ECONOMIC AFFAIRS by Colin TeeseNews Weekly
A change in economic direction is sorely needed
, August 30, 2014
Economics, as a discipline, has rarely been free from the temptation to cloak ordinarily simple propositions — frequently of questionable value — in difficult and confusing language.
U.S. Federal Reserve Chairman
Dr Janet Yellen
Perhaps there is a reliable rule-of-thumb applicable to this practice: the more difficult and confusing the explanatory language, the more questionable the conclusions.
And it is certainly true that issues of questionable credibility are more easily shielded from criticism if shrouded in abstruse language.
Moreover, confusing and difficult language allows economists to enjoy the advantage of craft protection. Outsiders, lacking the craft jargon, find it difficult to break into the inner circle of “experts”.
My favourite example is the NAIRU: in economic gobbledygook this is an acronym for the “non-accelerating inflation rate of unemployment”.
In reality it describes a quite simple proposition, though one of deeply questionable validity. Its protagonists pretend to have developed a theory which contends that full employment causes inflation. In order to avoid that undesirable outcome, levels of unemployment must be maintained at around 4 per cent or more.
The hidden agenda of the NAIRU proponents was to use unemployment, and the threat of unemployment, as a means of holding wages down. This does not work and, worse still, it introduces instability into the economy, and is socially disruptive.
The global financial crisis (GFC), which, incidentally, the world has still not shaken off, has given birth to more than a few silly opinions. One in particular, which has been pushed by a small, but influential group of economists, is that the downturn has not caused the rise in unemployment. Rather, those out of work have chosen leisure over employment.
A most unlikely proposition, if you think about it. To work or not to work, would be an option for no more than a small fraction of the workforce. Most rely on wages to provide the necessities of life.
Apart from this, the GFC has generated a new confusing terminology — confusing, but nevertheless important enough for us to take the trouble to understand it. Zero lower bound (ZLB) — or zero nominal lower bound (ZNLB) — and macro-prudential policy come readily to mind.
Zero lower bound describes nothing more than the fact that many central banks have reduced to zero the rate they charge private banks for their overnight borrowings. The expression may seem silly, but the concept is important.
Macro-prudential policy describes government and central bank techniques to stabilise the boom-and-bust business cycle by taking into account the inter-connectedness of individual financial institutions and markets.
Making sense of zero lower bound and macro-prudential policy can help us understand the monetary and
exchange rate problems besetting the Australian economy.
For many years, central banks in most Western economies, including Australia’s, have held to the orthodox opinion that economies can be kept stable by adjusting the interest rates that central banks charge commercial banks on their overnight borrowings.
In an “overheated” economy, interest rates are increased — the assumption being that this will deter people from investing and spending. Similarly, when the economy is sluggish, reducing interest rates will revitalise output and employment by encouraging people to spend and invest.
However, following the 2007/08 financial crash, this strategy did not seem to work any more.
RBA Governor Glenn Stevens
When the United States economy slumped, the U.S. Federal Reserve responded by pushing overnight rates ever lower in its efforts to restart economic activity. Ultimately, they reached zero and, quite obviously, could not go lower. They had reached the zero lower bound.
In the process, a serious and important consequence of zero interest rates had been uncovered. Quite obviously if, at zero interest rates, economic activity does not pick up (and this is what happened in the U.S.) — nothing more can be done to stimulate growth by reducing interest rates.
If, as a result, consumer prices head down, the economy can sink into deflation. Consumers are encouraged to hold off spending, believing that prices will fall further. That belief becomes a self-fulfilling prophecy, trapping the economy in a deflationary spiral.
Unlike Europe, at the point of the zero lower bound, the U.S. to date has avoided deflation.
There is no single reason for the difference. But, importantly, at the zero lower bound the U.S. pumped money into the banking system — so-called quantitative easing (QE). The Europeans chose the opposite path, opting for a policy of so-called “austerity”, apparently because Germany — the European Union’s dominating economic power — fears inflation more than deflation.
Picking our way through these processes is important because it allows us to understand that when a crisis hits, getting the policy responses right is crucial. The EU may be paying a heavy price for choosing the wrong policy path.
Meanwhile, the policy debate is moving beyond the matter of whether QE beats “austerity”. The question has become whether central banks can any longer maintain economic stability by fiddling with interest rates.
