominal rates are extremely misleading. We actually had the tighter money in mid-2008, not Australia.

    Marcus, Krugman ignores the fact that the 30% cut in income tax rates did not take effect until January 1983. But I do agree that monetary policy (falling NGDP growth), was the key factor.

    David#2, You said:

    “So yes, nominal rates don’t tell the whole story. However, from the above statement we know, for a fact, that the RBA thought NGDP had to slow more in 2008 in order to contain inflation. As a result, they raised rates at a time when the Fed was cutting. Anyone at the time would have concluded that the RBA was “tighter” than the Fed, which was making no such conclusions about NGDP at that time.”

    This view may reflect modern economics, but if so it is everything wrong with modern economics. Australia’s NGDP growth from mid-2007 to mid-2008 was running close to 10%, ours was just over 3%. Sure they were a bit tight in a relative sense, trying to slow down NGDP growth. But in an absolute sense they were still far more expansionary, shooting for a much higher NGDP growth rate than we were.

  10. Gravatar of Lorenzo from Oz Lorenzo from Oz
    18. January 2010 at 11:52

    Duke: Carlton Draught, not much of an improvement. Though I will grant that ‘Fosters’ is Australian for ‘cheap beer we sell to Americans’.

    Try Coopers (South Australian), Boags or Cascade (Tasmanian) or, if you must go for a Carlton product, Crown Lager.

    Chinese commodity prices and demand were definitely a factor in avoiding a recession. Possibly a large one, though commodity exports are not as big a factor in the contemporary Oz economy as people seem to think/imply.

    Comparison with Kiwiland (NZ) are a bit fraught since they are both a smaller and a narrower economy.

  11. Gravatar of Marcus Nunes Marcus Nunes
    18. January 2010 at 11:55

    StatsGuy
    I think that NZ is just as dependent on commodity exports as Australia. Both their currencies are known as “commodity currencies”. I had in mind the events following the Asia crisis in 97/98. NZ jacked up interest rates and Australia kept them stable. In 98 Australia kept on growing close to 5% (RGDP) while NZ grew zero. And inflation was the same (below target) in both countries.

  12. Gravatar of Lorenzo from Oz Lorenzo from Oz
    18. January 2010 at 11:55

    Scott posted while I was posting: your point about commodity prices is an excellent one.

  13. Gravatar of Greg Ransom Greg Ransom
    18. January 2010 at 12:17

    Because of massively increased output at lower cost (e.g. in computing) a stable money supply would have given us a much lower price level. Any price level which wasn’t falling represents inflation. Zero percent price level growth in an economy with rising productivity represents an inflation regime.

    Read George Selgin, _Less Than Zero_, available here:

    http://www.iea.org.uk/files/upld-book98pdf?.pdf

    The download page is here:

    http://www.iea.org.uk/record.jsp?ID=98&type=book

  14. Gravatar of Greg Ransom Greg Ransom
    18. January 2010 at 12:27

    “the liquidity trap we stumbled into”

    We didn’t “stumble” into anything — the Fed and the U.S. government moral hazard generators systematically distorted the time structure of the economy, across the production and relative price structure through time.

    As William White and his research team at the Bank of International Settlements explained to Greenspan and the rest of the world’s central bankers between 2003 and 2007, the systematic distortion of the structure of the economy was unsustainable. It was inevitable that leverage, money and credit would retrench. This wasn’t a “stumble” — the central bankers and the government drove straight off the cliff with their eyes wide open — with folks like White yelling at them to take their foot off the peddle. Greenspan, many on Wall Street, and the Ivy League macroeconomists insisted the cliff couldn’t exit — as a matter of “economic science”.

    In a contest between “economic science” and reality, “economic science” didn’t come out so well.

  15. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. January 2010 at 12:48

    Australia is interesting in a couple of other ways as well.

    It chose to enact a large fiscal stimulus (larger than the US’ stimulus as a percent of GDP in 2009) despite the fact it clearly was not in a liquidity trap (so no theoretical argument could be made that such a policy was really even necessary) and empirical evidence suggested that, not being committed to ZIRP, a discretionary fiscal stimulus would be much less effective. But as an Australian commenter on this site pointed out on a previous post the Labor government was very eager to avoid a recession.

