For the last decade or so, most of the English speaking countries have been running large and generally increasing trade deficits, and therefore running up increasing foreign debt. At the same time, until recently, both real and nominal world interest rates have been falling, which has made debt more affordable. This has produced a sense of security which is about to be reality-checked.
Short-term interest rates have been rising for the last couple of years, and now long-term rates are rising as well. The US 10-year bond rate is now 5.1 per cent, and has been rising fairly fast in recent weeks. The effect is to add a rising interest bill to a large and growing trade deficit. Brad Setser does the math for the US and it isn’t pretty.
If the average rate [on private and government debt] should rise to 6% — roughly the interest rate the US paid back in 2000 — the 2008 US interest bill would reach $420b. That is more than three times the 2005 interest bill.
Unless the trade deficit starts turning around fairly sharply, this would imply a current account deficit close to 10 per cent of GDP, which no country has ever sustained (please point out exceptions in comments).
The story for Australia is broadly similar, though the picture is complicated by the effects of commodity prices, which still seem to be generally rising. As long as that continues, our trade deficit should decline. But, high commodity prices have rarely been sustained for more than a few years at a stretch.
John Quiggin 
“The story for Australia is broadly similar, though the picture is complicated by the effects of commodity prices, which still seem to be generally rising. As long as that continues, our trade deficit should decline. But, high commodity prices have rarely been sustained for more than a few years at a stretch.”
If these high commodity prices are caused by high demand I might tend to agree with you. The rise in commodity prices seems accross the board affecting gold, silver, copper, oil, and even zinc. If these rises are caused by sustained devaluation of major trading currencies I think the picture is a little more grim.
JQ: Unless the trade deficit starts turning around fairly sharply,
What would this mean? That the demand in the US for Chinese made shirts, shoes, iPODs, etc. would be lower than the demand in China for US-made…____.
I can’t fill in the blank. Can you?
Long term interest rates may be rising but are they rising in real terms? Long term investors may be sniffing a chance of renewed inflation.
Im still not convinced this is a problem for most Australians, except those who travel frequently or consume significant imports.
Then again, the other affected group will be people who are mortgaged to the last cent with no juice in the tank – there are probably a fair few of those…
And if the US economy gets crunched by the rising interest bill, the outlook presumably won’t be too good for commodities.
Chris,
What Australian doesn’t consume significant imports??
soft landing or hard?
Patrick,
I do not.
I am delighted to see a reference to the balance of trade. It’s such a relief to see a real economic issue, related to actual production, coming to the fore instead of our unhealthy fascination with financial factors like interest rates and money supply. To me, finance is only the handmaiden of economics, which is about production, income and wealth. If the handmaiden gets ideas above her station, the mistress is likely to wear odd clothes and have a bad hair day.
“For the last decade or so, most of the English speaking countries have been running large and generally increasing trade deficits, and therefore running up increasing foreign debt. At the same time, until recently, both real and nominal world interest rates have been falling, which has made debt more affordable.”
I’d be interested to hear economists’ views on the kind and degree of correlation between these two facts.
Do low interest rates stimulate trade deficits?
or
Do trade deficits encourage a period of low interest rates?
or
Are these phenomena the artifacts of some larger set of circumstances?
or
Is their co-existence coincidental?
Or is there some other explanation that I have neglected?
“Do low interest rates stimulate trade deficits?”
Not necessarily, but if they are symptomatic of running the printing presses then the money matters brigade believe that’s exactly what will happen in the ‘short’ run before the inevitable correction. A decade or so does appear to be a little longer than previous definitions of the short run here though.
Modern economics is too often divorced from production. One thing that both Karl Marx and Adam Smith had in common was a focus on the ways and means of production. Marx recognised that labour was a key component in production (and misunderstood the role of the entrepreneur) whilst Smith clearly understood the nature of producer incentives. The supply-side school of economics is very much focused on the nature of production and whilst it possible a little contrived they claim both Karl Marx and Adam Smith as their own with some justification.
The most disappointing aspect of Keynesianism is that it created a popular misconception that an economy is driven by consumption. That the act of consumption will call forth production. The argument seems to be that people starve in Ethiopia due to a lack of demand and their government should help out by spending more (ie consuming more). When people starve on mass it is almost entirely to do with production problems.
