Monthly Archive for August, 2012

Glenn Stevens is not quite God

Alan Kohler has a piece on Crikey talking about electricity prices in Australia.  It’s an interesting piece and well worth a read, but it’s got a crucial economics mistake.  After talking about the politics and such, Alan gets down to brass tacks, telling us that:

  • Over the last two years, electricity prices in Australia have risen by 48% on average; and
  • Indeed, over the last five years, electricity prices have risen by more than 80% on average; but
  • Over the last twelve months, overall inflation has only been 1.5%, the lowest in three years.

He finishes by explaining:

That’s because the increase in power prices has been almost entirely offset by the high Australian dollar, which has produced tradeable goods deflation of 1.4% over the past year. In other words, thanks to the high Australian dollar we are getting a big improvement in energy infrastructure without an overall drop in living standards.

And thank goodness for fast rising power prices — without that, we’d have deflation. It’s true!

But it’s not true, and it’s not true for a very important reason.

Back in 1997, in the guts of of the Great Moderation (the time from the mid ’80s to the start of 2007 when US aggregate volatility was low) and before the real estate boom that presaged the financial crisis of 2007/2008, Paul Krugman famously wrote (this Economist piece is the best reference I could find in the two minutes I spent looking on Google) that unemployment was whatever Alan Greenspan wanted it to be, “plus or minus a random error reflecting the fact that he is not quite God.”

It’s popular to argue that Ben Bernanke lacks that power now that America has interest rates at zero. I disagree (see here and here), but I appreciate the argument.

Australia has no such problem. Interest rates are still strictly positive and the RBA has plenty of room to lower them if they wish.

So I have no qualms at all in saying that inflation in Australia is whatever Glenn Stevens (the governor of the RBA) wants it to be, plus or minus a random error to reflect the fact that he’s not quite God.

If the various state grids had all been upgraded a decade ago and electricity prices were currently stable, then interest rates would currently be lower too. They would be lower because that would ensure faster growth in general and a lower exchange rate, both of which would lead to higher inflation, thereby offsetting the lower inflation in electricity prices.

There’s a famous argument in economics called the Lucas Critique, named for the man that came up with it, that points out simply that if you change your policy, economic agents will change their actions in response.  It applies in reverse, too, though.  If economic agents change their actions, policy will change!

Alan Kohler ought to know this. Indeed, I suspect that Alan Kohler does know this, but it’s a slippery concept to keep at the front of your mind all the time and, besides, it would make it hard to write exciting opinion pieces. 🙂

Monetary policy still works at the ZLB

In case anybody was wondering, monetary policy definitely still has an effect at the zero lower bound.  In the UK, the banks have unwittingly (and certainly unwillingly) been part of a demonstration of a so-called helicopter-drop of money.  In a country of 60 million people, by mid 2008 there were over 20 million Payment Production Insurance (PPI) policies in effect and that number was growing fast.  In early 2011, they were ruled to have been mis-sold (customers were deemed, in general, to have been pressured or deceived into buying insurance they didn’t need) and banks were ordered to offer compensation.  Wikipedia has a summary here. From a pair of articles in the FT ([1], [2]):

[Article 1] About £4.8bn had already been paid out by the end of May – effectively acting as “helicopter money” dropped into the hands of those people who may be among the most likely to spend it.

[Article 2] The independent Office for Budget Responsibility, relying on estimates that PPI refunds would deliver £6bn over the year, revised up its estimate of the growth rate of real disposable household income by 0.5 percentage points in March from its November figure … the amounts set aside for PPI redress by the five biggest banks have now soared to almost £9bn.

[Article 2] The FSA said it does not know the average payout per claimant. But some of the “complaints management” companies, which have been making aggressive pitches to help consumers get their money back, say these average £2,000 to £3,000 per applicant.

[Article 1] “When I heard I was going to get over £2,000 in compensation I hired builders to fix a long-overdue problem with the eaves in my roof and put the rest of the money towards a holiday to Greece in September,” said Elaine Overten, a retired nurse from Derbyshire, who received compensation for PPI payments made on her NatWest mortgage over 10 years.

I just love the little (and not remotely subtle) hint from the FT that monetary stimulus would help Greece out of their hole.

Anyway, the point is simple.  If you put money in people’s hands, especially if those people are “credit constrained,” they will spend it.  That was the point of my “Monetary policy for 10 year olds” post a while ago.  It remains the point today.  It will always be the point.

The problem, of course, is that while PPI compensation payouts are acting as a positive stimulus, the corresponding hit to the banks will be causing them to hold back in their lending and so provide a negative stimulus at the same time.  If I had to guess, I’d say that the net effect of PPI compensation is to provide a positive stimulus because of the broad distribution and, I assume, the fact that a large fraction of the recipients really are currently credit constrained.