    Australia also had a major real estate price boom despite the fact that real central bank interest rates were never particularily low.

    In my opinion, despite what many have argued, central bank interest rate policy has little to do with housing price booms. People fail to notice that there were housing “bubbles” elsewhere on the planet, and there is no statistically significant correlation between central bank interest rate policy and housing price booms.

    Australia and Germany make an interesting contrast:

    1) Australia
    The RBA raised its rate from 4.25% in 2002 to 5.25% in 2003, to 5.50% in 2005 to 6.25% in 2006 to 6.75% in 2007. On an annual basis CPI varied from a low of 2.3% (2007) to a high of 3.5% (2006) over the same period. Housing prices surged by nearly 80% in nominal terms between Q1 2002 and Q4 2007 despite the fact that real central bank interest rates were never particularily low and in fact were actually quite high during almost the entire time period.

    Are there any government policies that might have contributed to this? Since 2000 Australia has had a $7000 First Home Owner’s Grant (FHOG) and an extra $7000 Commonwealth Additional Grant (CAG) if the house was new. Individual Australian states offer additional grants to first time home buyers of up to $5000, and an additional grant of $7000 was part of Australia’s fiscal stimulus. Consequently most first time house buyers in Australia put up little more than their grants when purchasing a house.

    2) Germany
    The ECB lowered its deposit facility rate to 1.0% in June 2003 and held it there straight through December 2005, a period of about two and a half years. On an annual basis CPI varied from a low of 1.0% (2003) to a high of 1.7% (2005) over that period. Housing prices were essentially flat from 2002-2006. In fact they fell slightly both in nominal and real terms, despite the fact that real central bank interest rates were negative for approximately three years.

    Is there anything special about Germany that made it immune to a housing price boom? Perhaps.
    1) Adjustable rate mortgages are virtually unknown.
    2) 20% downpayments are required.
    3) There is no mortgage interest tax deduction.

    If Australia and Germany are any guide the US housing price boom had little to do with “loose money.” It had much more to do with lax mortgage lending standards and a policy of subsidizing the ownership of housing through real estate tax policy.

    In fact I’ve always felt the Taxpayer Relief Act of 1997 is little recognized “smoking gun.” The act dramatically increased real estate capital gains exclusions in the US and extended real estate tax credits, deductions and exclusions to second homes for the first time ever. It’s not surprising to me that Shiller’s national real housing price index started skyrocketing the following year. It matches the US housing price boom timeline much better than any other major public policy change.

  16. Gravatar of Marcus Nunes Marcus Nunes
    18. January 2010 at 13:05

    Mark A
    Agree entirely. In addition, if you check home prices in the US, as you say they took off in 1998 and continued to climb when interest rates came down to 1% and kept on climbing with i increase after mid 2004, only peaking in mid 2006.

  17. Gravatar of DanC DanC
    18. January 2010 at 14:22

    Perhaps Scott could more fully answer the question I had many years ago.

    Is inflation a danger or is it unexpected inflation that is a danger?

  18. Gravatar of TravisA TravisA
    18. January 2010 at 15:04

    @Sadowski: John Taylor has a paper showing that there is a correlation between deviation from the Taylor rule and changes in housing investment in many different European countries.

    http://www.stanford.edu/~johntayl/FCPR.pdf

    Also, see this analysis of Canada:

    http://macromarketmusings.blogspot.com/2009/12/us-vs-canadian-monetary-policy-during.html

  19. Gravatar of jean_ jean_
    18. January 2010 at 16:37

    There is another reason why you may want an higher inflation/NGDP target (you mentionned it in another post): war on crime and on tax evasion. It levies a tax on cash holders (and admittedly on innocent ones)

  20. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. January 2010 at 17:06

    @TravisA
    John Taylor you say? It’s his Rule after all and who am I to quarrel with him? But seriously, lately I find that I agree with very little of what he is writing or saying.

    I’m familiar with the Taylor paper you linked to. The biggest problem I have with it is that he finds that there is a very significant correlation between Taylor Rule residuals and housing investment among ten nations in the Eurozone. What does this tell us about housing price appreciation? By itself, absolutely nothing.