Amoungst the foundations of supply-side economic thinking is that the producer is the central actor in any economy. That nobody has the means to demand anything in a process of trade until they have first produced something with appeal to others.
For those interested in how the Jude Wanniski (arguably the father of supply-side economics) embrased the production centred views of Karl Marx (even as he advised Ronald Reagan on how to reform the US economy in the 1980s) the following five part essay is worth reading:-
http://wanniski.com/searchbase/km1.htm
http://wanniski.com/searchbase/km2.htm
http://wanniski.com/searchbase/km3.htm
http://wanniski.com/searchbase/km4.htm
http://wanniski.com/searchbase/km5.htm
Terje,
When people starve en masse it is, without exception in the modern world, caused by their own government error (or malice).
In Ethiopia, for example, there was enough food produced or imported to feed everyone comfortably without the “Band Aid” offered. The then government simply had made sure it did not get to the regions that needed it as a deliberate strategy. It only later, and grudgingly, allowed it in under international pressure.
Other than that I would tend to agree with you.
Chris C- have you bought any clothing, computers; audiovisual equipment or electrical appliances in the past year?
Andrew,
Ethiopia starves because agricultural taxes approach 90%. This creates a disincentive to take any risks building surplus production capacity because the profits are socialised. Weak property rights also mean that improving the productive yield of a farm is a more risky undertaking than it might otherwise be. This system ensures that Ethiopians remain peasants living on the margin much as the mediaveal systems of Europe did. When a natural event like a drought strikes there is no reserve capacity.
Ethiopia is not primarily in need of charity (although who can argue with feeding people when they are starving). Primarily it needs its government to remove the barriers and disincentives to domestic production.
I stand by my assertion that mass starvation is indiciative of a problem with production. Nobody ever starves due to a lack of DESIRE for food. They starve due a lack of ability to DEMAND food. In a trade based system nobody can DEMAND anything unless they have the capacity to SUPPLY. And in a command based system nobody can COMMAND food unless there is a capacity to produce. Production is the necessary prerequisite for trade and a necessary prerequisite for consumption.
If we realy wanted to achieve a real solution we might make aid contingent on tax and property reform. However the usual agent we send to such places is the IMF and historically they insist on austerity (ie higher taxes) and currency devaluations (ie inflation). Kind of like feeding the starving with poison.
Regards,
Terje.
Ian,
I have bought clothes – none of the others.
Nonetheless, it is probably less helpful to look at my credit card bills than to really examine these linkages and possible impacts a little more carefully than has been done.
The gist of what I was saying is that if the good Prof’s arithmetic starts to take over, so what? Wheres the calamity?
The way I see it, if the CAD got to a ‘critical’ level, however defined, the next steps in the process would be:
CAD blows out > $ crashes > RBA MAY increase rates (although based on its most recent form, even a dive to 50 US cents doesnt seem to lead to this outcome)
Nevertheless, lets assume rates increase:
Rates increase > consumption falls, investment gets back in sync with savings > GDP slowdown possibly recession
As you will notice, there are a lot of ifs and maybes in there.
Theres a big if about the RBA putting rates up – there is no need for it to do so purely because of a depreciation, even a large one.
That is the beauty of a floating exchange rate – so why does everyone imagine that a CAD would lead to some horrible recession as it may have under the Bretton Woods regime? Ours is not a contagion-prone country.
The most likely catalyst of the next recession is overreaction by the RBA, not any external factors
What would lead to interest rates to be driven to a level that the market cannot bear? If the market screams when RBA raises the rates by 25 basis points, then how much facts on the ground has to change for interest rates to rise further?
For instance, we could always let the dollar devalue rather than raising rates.
We have had more than our fair share of horrible recessions under a floating exchange rate system.
If people can’t service their private debts it would seem likely that they will go bankrupt rather than the RBA devaluing their debt through monetary neglect. Otherwise the RBA would be in essence defrauding those Australians that are net savers.
Terje,
Ethiopia starves today because of that – agreed. In 1983-4 it was for the reasons I gave.
‘The most disappointing aspect of Keynesianism is that it created a popular misconception that an economy is driven by consumption.’
If ‘driven by consumption’ means only by consumption, this is a naive caricature. Keynes’s point was that demand matters as well as resources.
‘That the act of consumption will call forth production’.
Yes it will, if producers are operating with excess capacity. Consumption behaviour can change independently of income due to changes in consumer sentiment, credit, exchange rates, and a long list of other circumstances. Producers respond to an increase in orders if they can.
