Monday, August 08, 2016

Confusions over the economic outlook 2- the liquidity trap

At the end of Confusions over the economic outlook 1 interest rates, I said that I would next look at the liquidity trap. I will do so, but first a brief response to the discussion that followed that first post because it is linked.

The Comments

2 tanners suggested that the theory looked even more shaky if the banks simply increased profitability by not passing on interest rate cuts (as they appear not to be doing). This then freed them to make higher profits or support riskier speculation (e.g. in houses or stocks), neither of which generate real income.

 Winton wrote: "It seems that lowering the interest rate no longer has much effect on the exchange rate in Australia. I wonder what will happen if the whole world adopts exchange rate targeting as in Singapore." 

kvd initially focused on policy instability: "Sometimes I think that a government which simply announced that there'd be absolutely no major policy changes enacted for 10 years - i.e. what you've got is your predictable business and personal environment for the next decade - would be doing us all a favour. Instead", he suggested, "we're stuck in the vowels: avoidance of risk, exacerbated by
erratic political environment, leading to insufficient confidence, and then there's overregulation, all of which leads to unwillingness to invest."

Winton agreed:
kvd: That is a good point. Policy uncertainty looks to be a big factor behind the decline in investment in many high income countries over the last 15 years or so. It looks like we have low investment leading to low growth, increased job insecurity, the rise of xenophobia and hence greater policy instability.

However, I doubt whether we could have no policy change for ten years without a fiscal crisis. If no policy change Involved no increase in government spending in real terms it would actually be a major reform. 
In terms of monetary policy, no policy change would involve sticking to the inflation targeting rules we currently have. However, the Reserve bank seems to have a problem in convincing people that it has the means and the determination to meet those targets
Winton and kvd continued in general agreement. "Winton, I agree with your comments, except that instead of the publicised 'inflation target range' supposedly at the core of the RBA's activities, I'd make it a 'desired upper bound over the economic cycle' with no downside responsibility/action." 

Continuing a theme from an earlier comment thread, kvd also suggested that "inflation really is a stealth tax (it advantages both government and borrowers; both being users, not providors, of capital), so why give any sort of encouragement for government action which would seek to promote it in the event it falls below 'target'?" He was cautious about an exchange rate target: "would that not lead to artificiality, and hence vulnerability, in an economy as small as ours?"

Winton and kvd continued in agreement: "kvd, I agree that the idea that any amount of inflation can be optimal seems peculiar. The way I rationalise it is that because of quality change issues, price indexes tend to overstate the rate of inflation. So, our target band might not be too far away from zero inflation. We also need to consider expectations. If people have come to accept 2% p.a. CPI increase is the norm, it will take many years to persuade them that they should expect the rate of CPI increase to be 0% p.a. in future." 

Winton then expressed a concern about the Singapore approach. "It will be interesting to see how Singapore goes ... If we went down that path my concern is that the import-competing and exporting industries would always be lobbying the government to lower the exchange rate target to improve their "competitiveness". If the whole world does it, we will be in a world of competitive devaluations."

Finally, Jasper Gnomes wondered what the Reserve Bank actually did. 


I have outlined the brief discussion on that first post at length because it raises a number of points germane to my argument.

The issue about that dreaded policy instability is something we have talked about here a fair bit. It affects macro-economic policy, but it is still more common in other policy areas. It creates confusion. I am reasonably bright and indeed have been a policy adviser on macro-economics, tax, finance and industry policy as well as aspects of social policy, but I get totally lost now. It makes planning difficult and, to the degree that policy success depends upon the expectations, it ensures policy failure.

 So we might well be better off freezing policy, accepting imperfections and just getting on with it.

On the question of inflation and inflation targeting and the associated question of what (if anything) to do about deflation is again something that we have talked about. The original idea that a central bank should set an inflation target actually dates back, I think, to the stagflation of the 1970s.

