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Global economic outlook + Aussie inflation & house prices – EP150

The message from the IMF July 2022 World Economic Outlook was that the outlook is “Gloomy and More Uncertain”. This week also saw the United States slide into a technical recession. Certainly there are big risks to the global outlook. It’s possible that central banks could tip many economies into recession as they hike interest rates to tame inflation. This episode considers the global economic outlook as well as the economic challenges facing Australia’s new federal government. It’s an abridged version of a conversation that show host Gene Tunny had with Decactivist host Randall Evans on his show. The conversation was recorded prior to the US GDP release, but Gene remarks on the data in his introduction to this episode.

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcasts, Spotify, and Stitcher.

Randall Evans’ Deactivist show:

https://www.youtube.com/c/Deactivist

IMF World Economic Outlook July 2022: Gloomy and More Uncertain:

https://www.imf.org/en/Publications/WEO/Issues/2022/07/26/world-economic-outlook-update-july-2022

US recession news from NPR:

https://www.npr.org/2022/07/28/1113649843/gdp-2q-economy-2022-recession-two-quarters

Transcript: Global economic outlook + Aussie inflation & house prices – EP150

Gene Tunny  00:01

Coming up on Economics Explored.

Randall Evans  00:04

I don’t know if you saw the lineup for Qantas, I think two days ago. But it was out the door all the way down the road for Qantas flights in Sydney, like all the way out there. Never seen it like that, it’s insane.

Gene Tunny  00:21

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host, Gene Tunny. I’m a professional Economist based in Brisbane, Australia, and I’m a former Australian Treasury official. This is episode 150 on the Economic Outlook. 

We are at a risky point in the global economy. It’s possible that Central banks could tip economies into recession as they hike interest rates to tame inflation. Indeed, I’ve just seen the news that the US has experienced the second quarter of negative economic growth. So, according to the traditional definition, the US economy is in a recession. I’ll have to cover this in more depth in a future episode. But for now, I’ll know that there will be a big debate about this, given the jobs growth has been really good in the States, something noted by US Treasury Secretary, Janet Yellen, she’s claimed the two quarters of negative growth rule for a recession can be misleading. And you need to look at a broader range of indicators, as the National Bureau of Economic Research does when it calls recessions. There’s a lot to explore here, so I’ll leave it to a future episode. 

Okay, I should note that this current episode is an abridged version of a conversation that I had with fellow Australian podcaster, Randall Evans, on his Deactivators show earlier this week, on Wednesday, 27th, July 2022. I’ll put a link to Randall’s YouTube channel in the show notes. So, you can check out the full unedited chat, and Randle’s other videos. 

You may notice I’m short of breath at some points in this episode. That’s because I’m still recovering from COVID. I picked it up at the Conference of Economists in Hobart, two weeks ago. It was an awesome conference, but it was also a super spreader event. Alas. 

In the show notes, you can find relevant links and details of how you can get in touch with any questions, comments or suggestions. Please get in touch and let me know your thoughts on this episode. I’d love to hear from you. 

Right on, for my conversation with Randall on the Economic Outlook. I hope you enjoy it.

Randall Evans  02:38

Hello, everyone and welcome to the show. We’re here with Gene Tunny. Gene, how’re you doing?

Gene Tunny  02:42

Good. Thanks, Randall. How are you?

Randall Evans  02:44

I’m pretty well. For people who don’t know you, why don’t you give us a little background about yourself and what you do?

Gene Tunny  02:52

Okay, I’m an Economist. I’ve got my own consultancy business, Adept Economics. So, I do project work for different clients, private businesses, nonprofits, some government agencies, councils. So, often business cases for different projects or analysis of different policies or programs. So, I’ve been doing that for the last 10 years or so. Before that, I was in the Federal Treasury. So, we’ve got a broad background in Economics.

Randall Evans  03:27

And you’ve also got your podcast as well with over 130 old episodes I think, so far.

Gene Tunny  03:33

Yeah. Economics Explored. Yeah, that’s going well. I’m really happy with how that’s going. I mean, we’ve covered you know, a wide variety of issues on that, including housing and inflation and the RBA and the current review of the RBA. So, yeah, that’s going really well.

Randall Evans  03:55

What’s the current review of the RBA? Is to get rid of it? 