    Now it’s true that there is a correlation between housing investment and housing price appreciation. But if one runs a regression using these same ten nations between Taylor Rule residuals and housing price appreciation you’ll find that the correlation is dramatically weaker although still statistically significant. But I suspect that Taylor was data mining. Why these ten nations?

    As for the David Beckworth’s US versus Canada post I’m not sure what to make of his argument. He is critical of James MacGee’s article comparing the Canadian and US housing price booms.

    I’m familiar with MacGee’s article. MacGee essentially makes the argument that the similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. Macgee thinks that factor is the lower incidence of high loan to value mortgages in Canada. I largely agree with MacGee.

    Beckworth makes the case based on labor productivity that US monetary stance was looser than the US dueing 2002-2006. I have no real quarrel with that and it agrees with both the Taylor Rule residuals and average real interest rates of Canada and the US during this period as calculated by the IMF. He then proceeds to show that US ARM rates are influenced by the fed funds rate.

    One problem I have with Beckworth’s argument is that the differences between the US and Canadian monetary stances and housing price appreciation are very modest and yet the difference in foreclosure rates are substantial. Based on this I still agree with MacGee that the degree of leverage is the primary factor in explaining the different outcomes.

    As for the effect of the fed funds rates on ARMs, that only underscores my earlier comment concerning Australia versus Germany. Germany had very low real interest rates in 2003-2006 and absolutely no housing price appreciation. Germany also does not have ARMs.

    The IMF has done some analysis of the relationship between monetary policy stance and housing price appreciation. They found no statistically significant relationship (with either Taylor Rule residuals or real interest rate) when looking at a sample of 20 advanced nations. See Figure 3.13:

    http://www.imf.org/external/pubs/ft/weo/2009/02/pdf/c3.pdf

  21. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. January 2010 at 17:12

    Edit:
    “Beckworth makes the case based on labor productivity that US monetary stance was looser than the US dueing 2002-2006.”

    should read

    “Beckworth makes the case based on labor productivity that US monetary stance was looser than Canada’s during 2002-2006.”

    of course.

  22. Gravatar of Winton Bates Winton Bates
    18. January 2010 at 21:43

    I think that New Zealand might be a better example than Australia. NZ’s inflation target is now 1-3 percent, not much different to that for Australia (2-3 percent). The NZ economy seems to have come through the financial crisis fairly well, with much less fiscal stimulus than in Australia.

    Some of the NZ beer isn’t too bad either. In my view Steinlager is better than Fosters, but not as good as Cascade premium or Coopers pale ale.

  23. Gravatar of Jim Jim
    18. January 2010 at 23:19

    It is difficult for me to believe inflation of any kind is not an exorbitant tax on the poor.

    Certainly targeting 0% inflation can be done without crashing the economy, although we do need more boring banking stances.

    Please help me a struggling reader understand.

  24. Gravatar of Philo Philo
    19. January 2010 at 08:30

    (Off topic)

    Scott–

    Do I detect your influence on Tyler Cowen’s thinking, when the third (of thirteen) ideas he presents (on Marginal Revolution, http://www.marginalrevolution.com/marginalrevolution/2010/01/other-ways-to-help-haiti.html)
    for helping Haiti is: Stabilize Haitian nominal GDP! By the way, I assume you would agree with this prescription.

  25. Gravatar of Matthew Yglesias » Monetary Policy Lessons From Down Under Matthew Yglesias » Monetary Policy Lessons From Down Under
    19. January 2010 at 12:15

    [...] Sumner chimes in with support for the Harless view from Australia: Interestingly, I know of only one country that stayed away from the ever lower inflation obsession [...]

  26. Gravatar of scott sumner scott sumner
    19. January 2010 at 18:34

    Marcus, I’m no expert here, but isn’t New Zealand more dependent on agriculture, and Australia on mining? The Kiwis have very efficient farming, but face a lot of highly protected markets. This comment might not have any application to the cyclical issues you are discussing, but I thought I would throw it out there.

    I am puzzled as to why New Zealand’s GDP per person is so low, and wondered if it might be due to their comp. advantage being agriculture. Or perhaps their small size and isolation. The have the same population as Ireland, and are also English-speaking with a fairly free market economy. But Ireland obviously gets much more US multinational investment. Is that due to the fact that Ireland is closer to the US?