Thinking of Jasper, the Reserve Bank web site describes the Bank's role in these terms.
The Reserve Bank of Australia is Australia's central bank. It conducts monetary policy, works to maintain a strong financial system and issues the nation's currency. As well as being a policy-making body, the Reserve Bank provides selected banking and registry services to a range of Australian government agencies and to a number of overseas central banks and official institutions. It also manages Australia's gold and foreign exchange reserves. 
The role and functions of the Reserve Bank are underpinned by various pieces of legislation. The Bank is a statutory authority, established by an Act of Parliament, the Reserve Bank Act 1959, which gives it specific powers and obligations. In terms of the Act, there are two Boards: the Reserve Bank Board and the Payments System Board. 
The Reserve Bank Board's obligations with respect to monetary policy are laid out in Sections 10(2) and 11(1) of the Act. Section 10(2) of the Act, which is often referred to as the Bank's ‘charter’, says: 
It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
a. the stability of the currency of Australia;
b. the maintenance of full employment in Australia; and
c. the economic prosperity and welfare of the people of Australia. 
Section 11(1) of the Act covers the need to consult with Government; "the Reserve Bank Board is to inform the Government, from time to time, of the Bank's monetary and banking policy." 
The ‘charter’ of the Payments System Board is defined in section 10B(3) of the Act as follows: 
It is the duty of the Payments System Board to ensure, within the limits of its powers, that:
a. the Bank's payments system policy is directed to the greatest advantage of the people of Australia; and
b. the powers of the Bank under the Payment Systems (Regulation) Act 1998 and the Payment Systems and Netting Act 1998 are exercised in a way that, in the Board's opinion, will best contribute to:
     (i)controlling risk in the financial system;
     (ii) promoting the efficiency of payments system; and
     (iii) promoting competition in the market for payment services, consistent with the overall stability of the financial system; and
c. the powers and functions of the Bank under Part 7.3 of the Corporations Act 2001 are exercised in a way that, in the Board's opinion, will best contribute to the overall stability of the financial system.

Sorry for the clunky formatting. 

Up until the 1970s, relatively greater weight was placed upon the maintenance of full employment. Further, fiscal policy - the use of the budget to manage levels of economic activity - was seen as more important than monetary policy. Monetary and fiscal policy were meant to work in tandem.

The stagflation of the 1970s - the combination of high unemployment with high inflation - effectively discredited fiscal policy as a tool. The focus shifted to monetary policy and reduction in inflation. This combined with another trend, the rise of the independent central bank. As part of this, inflation targeting became a key central bank objective. The aim was to get inflation down and then keep it an acceptable level.

During the Global Financial Crisis, fiscal policy came back, if in a fairly ham-fisted way. However, the policy settings and institutional structures that had developed made central banks and monetary policy the dominant instrument for trying to manage the crisis. One side-effect was a world suddenly awash with money. However, that cash could not find its way into,productive investment but instead found its way into assets. So we had a world of low inflation or even deflation, very low interest rates but inflating asset prices as the only game left in town for getting a reasonable rate of return. Now the central banks with their inflation targets were no longer concerned with getting inflation down to target, but actually getting it up.  

Now we come to the liquidity trap. I no longer pretend to understand the theoretical arguments around this, so let me give you the grossly simplistic points that I internalised when I first did macro-economics all those years ago in what now seems a different planet. 

You increase the supply of money. Part of that goes into new spend. With more money, interest rates also fall thus encouraging investment. But what if people want to save the money rather than spend it, what if  nobody wants to invest in new productive activities because the risks are too high, the returns to low.? Then the money supply increases but only goes into chasing assets with existing returns because there is no other game in town? Then you have a liquidity trap. 

I think that is just what has happened. The effect is actually to increase the imbalances in the global economy, making later recovery more difficult. 

In my next post in this series I will look at responses. I will also pick up the exchange rate point.


Winton Bates wrote:" Jim, A good place to start the discussion might be with the article Noric referred to in the discussion on your previous post. I think we are dealing with a secular low investment problem rather than a Keynesian liquidity trap."

This is the article Noric referred to: "We’re in a Low-Growth World. How Did We Get Here?" I think a key point with the liquidity trap as I interpret it is that its an outcome of other things that then has its own effects. One cause is a reduced desire to invest.

On the Reserve Bank, two points flowing from discussion:

  • inflation targeting is quite new
  • as are formal agreements between the Reserve Bank of Australia and the Government, beginning in 1996. You will find the agreements here, the first agreement here.


Winton Bates said...

Jim, A good place to start the discussion might be with the article Noric referred to in the discussion on your previous post. I think we are dealing with a secular low investment problem rather than a Keynesian liquidity trap.

Anonymous said...