Gene Tunny  04:02

Some people might want that. There are some libertarians out there who are pushing for the abolition of Central banks and the abolition of fiat currency. But no, they’re not going to do that. I mean, they probably won’t do anything too radical, they might make some changes to the board composition, they might make some changes to the language around what the Reserve Bank is supposed to do in terms of targeting inflation. But yeah, there won’t be any radical changes, I’m afraid. Particularly if you look at the people who are who are going to be doing the review. They’ve got an academic Economist. They’ve got a former government bureaucrat, Gordon Brewer, and then they’ve got a deputy head of the Central Bank of Canada. So, you’ve got fairly mainstream people there. So, I don’t think we’ll see big changes. Having said that though, I mean, the Reserve Bank certainly needs reviewing, because there’s been a lot of concern that their policy settings have been wrong at different times. Phil Lowe’s, arguably misled people last year, and there are a lot of people who are concerned about that. His forecast, which was widely reported that interest rates wouldn’t be increasing until 2024. And he was saying that late last year, and now, they’ve already gone up from 0.1; this is the official cash rate, the overnight cash rate, which is lower than what people pay for home mortgages. Now it’s at 1.35. It’ll go up to 1.85 tomorrow, sorry, not tomorrow, on Tuesday, next week.

Randall Evans  06:02

Is that just people wishful thinking that believed that it wouldn’t go up till 2024? I mean, we had mass quantitative easing and the inflation followed, and then the logical step was; interest rates are going to go up. So, who was saying we can hold off till 2024?

Gene Tunny  06:22

Well, I guess there was this view that the economy had changed. And, I mean, there was quantitative easing, not in Australia, but in other countries during and after the financial crisis. So, starting around, 09, 0-10. And there were people forecasting, oh, this is going to lead to runaway inflation at the time, and that didn’t really happen. But what we’re seeing in the last was over the pandemic period, is that we’ve had, you know, more quantitative easing, and we’ve had big budget deficits to try to stimulate the economy as well. And I think the combination of that has meant that, you know, inflation has really soared. So, they were lucky last time, it didn’t happen. Last time, they got away with it. I think perhaps they thought that they might be able to get away with it again. Yeah, they were wrong.

Randall Evans  07:32

Imagine my shock that they might have. So, I guess first off, one of my first questions would be, as you see, is it all doom and gloom for Australia, or are we In a place we have to be? Where do you see us going over the next 12 to 18 months?

Gene Tunny  07:55

Well, I think it’s doom and gloom for Australia. I mean, really, things have been pretty good when you think about it. I mean, we’ve recovered very strongly from the pandemic. And unemployment is now at three and a half percent, right? This is extraordinary. And now there’s talk about sign-on bonuses. I don’t know how legit this report is. But there was a report in Perth now, that McDonalds in WA is paying sign-on bonuses of $1,000 due to the shortage of people; how difficult it is to get people. And the mining sector is paying $10,000 sign-on bonuses just to get people, there’s a shortage. Partly, that’s related to the fact that we haven’t had; I mean, immigration starting to increase now. But we had a year or so when we weren’t letting anyone in the country. So, I guess we’ll start to see that impacting wages. That could end up leading to inflation itself. I mean, one of the things we want to avoid is what they call a wage price spiral, where inflation just keeps feeding on itself. And prices and wages just sort of, go up in this; once leads to so high wages lead to higher prices, higher prices lead to higher wages, because people need to be compensated for that and they push for it in their wage bargaining. So, yeah, that’s the sort of thing that people are concerned about.

Randall Evans  09:35

The unemployment rate, typically, when there’s high inflation will be low. And I think that’s on the Phillips curve, if I’m not mistaken. Can you just explain that for the for the layman viewing?

Gene Tunny  09:52

I probably should finish the previous question, first. I will get on to that, Randall. I just realized you asked me about if it’s gloomy; I don’t want to be too positive, because, there certainly are risks in Australia, I better clarify that. Because of the rising interest rates, and it looks like, people probably; many households possibly overextended themselves, borrowed too much. There was that fear of missing out. And so therefore, as interest rates increase, even though they’re not going to get up to the really crazy levels that they got up to, in the late 80s, when they were up around 17, 18%. I mean, that won’t happen. But I mean, still many households could get into trouble. We’ve seen consumer’s confidence really plummet, and it’s at you would associate with before, like just before a downturn or a recession. So, there are levels that are almost recessionary. I think one of the bank economists, may have been the ANZ, economist, who said that. So, there’s certainly concerns about that.