    Thanks Lorenzo.

    Greg, I don’t consider stable prices to be inflation, most economists define inflation as rising prices.

    Greg#2, If the trend rate of inflation was higher, there would have been no liquidity trap, even with a housing bubble of equal size.

    Mark, Those are very good points. I have never thought that monetary policy caused the housing bubble, because monetary policy was not all that expansionary, and other countries had similar bubbles as you point out.

    I recall that Australia’s fiscal stimulus was slightly larger than the US, which indicates that it had little to do with the huge differences in the macroeconomic outcomes of the two countries.

    DanC, Long term expected inflation hurts saving and investment, and thus productivity. This is because inflation increases the real tax rate on capital. Unexpected changes in inflation can lead to business cycles. (The Phillips curve.)

    TravisA, That may be so, but I am not a fan of the Taylor rule, so I don’t get too concerned when we deviate from it. Last year Taylor said it would be a mistake to ease monetary policy further. I strongly disagreed.

    jean, That’s right, although my response to DanC cuts the other way.

    Winton, That’s a good point. Regarding beer, even over at Yglesias’ blog I am being hammered for the Foster’s comment. I should stick to money.

    Jim, First an empirical argument:

    In 2009 we had the closest to zero inflation since 1955, the year I was born. And yet the poor didn’t do well.

    Now the theory.

    The reason is that people were expecting more than zero inflation, and this was built into debt and wage contracts. When inflation came in lower than expected, people could pay debts and companies couldn’t pay wages. Defaults and unemployment soared.

    Philo, Interestingly I noticed the same thing–in my next post I claimed it was a sarcastic joke. But I was flattered anyway.

  27. Gravatar of scott sumner scott sumner
    19. January 2010 at 18:39

    Statsguy, But commodities suffered sharp price drop during the recession.

    I don’t follow your political point about the Fed. Are you saying they can’t inflate? Or just don’t want to? If it is the latter, I agree that would be a problem.

  28. Gravatar of Peter Whiteford Peter Whiteford
    19. January 2010 at 18:48

    While controversial in certain circles in Australia (not with the Government or Treasury Department) there is evidence that the stimulus boosted retail turnover at a crucial time.

    http://1.bp.blogspot.com/_KbiBt2BFLiI/SxhoS_gHYLI/AAAAAAAAAUM/gFTL3LuEXr0/s1600-h/retail+oct2009.JPG

    It also helped that the Commonwealth government has been running budget surpluses for a considerable period of time so that there was no net government debt.

    Australia has also done considerably better than New Zealand. see
    http://2.bp.blogspot.com/_KbiBt2BFLiI/S0UlXR6JmwI/AAAAAAAAAcg/LB9wnL3ZNvg/s1600-h/Fig2_large.jpg

  29. Gravatar of Marcus Nunes Marcus Nunes
    19. January 2010 at 20:04

    Scott: You wrote:
    Marcus, I’m no expert here, but isn’t New Zealand more dependent on agriculture, and Australia on mining? The Kiwis have very efficient farming, but face a lot of highly protected markets. This comment might not have any application to the cyclical issues you are discussing, but I thought I would throw it out there.

    I am puzzled as to why New Zealand’s GDP per person is so low, and wondered if it might be due to their comp. advantage being agriculture. Or perhaps their small size and isolation. The have the same population as Ireland, and are also English-speaking with a fairly free market economy. But Ireland obviously gets much more US multinational investment. Is that due to the fact that Ireland is closer to the US?

    Yes, NZ is mostly agriculture, but that really has no bearing on the cyclical issues. Until the first oil shock, NZ and Australia GDP-PC evolved together (and were at the same level). After the oil shock Australia´s GDP-PC grew faster than NZ´s. I should think, especially after observing the different reactions of both countries to to crisis in Asia, that NZ´s economic policy “worsened” after 1974. In the case of Ireland the “miracle” began in 1986 when Charles Haughey (a very leftist guy who had adopted terrible policies in his first stint as PM (1979/82) was elected and “recanted” on his previous “sins”. Until recently, Ireland was known as the “Celtic Tiger” having beaten all the Euro-15 (except Luxemburg) in GDP-PC terms (obviously surpassing Australia).
    Econ policy (not comp advantage) explains Australia´s success relative to NZ. Policy change in Ireland (although being an Euro member also helped) goes a long way in explaining its success.