It was interesting that (in the large block of red text Jim provided from the RBA website) I can find no reference to the word 'inflation'. So I went back to a pdf of the full 1959 Act, and again, not a mention of the word 'inflation' - let alone 'targeting it' or 'setting broad goals' for it.

To repeat - from Jim's block of text - it seems the RBA is charged under two broad headings, first RBA Board Obligations:

1) currency stability
2) full employment
3) prosperity and welfare

and then, secondly a 'Payments Systems Board' to supervise the banking system as to:

1) risk
2) efficiency, and
3) competition

The first role is completely different to the second - hence, in fact, there are two separate boards as far as I can tell.

And finally - since when has the RBA Board's statutory duty, viz: the Reserve Bank Board is to inform the Government, from time to time, of the Bank's monetary and banking policy by any normal interpretation of the English language categorised as a duty to consult?


Anonymous said...

Glenn Stevens' final speech was brilliant, I thought:

(SMH - sorry Jim :)

He wants the government to basically print some money and invest/spend it wisely - and therein lies the problem.

We were all bored to death with the 'pink batts' failure of past governments, but have a browse of Neil Whitfield's comments on the complete mess the present government is making of the 'private colleges' education funding; equally pathetic, and near incompetent, as administrators. Point being, our federal government is competent in the provision of funds, but complete crap in supervising same.

Stevens is saying we need a direct infusion of nation-building funds - which goes around, and comes around - which I agree with; but he left off the bit about just who is competent to supervise same.

He doesn't know, and neither do I - except surely there are entrepeneurs out there who are willing to turn an honest dollar for an honest job?


Anonymous said...

Infrastructure. Something big, bold; maybe of this magnnitude:


Jim Belshaw said...

Have brought Noric's link up in the main post, Winton.

Glad you retain your sense of humour kvd re private entrepreneurs. Certainly some from the VET sector might be able to help.

Dealing with the RBA first, you are right to point to apparent conflict in roles. I have brought the formal agreements (they are just twenty years old as a practice) up in the main post.

Infrastructure I will deal with in this series. You give me a good entry point

Winton Bates said...

Thanks Jim. Perhaps I might appear to be less confused if I make a distinction between the monetary issues and the real economy issues.

Regarding money, I think it still makes sense for the Reserve Bank to pursue a simple inflation target (or target band) as at present. A nominal GDP target is better in theory, but I doubt that it makes a huge amount of difference in practice. It is very important to make the commitment credible. The RBA should leave no doubt that it will use quantitative easing if necessary to pursue its policy objective.

We will still have a problem with the real economy - low economic growth - even if monetary policy keeps inflation within the target band. I see that as mainly a problem of low investment. And I am a bit sceptical of the view that government investment in infrastructure provides the answer.

I wrote about relevant issues here:

Anonymous said...

Winton that is a very interesting post of yours, made more so by your references to "US secular stagnation" (SS) and "index of economic policy uncertainty" (IPU). I can understand why you reach the tentative conclusion you state. But a couple of observations which might assist my understanding, if you will?

1) I'm finding it hard to find much correlation between the SS's movement of net business investment (as % GDP) and the IPU's movement in policy uncertainty? Take just the period 2010-2015 from both your references: net business investment went steadily upwards from -1% to about 3% - while the IPU (fig.1) for that period was significantly affected by such things as 'euro crisis' 'debt ceiling' 'fiscal cliff' and 'government shutdown' spikes. Is it a case of lead timings for investment?

2) fig.3 in the IPU reference looks at two specific areas - health care and national security. Again, just looking at the 2010-2015 period, there seems to be a large difference between the significance (i.e. the importance?) of those two headings? and secondly, national security has flatlined, if not trended down - which is quite the opposite of my personal impression of this period. So, am I reading it right?

And finally, on the question of 'lead times' for business investment - one of the links I found interesting in that eastwestline project I linked above as example was the 'project timeline': started 2012, projected completion 2023. I'm saying there's that 10 year viewpoint we were talking about earlier. Nothing of that size could be significantly affected by the dips and spikes of the IPU, surely?


Winton Bates said...

kvd: I think you are probably right about lead times for investment. I am also unsure how well the indexes are actually able to measure policy uncertainty. I was impressed that got some results that seemed to make sense. I think it is important to try to measure policy uncertainty, but I have to admit it is a fairly nebulous concept.

The flat national security line does not surprise me. I think the US government has shown greater reluctance to get further embroiled in conflicts in the Middle East. The US military response to Islamic state was relatively limited. All that may change after the US elections!