On this point about unemployment and inflation. Yes, I mean, the traditional view, and this is a view that we learned was not correct. It broke down in the 70s was that, there is this tradeoff between unemployment and inflation; one story you can tell is if you have low unemployment, that means that workers have more bargaining power. Labor is scarce and so, workers are able to negotiate better with their bosses, and that pushes up wages. So, that’s the theory. 

So far, at least in the official data we’ve had up till March, we haven’t really seen a wages breakout in Australia, that’s why there’s was all their talk about declining real wages. And I think that cost Scott Morrison at the last election. That was really a strong attacking point that the then opposition, now government were able to make against the then government that you’ve got inflation running at the time was 5.1%. Now 6.1% yearly, and wages are only grown at 2½%  So, you’ve got a real wage decline of over 2 ½%. So, that was a bit of a worry. 

The traditional story was that, if you had low unemployment, you’d get high inflation. Conversely, you could, if you wanted to reduce inflation, you had to have high unemployment, because that would give workers less bargaining power. Okay, so there’s this tradeoff between unemployment and inflation. And this was based on a study by a New Zealand economist, Bill Phillips, who was actually an engineer, but he was an economist as well. And he might have been at LSE, in London, at the time. But that whole thing sort of, broke down in the 70s because what we noticed is that there wasn’t this stable tradeoff between inflation and unemployment. What there was, was the possibility that you could have both high unemployment and high inflation, and indeed, you could have unemployment increasing and inflation increasing, you could have what’s called stagflation. 

So, there’s no real trade off in the long run between unemployment and inflation. You can have high unemployment and high inflation at the same time, if people come to expect inflation, if there are, what you call inflationary expectations if they increase. So, that’s one of the concerns that people have about the global economy at the moment. The IMF, World Economic Outlook came out overnight. So, it came out Tuesday, in the US, and it’s gloomy; it’s talking about a gloomy outlook, globally. And I think it’s suggesting  we have very high inflation globally. Was it 6 or 7? It was it was a high rate. I’ll have to just check it. But there’s a lot of talk globally about stagflation, where they will end up in stagflation. And then there’s acknowledgement by international agencies that we could end up in a situation with high unemployment and high inflation down the track. I mean, it’s not likely at the moment. I mean, we are having global growth slowdown, because we’ve had this shock from the war in Ukraine, which has increased the oil price and petrol prices. So, one of the reasons you can have a stagflation is if you have this shock to the economy, such as higher oil prices, which push up the costs of production. And that means that it’s less profitable for businesses to produce what they were doing. And so that could lead to reductions in economic activity, and at the same time as costs of production is increasing, that’s passed on to consumers and increases prices. So, that’s one of the great concerns now.

That’s certainly something that, you know, people are concerned about, and you couldn’t rule it out as a possibility. I’d like to be a bit more optimistic than that, though. But so much depends on what happens with this war in Ukraine, and whether we can resolve that; the oil prices are coming down, but they’re still higher than they were a few years ago. So, a lot is going to depend on what happens there. Also the pandemic, which is causing all sorts of problems with the supply chain, it’s very disruptive. Things just don’t work now, as they did before. I mean, you’d see you see all the delays with Qantas and the disruptions that are occurring.

Randall Evans  17:04

I don’t know if you saw the lineup for Qantas, I think two days ago. But it was out the door all the way down the road for Qantas flights in Sydney, like all the way out there. Never seen it like that, it’s insane. I did want to ask you, and perhaps you should explain the theory first because the question from cue, which disappeared off the chat, was whether the RBA will actually increase interest rates enough to slow down inflation. But first of all, what is that theory though? How does that work? And then, what do we expect the right to probably go to?

Gene Tunny  17:46

Okay. Let’s begin with the fact that inflation is a monetary phenomenon. So, this is a famous quote from Milton Friedman. So, inflation is always in everywhere, a monetary phenomenon. In that, it’s associated with an expansion of the supply of money or the stock of money. So, this is currency that we have, but it’s largely; it’s mostly deposits sitting in the bank accounts of households and businesses. Okay, so, there’s the view that although the understanding that we end up with inflation, because the amount of money is expanding, and it’s expanding faster than the capacity of the economy. So, what we have is too much money chasing too few goods. 