  30. Gravatar of Greg Ransom Greg Ransom
    19. January 2010 at 21:22

    Scott, I’m aware of how economists typically use language, the issue is whether a stable money supply under conditions of productivity growth imply a gently falling price level. A debate over how to use language isn’t the issue at hand here.

    Scott writes:

    “Greg, I don’t consider stable prices to be inflation, most economists define inflation as rising prices.”

  31. Gravatar of Greg Ransom Greg Ransom
    19. January 2010 at 21:22

    I’m aware of how economists typically use language, the issue is whether a stable money supply under conditions of productivity growth imply a gently falling price level. A debate over how to use language isn’t the issue at hand here.

    Scott writes:

    “Greg, I don’t consider stable prices to be inflation, most economists define inflation as rising prices.”

  32. Gravatar of Greg Ransom Greg Ransom
    19. January 2010 at 21:30

    At issue is whether a retrenchment of leverage, money and credit could have been prevented without a regime of ever and increasingly accelerating leverage, credit, and inflation — ultimately an unsustainable policy regime

    The claim that retrenchment of leverage, credit and money was unavoidable and inevitable is a claim that a policy dependent on an ever accelerating distortion of the production and price relation structure of the economy is ultimately unsustainable, and at some point the system spins out of control and fails.

    You don’t provide evidence or an argument for believing otherwise. You simply beg the question, while failing to show understanding of the issues at hand.

    Scott writes:

    “Greg#2, If the trend rate of inflation was higher, there would have been no liquidity trap, even with a housing bubble of equal size.”

  33. Gravatar of StatsGuy StatsGuy
    19. January 2010 at 21:31

    The spot trade price dip for Australian commodity exports is somewhat deceptive. Much of Australia’s major commodity export bulk (e.g. iron) was not entirely on the spot market, and China central gvt intervened to support global commodity prices in general. New Zealand had more exposure, although I’m not saying New Zealand ran an expansive monetary policy. I will readily concede that New Zealand’s currency has been the most tightly coupled currency to gold of any.

    http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp

    Regarding the political economy of the Fed – the political barriers to the Fed executing “creative” monetary expansion are more substantial than the barriers to interest rate manipulation. Among other things, creative mechanisms can occur in one of several markets, and this creates winners/losers. The losers complain more loudly than the winners (or potential winners) celebrate – this is a central feature of the political context in the US. This creates a political barrier to such Fed intervention, and the existence of that political barrier increases skepticism that the Fed would act aggressively at the zero bound, which means this lack of credibility moves NGDP lower, which means increases the chances that the Fed will NEED to act creatively at the lower bound.

    In other words, comparing 3-4% inflation target (if we were doing inflation targeting) to 2% on a purely economics basis is too limited; 2% (or even lower) might be more appealing (as argued by Cowen et. al.), but it increases the likelihood of a deflationary trap due to the political barriers to non-traditional action at the zero bound.

  34. Gravatar of Dr Inflationdove or: How I Learned to Stop Worrying and Love the MPC | Think Politics Blog Dr Inflationdove or: How I Learned to Stop Worrying and Love the MPC | Think Politics Blog
    20. January 2010 at 03:11

    [...] he discovered an article from Scott Sumner, professor of economics at Bentley University, which argued that inflation at 5% may be optimum, citing Australia as an [...]

  35. Gravatar of Lorenzo from Oz Lorenzo from Oz
    20. January 2010 at 03:37

    Mark A. Sadowski: the difference in Australian and German house prices is very easily explained: it is a microeconomic phenomenon due to different regulatory structures.

    In Germany a “right to build” is built into the constitution. It is legally very hard for officials to stop people building or extending houses. So, house price supply responds directly to house price demand. The result is house prices which move at about the rate of inflation (less, after the sub-standard East German housing stock was added in).

    In Australia, State and Territory governments control the purposes for which land can be used. Their “releases” of land for housing significantly lag housing demand. So housing supply cannot directly respond to housing demand. The result is upward pressure on (housing) land prices. A useful publication is here (pdf).

    It is much the same as the difference in regulatory structures between California and Texas, for example.