‘The argument seems to be that people starve in Ethiopia due to a lack of demand and their government should help out by spending more (ie consuming more).’
No, it isn’t.
‘When people starve on mass it is almost entirely to do with production problems.’
Are you talking about Ethiopia, this is uncontroversial. There hasn’t been any mass starvation in industrial capitalist economies, but there was plenty of hunger and malnutrition during the Depression.
The argument is not that changes in demand magically cause changes in productive capacity, but rather that they cause changes in the degree of utilisation of those resources. This is acutally pretty uncontroversial, except among a small band of ‘real business cycle theorists’. The controversy in the mainstream is over the degree to which price adjustments alone can correct a downswing.
James,
By “popular misconception” I mean that lay people and politians justify certain political acts with the defence that consumption is a good thing for the economy. For instance the space program inititated by JFK in the USA was touted as “good for the economy” because if involved the government spending lots of money and consuming lots of resources.
Regards,
Terje.
So it’s popular misconception of Keynesianism that disappoint you rather than Keynesianism itself. Thanks for clarifiyng that.
The popular conception as opposed to misconception would be that Keynesianism advocates public infrastructure projects (i.e. investment), not consumption, as a remedy for unemployment. The space program is consumption in the first instance, so it’s not a good example. Certainly it would have boosted demand though – I don’t imagine anyone would dispute that.
By the way, I notice you’re still going on about currency. I’m not sure if you read my response to your last reply on that.
Actually the Keynesian virtual denial of Says law disappoints me and I don’t think that is a misconception. And the inability of Keynesian theory to explain stagflation was a real world disappointment.
Public investment as a remedy for unemployment works for me. So long as it really is investment. However one of the best investments that a government can make in times of unemployment is an investment in the tax base (ie tax cuts).
It might have boosted demand for astronauts, however it would have lowed the demand for other things.
I am not sure if I read it either. However I am pretty sure I did. If you wish to requote the relevant bits here then I will happily respond.
Interest rates to date do not seem to be restricting credit growth. In fact, in the global sphere and especially in Europe, credit growth is on the increase (see broker’s balance sheets for example, ABS, M&A, share repurchases, repos, CP, etc.). Borrowing costs may yet change that, but I doubt it. And neither do I think the losses in the fixed income market- levered though they may be- have yet to amount to much. Cost pressures and their effect on inflation expectations or other means to shake investor confidence such as emerging market or hedge fund crises (and the former- to include the Kiwi $- is looking promising) are what to watch. Bottom line, whether central bankers will ‘pop’ the mother of all credit/asset bubbles is not in question- they certainly will not. The question is rather how much longer their acquiescence will remain relevant.
Btw, Chris C, your comment:
is choice. Please don’t forget to add that the biggest ship in the world could never sink.
Best to leave Say’s Law out of it. It’s more a reference to a cluster of related ideas than a single proposition that can be articulated clearly. In any case, no classical subscribed to Say’s Law as Keynes represented it, at least not consistently. He was quite capable of caricaturing other people’s ideas himself.
As for the other things, all I can do is repeat the advice to read a couple of introductory textbooks.
The currency comment was at the end of this thread.
Terje,
You missed my point.
I am not suggesting that a floating exchange rate makes us recession-proof.
What I am saying is that the main advantage of floating the currency is that it frees us from the situation under fixed rate systems whereby a trade imbalance would cause a domestic slowdown.
The “CAD Chicken Littles” have not yet provided a compelling argument about why domestic economic policy should target ‘external balance’ (whatever that means) over more humdrum goals such as reducing unemployment and inflation.
WRT your argument that cutting the tax base is a preferable ‘investment’ in times of unemployment to public works was demolished in practice by the onset of the Great Depression, and in theory by ‘The General Theory’.
Marjoram,
In future, we may well become a contagion-prone country, but why should we undertake growth-slowing policy actions IN CASE this happens?
Nonetheless, in practice I think our policy prescription would be the same – tighter monetary policy – I agree that central banks are ignoring the elephant in the room (asset prices).
“Unless the trade deficit starts turning around fairly sharply, this would imply a current account deficit close to 10 per cent of GDP, which no country has ever sustained (please point out exceptions in comments).”