So, inflation is a monetary phenomenon. The Central bank, the Reserve Bank is responsible for the money supply. And so therefore, it’s the RBA that has responsibility for dealing with inflation through monetary policy. So, the way they do that is by manipulating the overnight cash rate, this is the standard way of doing it, the official cash rate. This is what they call the cash market, which is a market in which banks and other market participants will borrow money overnight. And banks need money so that they can settle their accounts with each other at the RBA. The RBA controls this overnight interest rate. And what it’s trying to do is it’s trying to influence all the interest rates in the economy that are have a longer term. And so, what happens is as the cash rate increases, though the cost of borrowing money overnight increases, and that has a knock on effect to the cost of borrowing money for 30 days and six months and 12 months, etc. 

What they’re trying to do there is a few things and the RBA talks about different channels by which monetary policy works. Now, let’s think about what those channels are; one of those channels is through the amount of credit that’s created in the economy. One of the reasons we’ve had the big expansion in the money supply in the last couple of years during the pandemic, it’s not just because of the quantitative easing that the bank has engaged in, it’s not just because of their own money printing in their purchases of bonds. It’s also because with the very low interest rates that the bank has said, that’s meant that more people have borrowed money, or the bigger mortgages. So, we’ve had this expansion of Housing Credit. And the new credit, so the net additions the Housing Credit, that is expanding the money supply, I mean, there’s additional money in the economy. 

Okay, so one thing that the bank needs to do through increasing interest rates is reducing the amount of borrowing for housing and new credit creation. So, that’s one thing they’re trying to do. The other way it works is possibly more direct, or more immediate. It’s the fact that I mean, when they increase the cash rate, and that flows through to variable interest rates, mortgage rates, and eventually to fixed rates, when they reset, people have fixed rates for a few years, and then they reset at higher interest rates. What that means is households have less money to spend, they’re paying more to the bank, the bank gets the money, but the bank may not necessarily lend it to someone who’s going to spend it then. So, you have this subtraction from demand that way. So, that’s another channel by which monetary policy works, what the what the bank, what the Reserve Bank, what all Central banks are trying to do is they’re trying to take some of the heat, well, they’re trying to take the heat out of the economy, they want to have the economy go on this Goldilocks path, not too hot, not too cold. So, make sense? 

So, with the interest rate increases, the idea is you can pull some money out of the economy; will have the money supply, expand at a slower rate, or even contract, so that you can get inflation under control. And because you’ve got less, people don’t have as much to spend, that puts less pressure on the economy; it’s not overheating, there’s not as much demand out there. There’s not as much money chasing the few goods that we talked about before; too much money chasing too few goods. So, that’s the general idea. There are multiple channels, we know that if you do increase interest rates, it does eventually slow the economy. The great challenge is knowing how far you have to do that. And it’s not always obvious in advance how much you have to do that. And the problem in the 80s, the late 80s, in the lead up to the recession, is that they discovered that they really did have to increase those interest rates a lot to be able to slow the economy.

Randall Evans  24:18

Yeah. I was going to ask you a question, but then I was reading a comment.

Gene Tunny  24:28

Was the comment okay?

Randall Evans  24:31

Yeah, it was just should Australia be concerned with China’s financial issues that seem to be compounding? And also, these crazy images coming out of China of the tanks rolling in front of the banks not lending money out. What are your thoughts on what’s going on in China, and will it will impact us? I know, that’s kind of off topic to inflation and the housing market, but can we have your initial thoughts?

Gene Tunny  24:59

Clearly, we need to worry about what happens with China given that it has become such an important part of the global economy. And yes, if the Chinese economy did crash; it is slowing. So, we know that it has been slowing down. And the IMF is concerned about the outlook. I mean, there are risks from you know, that the property market, and construction sector, we know about Evergrande. Look, , it could be a could be a real concern for us, because so much of the commodities boom that we experienced, starting around 2003; we had the first phase of that over about 2003 through to 2013. And then, late to late last decade, commodity prices started rising again, then there was a bit of a downturn before; I think coal prices came down even before the pandemic. But since, end of last year, I think this started picking up with the global recovery, the global recovery was stronger than we thought. And then this year, commodity prices have gone absolutely nuts because of what’s happened in Ukraine. So, I guess, China is important. At the moment, it’s hard to forecast what would happen if we did have a downturn in China, because they’re probably, given all the disruptions that have occurred in the world and the fact that they need our; the world needs our coal, and coal prices are crazily high because of that. We probably would be okay in terms of coal. Iron ore would suffer because China has been a major purchaser of that. So, yeah, I mean, it certainly would be a problem. I mean, it’s hard to know what’s going on with China. Just a very difficult place to understand, really?