    This is why I get quite impatient with explanations of housing bubbles in terms of macro economic policy.

    Ben Bernanke gave a speech which reviewed the evidence on monetary policy and housing bubbles. Unsurprisingly, the evidence of a connection is not strong.

  36. Gravatar of Lorenzo from Oz Lorenzo from Oz
    20. January 2010 at 03:38

    That should be “house supply response directly to house demand”. Why I stuck the extra ‘prices’ in their I do not know: I must be tired.

  37. Gravatar of Lorenzo from Oz Lorenzo from Oz
    20. January 2010 at 03:39

    And now the wrong use of ‘there’. Sigh. Off to bed.

  38. Gravatar of Mark A. Sadowski Mark A. Sadowski
    20. January 2010 at 07:01

    Lorenzo from Oz,
    I had read in various Australian articles on their housing market that the lack of supply was also a factor but I wasn’t familiar with precisely why. Thanks for clarifying that issue as well as pointing out the German “right to build” law. I think I was focusing on demand side factors and clearly there are supply side factors at work as well.

    In fact Krugman wrote an article in 2005 comparing “flatland” to “zoned zone,” Texas being an example of the former and California of the latter:

    http://www.nytimes.com/2005/08/08/opinion/08krugman.html?_r=1

    But apparently tighter mortgage regulations in Texas may have also played a role:

    http://rortybomb.wordpress.com/2009/04/21/ban-mortgage-prepayment-penalties-at-the-federal-level-1-texas/

    The bottom line is that microeconomic supply and demand forces explain housing booms and busts much better than macroeconomic forces. And since that’s the case we shouldn’t be adding one more objective to monetary policy (controlling asset “bubbles”). It’s hard enough just to achieve two objectives (inflation stabiity and full employment). (Of course NGDP level targeting would simplify that task.)

  39. Gravatar of Lorenzo from Oz Lorenzo from Oz
    20. January 2010 at 11:47

    Mark A. Sadowski,
    Agree entirely. Personally, I would not have full employment as a monetary policy target since it gives the monetary authorities too much of an “out”.

    I used to be a straightforward inflation stability person, but Scott has convinced me on NGDP targeting.

  40. Gravatar of ssumner ssumner
    20. January 2010 at 19:20

    Peter, Thanks for the data. Taegeted stimulus can certainly boost some sectors. Cash for clunkers boosted auto sales in America. What kind of stimulus was it? Was it targeted at retailing? Or just a general tax cut? That would make a big difference in how one interprets the figures. My guess is that the Aussies were smarter than us in the way they set up the stimulus.

    And they are very smart to have almost no national debt.

    Marcus, You may be right, but Heritage ranks NZ and Ireland almost identical on their economic freedom index. I believe Ireland has lower taxes, however, so perhaps that attracts investment.

    Greg, I simply don’t see how easy money could blow up a housing bubble. Inflation? Yes. Cyclical overheating? Yes? But a housing bubble? I just don’t get it. Easy credit could create a bubble, but the Fed doesn’t determine credit conditions through monetary policy. Banks are to blame for the easy credit, along with regulators and F&F and FHA, CRA etc.

    Statsguy, I mostly agree. But one quibble. Wouldn’t Chinese purchases aimed at supporting commodities also hold up spot prices? But we know that spot prices fell very sharply. I can’t see how that doesn’t reduce new investment in mining ventures.

    I agree about inflation.

    Lorenzo, Very good points.

  41. Gravatar of Greg Ransom Greg Ransom
    20. January 2010 at 22:18

    Scott, these things worked together — I don’t see how youndon’t see it.

    If the Fed does anything it manipulates prices and quantities — it’s a price control entity and a supply control entity. It manipulates the cost of money over time and the supply of money over time. These thing influence the behavior of those who also create leverage and money and prices of moneynover time.

    If the Fed doesn’t do that, I need help understanding how you claim it does anything at all.

    Scott wrote,

    “Greg, I simply don’t see how easy money could blow up a housing bubble. Inflation? Yes. Cyclical overheating? Yes? But a housing bubble? I just don’t get it. Easy credit could create a bubble, but the Fed doesn’t determine credit conditions through monetary policy. Banks are to blame for the easy credit, along with regulators and F&F and FHA, CRA etc.”