I suppose the answer depends on one’s notion of a ‘country’. Current account deficits could grow until all physical assets are sold off or mortgaged in return for foreign exchange to buy imports in excess of the value of exports. Once the incomes of the population in such a country drops sufficiently low to become ‘internationally competitive’ but too low to pay for private mortgages, more asset sales are on. Then there would be, in some sense, a ‘new management’, even though it would not be noticed in the description of the institutional environment of such a country, as understood in law and politics. Accumulated budget surpluses by the governments of such countries per se would not prevent the (political-legal institutional) rule ‘one head one vote’ becoming economically subservient to the (economic) rule ‘one dollar one vote’ (‘dollar’ stands for name of ‘money’). I don’t know whether this is the idea of a ‘country’ in ‘globalisation’ – I’ve never came across a coherent expose of the ideas, if any, that are to be associated with the word ‘globalisation’.
As for statistical data, I can’t think of an epoch which is both long enough and has ideological, technological and institutional features which are close to the contemporary international environment to look for data in answer to the specific question. (My answer to Katz’ options is that the phenomena stated are the artifacts of some larger set of circumstances.)
As to the notion of a ‘country’ the following site indicates to me that there enough people in Australia who don’t buy the ‘one shoe fits all’ ideology on ‘competition’ and who understand the relationship between education and technological know-how that gives economic, cultural and political meaning to the label ‘country’. http://www.pr.mq.edu.au/events/index.asp?ItemID=2430. (The data was collected in 2005).
Thanks, Majorajam, for your perceptions on the financial markets (paragraph 1). They happen to be compatible with the insights from theoretical models of economies with financial securities (eg from Radner, 1972, onward).
“I suppose the answer depends on one’s notion of a ‘country’. Current account deficits could grow until all physical assets are sold off or mortgaged in return for foreign exchange to buy imports in excess of the value of exports. Once the incomes of the population in such a country drops sufficiently low to become ‘internationally competitive’ but too low to pay for private mortgages, more asset sales are on.”
Engaging.
EG is describing a chain of events which may end in institutional crisis.
In other words, one scenario is that “business as usual” continues until a significant weight of unserviceable debt undermines the ability of national financial institutions to pay back their creditors in debt denominated in a foreign currency. (I use the word “national” here deliberately because deregulation of the currency markets has not proceeded to many national governments relinquishing their role as lenders of last resort. Thus private debt can be transmogrified into public liability. Is this one of the larger sets of circumstances which has allowed the co-existence of rapidly growing trade deficits and low interest rates?)
The opposite scenario to the above is that financial arbitrage smoothes out moments of institutional crisis. Under this scenario crisis moments are never reached. (Is belief the subtleness and suppleness of financial markets another reason for the co-existence of rapidly growing trade deficits and low interest rates?)
Paradoxically, perhaps, these two sources of confidence in current financial arrangements are contradictory. One posits the efficacy of state intervention, the other denies its need to exist.
i have some questions,
if the dollar nose dives will it take the US economy into a crash of sorts,
is it bad for the foreign holders of US debt if the dollar crashes
can the world economy sustain itself with a reasonable collapse of the US economy
more questions, is increasing interest rates inflationary or not,?
people keep saying that theres no inflation which i dont believe,
but the american Fed has increased interest rates 15 times in a row since June 2004
Smiths,
My opinions on the answers to your questions:
“if the dollar nose dives will it take the US economy into a crash of sorts?”
1) Not necessarily – there seems to be an assumption that a dollar crash will lead automatically to a sharp increase in US interest rates. Mainly this appears to be an assumption of people that think we are still in a fixed exchange rate world. Remember people, the US’ international traded goods exposure is only around 6% GDP!
“is it bad for the foreign holders of US debt if the dollar crashes”
2) Almost certainly – the interest payments on (US dollar denominated) debt are expressed in X amount of US $. If the $US falls, then those returns as denominated in another currency also fall. This would be compounded i.f.f US interest rates increase, which reduces the “capital” value of the debt
“can the world economy sustain itself with a reasonable collapse of the US economy”
3) Doubtful – they are still the major engine of growth for most other major (and not so major) economies. Particularly at the moment, while Japan remains anaemic, Europe is sluggish and the BRICs remain heavily export-dependent.
Terje: Ethiopia starves because agricultural taxes approach 90%.
There’s something almost endearing about Terje’s ability to keep repeating this with a straight face.