I will have to think more about your last para.

Winton Bates said...

kvd: I think potential investors in the east west line project would need to take into account uncertainty concerning long term policy trends. For example, if they undertake the project on the basis that certain firms will have exclusive use or priority, there is uncertainty about policies that future governments might adopt to favour other potential users. If the railway makes large profits, governments will probably want to collect some rents. If it crosses aboriginal lands, royalties will probably need to be paid. Environmentalists will probably find a few endangered species along the route, so that might add considerably to the costs.

Two points:
1) The IPU would not pick up much of that uncertainty.
2) I think the important issue is the influence of policy uncertainty on the hurdle rate. If there is too much uncertainty you shelve the project for a while. If the policy environment improves you might do some further evaluations.

Changing the subject slightly, before we all get too excited about policy uncertainty it might be a good idea to include the IPU in regression models along with other relevant variables to see how much contribution it makes to explaining investment levels over time and internationally. We need to be able to disentangle the impacts of policy uncertainty and bad policy. I have not yet found research which seeks to do this.

Anonymous said...

Thanks Winton. Please understand that I only linked that eastwestline project as an example; there are several others of similar size - a DC power supply from us to Indonesia and onwards; water reticulation - east-west; and even (heaven forbid!) a native nuclear industry, as examples of projects which by their size might need a government 'push'.

Coming back to subject, my vague thought is that I cannot see how the IPU index is indicative of the concerns affecting possible investment decisions on investments of such scale - or, if it does, I would be disappointed. It certainly provides some sort of measure of current, very temporary, considerations - but for long term (i.e. length-of-project term) it represents no more than 'static'.

Very interested to be informed/corrected on this, but my feeling is that political stability (i.o.w policy stability) becomes more of an issue as you move from a democracy such as ours (such as it is) to more 'fluid' situations.

You might think it very 'low rent' but I have been watching very closely the NSW government's push to ban greyhound racing. This is the sort of sovereign action that should (and I hope would) concern any potential NSW investor - and it will be interesting to see how it plays out. I see it as an example of 'future uncertainty' which I don't think we've seen before here in staid old Oz.


Winton Bates said...

kvd: Yes, I would think greater sovereign risk leads to more political instability and vice versa.

Re the ban on greyhound racing. I am feeling a bit ashamed that I have not been taking more interest in the infringement of liberty that seems to be involved. It is hard to believe that there is no way that it is possible to conduct a dog race that would not be cruel to animals.

2 tanners said...

Just on kvd's comment about not having seen such a thing before in Oz, I would have thought than an extremely directly parallel was the live meat export ban. Pretty much all the same arguments, but a shedload more dollars at risk. About the only difference is that greyhound racing is entertainment, not feeding people (directly) but most of the arguments on both sides amount to shocking/tragic photo, one-sided, one sentence slogan and "Click if you agree!".

If two grown but possibly ill-educated men, with few other life choices, can be convinced to pummel the living daylights out of each other for the enjoyment of a paying crowd, then people who are silent about that but need to show sympathy for the little doggies have lost me.

But animal races without cruelty? Throw away the horse whips, get rid of wagering and then you might have a chance. But of course that would kill the REAL industry, which is not racing, it's gambling.

2 tanners said...

BTW, I'm as near to NSW as I'm likely to be in months, if not years. Ergo Happy 2T-in-NSW day, or nearest local equivalent. :)

Anonymous said...

tanners is correct to point to the live meat export ban as a prior example - and a happy 2T-in-NSW day back at you, tanners!

On policy stability, here's a paragraph which sums it up quite nicely:

The need for a long-term point of view is essential to allow for the time, the coherence, and the predictability so necessary for success. This long-term view is as important for day-to-day problem solving as for the making of large policy decisions. Most decisions in government are made in the process of responding to problems of the moment. The danger is that this daily fire fighting can lead the policy-maker farther and farther from his goals. A clear sense of guiding strategy makes it possible to move in the desired direction in the unending process of contending with issues of the day. Many failures of government can be traced to an attempt to solve problems piecemeal. The resulting patchwork of ad hoc solutions often makes such fundamental goals as military strength, price stability, and economic growth more difficult to achieve.

- from the Schultz economic memo to President-elect Reagan, November 1980.

Much like Jim's own commentary over the years, I think.