  42. Gravatar of Greg Ransom Greg Ransom
    20. January 2010 at 22:32

    What I’d really like to see Scott is your account of where William White and his BIS research team went wrong in their papers on the distortion of the macroeconomy and it’s inevitable crack upmpublished between 2003 and 2008.

    You’ve taken on people who never had a clue what was happenin asmi happened, but you’ve never taken on a top research economist in the central banking profession who was on top of things as they happened.

    This is like ignoring the rocket scientist who was on the job site and in charge of advising the rocket engineers on the structual soundness of their rocket engine — and who told them it would blow up, which it did.

    Why are you academics pretending that William White and his BIS research team don’t exist?

  43. Gravatar of Greg Ransom Greg Ransom
    20. January 2010 at 22:52

    I should add that William White not only said the rocket would blow up, in 2003 he said how it would blow up. And 2008 played out pretty much as White warned it would.

  44. Gravatar of Greg Ransom Greg Ransom
    20. January 2010 at 22:56

    Here’s an account of what White told Greenspan and Bernanke beginninmin 2003:

    http://www.spiegel.de/international/business/0,1518,635051,00.html

    White’s annual research papers can be found at the Bank of Internation Settlements web
    site.

  45. Gravatar of Doc Merlin Doc Merlin
    20. January 2010 at 23:36

    @ Lorenzo

    Re: micro reasons for housing bubble

    I’ve said it before, and the more I think about it, the more I think it is true. A good theory of growth and bubbles will be one of transaction costs.

  46. Gravatar of Kien Kien
    22. January 2010 at 22:50

    If there is one country in the world that is committed to a NGDP growth target, would that not be China?

  47. Gravatar of scott sumner scott sumner
    23. January 2010 at 06:27

    Greg, You said;

    “If the Fed does anything it manipulates prices and quantities — it’s a price control entity and a supply control entity. It manipulates the cost of money over time and the supply of money over time. These thing influence the behavior of those who also create leverage and money and prices of moneynover time.

    If the Fed doesn’t do that, I need help understanding how you claim it does anything at all.”

    If by “cost of money” you mean real interest rates, I disagree. The Fed controls the price level “over time” not real variables. Fed policy doesn’t make credit cheap.

    Greg#2, I don’t know Mr White, but your accusation is groundless. I must have mentioned Nourel Roubini 100 times, and I always give him kudos for predicting exactly how things would play out. I have never argued that isolated individuals could never beat the market, rather I argue that investors as a class, or regulators as a class cannot predict these things. If they could, they would prevent them. All we can do is sit back and marvel at the few who had foresight. But next time around we will be equally unable to predict (in the aggregate) as we don’t know who the next Roubini (or White) will be. Most great forecasters are successful only once. Roubini has done very poorly since his initial success. I would have lost a fortune if I had followed his advice last year.

    Greg, I think White was wrong in 2003. There were fears of deflation and the Fed was right to set interest rates at a very low level. Those low interest rates in 2003 did not create the subprime fiasco, nor did they cause the economy to overheat. So I think White was completely wrong in 2003.

    Kien. That is a good question. They certainly act like they understand the dangers of falling NGDP.

  48. Gravatar of Greg Ransom Greg Ransom
    23. January 2010 at 09:54

    The folks generating this fear were Bernanke and Greenspan and the Fed bureaucracy.

    Bernanke and Greenspan were saying the most absurd things, as I documented on my blog at the time.

    Scott wrote:

    “There were fears of deflation … “

  49. Gravatar of Greg Ransom Greg Ransom
    23. January 2010 at 09:59

    Scott, manipulations of the quantity and price of money is a structural thing. Reducing it all to “the price level” or “cheap credit” obliterates the structure relations that are of causal interest to macroeconomics, and to such macroeconomists as William White, Steve Hanke, and Friedrich Hayek.

    You write:

    “If by “cost of money” you mean real interest rates, I disagree. The Fed controls the price level “over time” not real variables. Fed policy doesn’t make credit cheap.”

  50. Gravatar of Greg Ransom Greg Ransom
    23. January 2010 at 10:05

    Scott,

    Imagine a price control regime that manipulated the price of something across time — say a bizarre and randomized price control regime on oil that structurally controlled prices at different rates at different times across the years, but which was never fixed but changed in a systematically related way, but also with a randomizer built in as well.