So, I haven’t read in detail every single psot on this thread but there seems ot be a mssive lack of response to John’s request for exampels of coutnries that have sustained CAD’s above 10% without major economic pain.
Katz: ” …deregulation of the currency markets has not proceeded to many national governments relinquishing their role as lenders of last resort.”
Does the current version(s) of ‘lender of last resort’ relate to anything more than honouring ‘bank’ deposits by the public denominated in the domestic currency?
[‘bank’ stands for the set of financial institutions who would qualify for the condition.]
I’m referring to the FDIC and FSLIC.
These commit the US Federal Govt. to make recompense in $US if banks default on depositors. Such a defalcation may arise from several causes, including the inability of the bank to raise loans in foreign capital markets.
Any US government committed to recompense would be required to raise taxes and/or reduce expenditure and/or raise loans either in domestic or foreign capital markets.
No less a personage than free enterprise champion Milton Friedman commented on the confidence building effects of the FDIC and FSLIC on investor confidence in US financial corporations:
“Improved quality of savings and loan shares as a result of insurance plus the time it takes for asset holders to adjust on the demand side and savings and loan associations on the supply side, seem to us to explain in large part the willingness of asset holders to hold [a rapidly growing] amount of savings and loan shares, despite a narrowing of the differential between the yield on them and on time and savings deposits.” (“Monetary History of the United States”).
I wonder what it would take to cause asset holders to come to a different conclusion about the soundness of the guarantees entailed in the FDIC and FSLIC.
I’ve always been a fan of compound interest because even folks on meagre wages can rabbit away a bit of money weekly and end up millionaires in retirement.
“I am delighted to see a reference to the balance of trade. It’s such a relief to see a real economic issue, related to actual production, coming to the fore instead of our unhealthy fascination with financial factors like interest rates and money supply. To me, finance is only the handmaiden of economics, which is about production, income and wealth. If the handmaiden gets ideas above her station, the mistress is likely to wear odd clothes and have a bad hair day”
And how would the following fit into the mental model?
finance.http://www.fdic.gov/regulations/laws/walmart/Pages%20from%20Wal-Mart_Federal_Deposit_Insurance_Application_Public_File_1.pdf
Pity their millions aren’t worth anything by the time they retire.
Chris C, you’re just piling on at this point:
Perhaps you missed the title of this thread? JQ’s entire commentary, etc.?… In any event, there couldn’t be more reason to worry about eye watering current account deficits such as enjoyed by Australia and the US.
I’ll make this plain: What you are witnessing now, in this blow off phase of speculative and credit excess alternatively known as a period of unparalleled global prosperity, is in actuality little more than a confidence scam. A Ponzi scheme, with everyone passing around silly little pieces of paper each betting there will be a greater fool they can flip them to for a tidy (levered) gain. Some even with the knowledge that it may be they who are left without a chair when the music stops. As with all Ponzi schemes this one will end when the courage of wanton greed gives way to the hysteria of wide-eyed panic. Now, there are two broad narratives to consider, each with their own potential catalysts, both relating to the importance of perception in any confidence scheme:
1) Creditors most notably holding the bag, in our case currency manipulating central banks, pull the plug.
There are myriad incentives for these actors to remain faithful to their doctrine of cognitive dissonance, but a steaming pile of dung can only be allowed to fester for so long before it requires attention. At some point, only the most obtuse (or, as is more often the case, aligned of incentive) pundits will maintain that the mountain of toilet roll they have been accumulating is actually a pot of gold. That point is unavoidable, courtesy of the unpleasant arithmetic of compound interest.
2) And far more expeditiously, asset/credit bubbles blow of their own volition.
The catalysts for this are the various means by which a liquidity crisis can ensue. Credit devoted to feeding asset bubbles creates false prosperity, greed for more prosperity and concomittant malinvestment- i.e. real resources chasing investor whimsy and the riches that are its reward. When inevitably these decisions result in non-performing credits, (often as a result of a reversal in asset prices- itself largely related to confidence, and, relatedly, the persuasiveness of the arguments of unreconstructed Pollyannas such as the chairman of the Fed and predecessor), you get defaults. When these defaults reach critical mass you get margin calls on scale (and, given the extent to which this malinvestment is concentrated in the hands of a woefully undercapitalized leveraged speculating community, this critical mass shant be very massive). The interrelatedness of these credits, (falling mostly on the balance sheets of a number of banks you can count on one hand), is what gives rise to the phenomenon known as “contagion” that can afflict all borrowers beholden to international capital with the exception of Australia.