No less eminent a person than the newly appointed Chair of the Board of Governors of the U.S. Federal Reserve, Janet Yellen, has actually suggested that central banks’ fine-tuning of interest rates may no longer be the means for securing economic stability.
Dr Yellen uses the term macro-prudential policy to capture the idea of a combination of safeguard and regulatory measures covering all financial institutions as a means of heading off future financial crises. Previously, the U.S. believed it was enough to cover the possibility of rescuing a single institution (micro-prudential policy). The recent crisis demonstrated that this was inadequate.
Dr Yellen’s approach is, to say the least, controversial. The Bank for International Settlements (BIS) — the central banks’ central bank — is clinging grimly to the old idea of interest rates as the safe road to stability. (Our own Reserve Bank of Australia governor Glenn Stevens appears to share that view.)
Holding that position in the face of U.S. Federal Reserve opposition might be difficult. If the weight of U.S. official economic policy and business power gets behind her, Yellen’s approach may prevail.
All of this has direct implications for Australia’s trouble with its exchange rate. At the zero lower bound, the value of the U.S. dollar, relative to other currencies, including ours, fell dramatically. This was good for the U.S. economy, because it made its imports dearer and exports cheaper, but disastrous for Australia.
We chose not to follow the example of most of our important trading partners who have fashioned their own corrective responses. As a result, we are losing the currency war.
The Reserve Bank of Australia (RBA) has reduced its overnight interest rate to 2.5 per cent — the lowest it has been for decades. But the Australian dollar remains uncomfortably high. Despite the serious consequences for our economy, the problems associated with our exchange rate are being given scant attention on either side of the political divide.
RBA governor Glenn Stevens, trapped in a straitjacket of orthodoxy originating in the Bank for International Settlements, is finding it difficult to deal with the peculiarly Australian problems he must confront.
The Australian dollar currently stands at around 94 cents to the U.S. dollar. (It has been as high as US$1.05.) It should be around 70-75 cents. What remains of our manufacturing and service industries faces total destruction if our dollar remains at or near its current level for very much longer.
With interest rates being so low, Stevens has hinted darkly about the risk of inflation. In this he is echoing what may well be the misguided view of the Bank for International Settlements.
Nevertheless, he must be concerned when he considers how few and limited are his options. He dare not push interest rates down any further, or even keep them at their present record low levels — without risking igniting a boom in asset prices (especially property and shares). Nor can he increase interest rates without stimulating an unwelcome surge in the level of capital inflow — which will almost certainly further push up the value of our dollar relative to other currencies.
In short, the interest rate option, the only instrument at the disposal of the governor of the RBA, can no longer stabilise the Australian economy, much less protect us from the consequences of others engaging in what continues to be a beggar-my-neighbour currency war.
Notwithstanding, other effective policy options are not beyond reach. Any new effective policies would of course represent a clear break with domestic economic orthodoxy, and would be unlikely to find favour on either side of the Australian political divide. They would however be moving in the “Yellen direction” of finding ways other than interest rate adjustments as a means of stabilising the economy.
In this manner, the way would be opened for other necessary interventionist policies. For example, the government might apply strict limits on bank lending for house and share purchases. Properly structured, these limitations could head off the possibility of asset price booms.
The exchange rate problem would require a different approach. Downward pressure on the value of our dollar could best be achieved by immediately preventing the importation of capital, except for new investment in productive activity.
By way of an epilogue, Yellen’s phrase, “macro-prudential policy”, is a piece of economic jargon sheltering two important changes in economic direction: a return to a closely regulated financial sector, and a rethink of the current orthodoxy of central banks using interest rates as the sole means of stabilising the economy.
Practical considerations rather than ideology appear to be driving Yellen. What policies led us into the 2007 financial crash and subsequent global financial crisis? And what are the changes we need to make?
She obviously wants to build on the U.S. Federal Reserve’s achievements to date. Perhaps it has not done everything right, but its low interest rate/QE response, in her view, seems to have worked better than European austerity.
Presumably, she hopes to persuade other industrialised economies to break free from past policy processes, which may no longer be appropriate for today’s world.
However much Australia’s political class may be committed to the old ideas, they will be doing a serious disservice to those they are obliged to serve if they don’t give Janet Yellen’s ideas a decent hearing.
Colin Teese is a former deputy secretary of the Department of Trade.