    Now imagine EVERY price in the economy priced like this.

    THAT is what happens due to the fact that the Fed is in the price control business, manipulating VARIOUS interest rates, VARIOUS quantities, and VARIOUS “price levels”.

    It seems macroeconomists perhaps don’t see the obvious, because the obvious — i.e. disaggregation — isn’t allowed in their no-disaggregation-allowed math constructs.

  51. Gravatar of ssumner ssumner
    24. January 2010 at 09:27

    Greg, Given what had recently happened in Japan, I don’t think the fears were groundless. If we had had tighter money in 2002, then we might well have slipped into deflation.

    Regarding your last point, I want a stable monetary policy that minimizes monetary shocks. Like Hayek I think that is achieved by stablizing NGDP (or its growth rate at a low level.) If you do that, you will reduce the relative price distortions that you correctly point to.

  52. Gravatar of M. Belongia M. Belongia
    2. March 2010 at 13:48

    For what it’s worth, the RBA website reports that the objective for monetary policy is an inflation rate between 2-3 percent.

    Beyond that, comparing the US is apples to oranges….to bananas. Whereas the RBA has a single objective for inflation, the Fed has its conflicting dual mandate for price stability and full employment; add Greenspan’s bizarre comment about “irrational exuberance” on one hand and Ritholz’s assertion that Greenspan used monetary policy to inflate asset prices and you have a third objective added to the policy mix. How to evaluate the relative performance of two central banks in this context is unclear.

    The waters are made more muddy by the complete breakdown of underwriting standards in the US mortgage market and the abundant regulatory failures of the SEC, CFTC and Fed as well as ratings agencies with regard to CDOs, credit default swaps and everything that led to the collapse of equity and housing markets in the US; although I know almost nothing about conditions in Australia, it is hard to imagine it experienced anything like this scale or scope of regulatory failure, which would go a long way in explaining why its markets never rose as high nor fell as far as comparable markets in the US.

    Overall, if there’s a lesson to be learned, it may be that small, incremental policy changes are more likely to produce stability and that monetary policy works better when regulatory agencies do their jobs in promoting orderly market behavior.

  53. Gravatar of scott sumner scott sumner
    3. March 2010 at 06:22

    Mike, Thanks for the comment. I am not quite sure what message you take from the RBA’s 2-3% inflation target. Bernake recently said that a 3% inflation target would be a very bad thing. I take that as implied criticisim of the RBA as being too inflationary.

    I agree with much of what you say about regulation. In my view the US government should completely stop regulating the banking system, and instead pay the Canadians to regulate our system in exactly the same way they regulate their own system. Yes, I know, it’s not going to happen.

    And I agree that poor regulation can lead to banking problems, and that this can indirectly reduce velocity. If the central bank is incompetent, as ours is, then the fall in velocity can reduce NGDP and produce a demand side recession. I view the root cause of the recession as bad monetary policy, but I can see why others just assume monetary policy will be bad and argue the root cause in banking instability.

    But in the end monetary policy must address the regulatory system we have, not the one we wish we had. If velocity is goiung to be unstable, the the central bank must do one of two things, they must either learn how to operate in a zero rate environment (which is my preferecne, and I believe also your preference) or they need to have a higher trend rate of inflation to avoid the zero bound altogher. I think it would be unfortunate if we ended up having to take that option.

    One other point. I don’t believe inflation is a useful indicator of monetary policy, rather I prefer NGDP. Australia had significantly higher NGDP growth than the US over the past 10 years, and that (more than inflation) explains how they avoided the liquidity trap.

    Australia actually did have a US-style housing bubble. The difference is that the bubble still hasn’t popped, because the root cause of the problem in the US (falling NGDP) didn’t happen in Australia.

    Here’s one area where we might agree. If the Fed had a price level target (growing at say 2%) rather than a 2% inflation rate target, then the Fed would not need a higher inflation target to avoid liquidity traps. A money supply target would of course also do the job, but I favor targeting expectations because I have a lingering concern about the stability of money demand (although perhaps I should defer to your expertise in that area.)

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