Now, this circumstance I’ve described is the whole of which the current account deficit is only a part- however, it is a critical part and one likely to intensify the supernova to come beyond erstwhile imagination. Why worry about “external balance” whatever that means and not simply narrow inflation and unemployment/growth? Because systemic monetary collapse is not a pretty thing. A fact about to become far more personal to most.
Marjoram,
Before you keel over at the sheer grandeur of the forthcoming collapse, lets all understand something – Even if Australia is currently engaged in an orgy of speculation and bubble-fever, so what? As the Fed and RBA have demonstrated, it is possible to deflate these as both banks did in 2000-2001.
How does this automatically lead to “systematic monetary collapse”? Answer is: it does not – that requires the additional ingredient of a stupid central bank that fails to inject liquidity.
WRT:
“1) Creditors most notably holding the bag, in our case currency manipulating central banks, pull the plug. ”
Are you talking about Australia? If so, dya mean the Govt or private borrowers? Because last time I looked, our Govt has NO foreign-denominated (or $A denominated) debt.
PS to my last – in case I sound cavalier, I would rather the RBA/Fed DID take account of asset prices when setting monetary policy, but the fact that they dont just means inflation down the track.
To repeat: the main cause of any economic collapse precipitated by an asset bubble would be the RBA being asleep at the wheel, NOT a high CAD.
Ian Gould – Given that most data on CADs and international trade is less than 200 years old, and given that for most of that time we had fixed exzchange rates (which preclude the possibility of sustained CADs), I think that is a mug’s challenge.
Krugman made a good case for contagion, but that wont happen here or in the US in the forseeable future.
And before the chortles start, the reason I say that is that if ‘hot money’ deems the US and Australia to be too risky, where the heck would it consider a safe haven to park itself?
I posted a link which doesn’t work. I am unable to fix it. Please ignore it and the post. Apologies.
Katz, thank you for your reply. The apparent linkages between CAD, multinational corporations, export and import finance insurance via government bonds and deposit insurance of financial subsidiaries of multinational corporations is interesting. It surely provides a very much ‘larger set of circumstances’. I say ‘apparent’ because I haven’t read enough as yet to be confident in observing more than one special case. Apologies for the cryptic comment.
Chris C says: “To repeat: the main cause of any economic collapse precipitated by an asset bubble would be the RBA being asleep at the wheel, NOT a high CAD.”
Question: What measures could the RBA have taken to prevent an ‘asset bubble’?
Ernestine,
Currently the RBA (and many other central banks, to be fair) has as its main aim to target CONSUMER inflation of between 2-3% on average over the economic cycle.
However, I believe this is a too-narrow interpretation of price stability and that asset prices should also be considered when setting monetary policy, as wild swings in asset prices are no more good for sustainable growth than is consumer-good hyperinflation.
Accordingly, when asset prices started galloping in around 2000-2001, the RBA could have started gently increasing interest rates then, in order to head off the subsequent asset price inflation.
This is a gross simplification, and I am not suggesting it is an easy thing to do, but it is extremely myopic to be fixated only on consumer price inflation.
Chris C,
Asset price inflation is fundamentally different from consumer price inflation and the judgements have to be different. The longer-term assets used for asset price inflation calculations represent a call by their purchasers on their expectations of the future, not their picture of the present. When you buy a bottle of milk, it is expected to be for nearly immediate consumption. Buy a house and you expect it to have a use to you for years and a value when you sell it.
With the milk you look at your current needs, the current price of the milk and your current ability to afford it. Buy a house and you are looking at your current needs, the current price of the house, your current ability to afford it, your future needs, the future price, the future interest rates, and your future ability to afford it.
The reason why house prices were low in the 1980s was because of high inflation, high interest rates and future expectations. Now, in a low interest environment, the long term benefits of home ownership have changed. I am not saying that we are not going to go back to the 1980s, or that the current prices are sustainable, but a simple look at the price now and trying to factor that into an inflation calculation is not necessarily going to give an answer on which you can base monetary policy.
Chris C,
I agree with your comments on monetary policy objectives and on the measurement of price stability. It seems to me, Majorajam, has no objections.
The question is, what can the RBA do to control asset prices. You suggest that it could have raised interest rates earlier – since 2000-01. This is where I have some difficulties with your view.
Setting asside Majorajam’s specific prediction as to how the ‘asset bubble’ will play itself out, it seems to me Majorajam general point is that since financial market deregulations the complexity of international financial markets has grown, both in terms of the types of financial securities issued and in terms of the quantities issued (and the people who get into these markets). Thus, underlying the changes of prices of assets, such as real estate prices and basic securities, such as equity, is a paper mountain of financial securities with an almost intractable but fragile structure. I tend to agree with Majorajam on this point, assuming I did not misunderstand essentials.
I understand the credit creation in international financial markets is currently regulated by frequently changing ‘risk weighted asset ratios’, developed by the BIS in consultation with central bankers. These measures don’t seem to make a dent into the ‘growth’ in financial markets (ie growth in securities and turnover rate). I find the proposition that the RBA can have an impact by fiddling with the interest rate not convincing.
Andrew Reynolds,
I agree entirely, and am not for a moment suggesting that it is as easy as bunging it into the CPI basket.
For the reasons you have mentioned, central banks have been loathe to target asset prices.
However, these problems do not mean that it is inappropriate to take asset prices into account when setting monetary policy – it just makes it more difficult.
Ask yourself then – why does the RBA target ‘price stability’ at all? Why not the exchange rate, commodity prices, interest rates?
The answer is because that is how the RBA best thinks it will achieve maximum welfare for Australians.
Why? Because if inflation takes off, it has a tendency to self-perpetuate, leading to the need for ever-higher interest rates to get the genie back in the bottle, and ultimately recession and unemployment. It also knocks a big hole in peoples’ purchasing power.
Well, asset price inflation can impact severely on Australians welfare too.
Ask someone who rents whether they care more about the price of milk doubling, or the price of houses doubling (or indeed, rising at all, in the current market).
So, why do we cordon off asset price movements when setting monetary policy?
Moreover, to return to your milk analogy, current and future consumption should really just be different points on the chronological spectrum. Theoretically, (putting aside intangible factors), people should be calculating their NPV of housing consumption and comparing it to the price of housing to determine whether to buy or rent.
In reality, many do not – many are actually paying double or triple to own a home than they would to rent it.
This confirms that people are intertemporally myopic – the stupidity of people clamouring about a 25 bp rate rise off a record low base is further confirmation.
Should the RBA ‘manage’ this myopia? Ideally, someone should.
How would they do it? Havent got the faintest, the theory hasnt been written yet.
Prof Q – over to you.
Ernestine,
As far as I know, international credit creation is not regulated by the BIS – I believe credit creation in individual countries is regulated by the respective central bank.
Eg. if (US-headquartered) Citigroup’s German subsid. wants to issue credit greater than that allowed by the Bundesbank, it would not be allowed, even if it would be allowed in the US.
By extension, world credit growth cannot grow faster than allowed by respective national governments.
Of course, the channels for credit growth have now expanded beyond banks, NBFIs etc.
I agreed with Marjoram about the likelihood that we are in an asset price bubble – however, I am yet to hear a coherent set of linkages between a bubble and a “systemic monetary collapse”.
Lets assume the worst case scenario: speculative hot money has driven Aussie house prices up to tulip-like levels, then decides in a pink fit that Brazilian orange juice derivatives is where it has to be, immediately!
So tens of billions of dollars worth of RMBSs and CDOs are dumped, meaning many many speculators take an absolute bath. Now, they are left holding worthless paper but they still have the debt to finance. Some of them will be able to keep making the payments, others will default.
Lets assume a high proportion of them default – creditors foreclose on the collateral (houses, businesses, equities). This in turn triggers steep price falls in all these markets.
Some creditors themselves go to the wall, and maybe a big bank falls over, in turn leaving people losing deposits.
Etc etc
Now, what is to stop the RBA from flooding the system with liquidity at any one of these stages, thereby stopping the spiral?
Why do you doubt that it can do so?
Why does the internationalisation of finance preclude the RBA from doing this?
And if it does, why the heck are so many people jumping up and down about a tiny cash rate move from this impotent institution?
PS – Ernestine, before you answer, think about the Fed’s actions after the Asian crisis and the tech boom and how these might be examples of exactly what I have described.