Randall Evans  27:33

Yeah. I did remember my other question relates to housing as well, you were talking about interest rates in the economy at different times, because a lot of people on mortgages might be on a fixed term mortgage, and that might go for X number of years. So, that flow-in effect might not hit them, and might not actually reflect in the numbers, two years down the track. So, what do we expect for the housing market, even though interest rates just going to keep going up?

Gene Tunny  28:09

Well housing prices are already coming down. I don’t know if you’ve seen those statistics. But Christopher Joy, who’s one of the top financial commentators in Australia, he writes for the Australian Financial Review. I’ve actually done some work for him in the past. He’s incredibly a bright guy. He’s got a company called Coolibar Capital Investment. And they’ve got billions of dollars of money under management. So, they’re really paying attention to this stuff. Look, you just look at the losses in or the reductions in housing prices since the first interest rate increase in May. And this is suggesting that, look, this is already impacting how sales was. I don’t know the exact breakdown; I should have looked it up before I got on. But I mean, there are a lot of households that are on variable rates. We see in the data that house prices are falling. I guess that will be, because as the interest rates increase, people won’t be able to borrow as much as they could have previously. And so that means they don’t have as much or they can’t go to the auction with the same expectations as they did before. Or maybe they’re more cautious about borrowing. They’re more concerned they’re less willing to bid at an auction because they are worried about the future. We know that consumer confidence has dropped. So, I think the interest rate increases have started to have an impact. So, there are obviously enough people worried about it. And it’s also impacting prices because it’s reducing the ability of people to the amounts that they can borrow. So, what was seen as Sydney’s fall and 5%, Melbourne, 3%, Brisbane, around 1%. That since May, since the first rate hike, capital cities overall, that minus 2 ½%. So, look here we prices are going down.

Randall Evans  30:35

I was just saying you’re recovering from COVID and I forgot to thank you for coming on.

Gene Tunny  30:43

Thank you. I usually think I’m okay. I thought I was okay, before I started. And then as I keep talking; should be okay. So, what Chris was writing was, if you look at Sydney, it’s declining at an annual rate of 22%. So, house prices are falling, and it looks like they’re falling at an accelerating rate.

Randall Evans  31:10

That’s a huge number to be dropping at 22%.

Gene Tunny  31:15

That’s if you take the rate it’s dropping out at the moment and annualize it. So, it may not last over the year. Although, it’s possible that it could; house prices soared during that pandemic period, even though many forecasters were expecting they might fall, it actually, surged because there was all this additional borrowing. There’s the fear of missing out. And, the market went nuts. And so, they’ll probably land above where they were at the start of the pandemic, but a lot of the gains will have been lost; it’s looking like that now. Because those interest rate increases are having more of an impact than was expected.

Randall Evans  32:11

Yeah, I couldn’t believe how much housing prices rose during the pandemic, it was just so counter to what I thought was going to happen. But it did, and I guess we’re going to see that correction. Probably not an overcorrection, though maybe, like you said, probably just above pre pandemic levels.

Gene Tunny  32:35

Yeah. And that’s what we’re seeing. It’s it started for sure. The big unknown is just how vulnerable households are to interest rate increases and whether you will start; they will massively cut back on their spending and that could then lead to a downturn. At the moment, the labor markets going ridiculously strongly, we’ve got 3 ½% unemployment, 300,000 vacancies, I think I saw someone report the other day.

Randall Evans  33:11

The unemployment figure that includes people actively looking for work, right. Yes. So, I’m not sure if that’s a great signal to our strength, if there’s a lot of vacancies and a lot of people looking for work, or am I missing something?

Gene Tunny  33:33

But that’s showing that there’s hardly anyone looking for work compared with before the pandemic. And there’s lots of vacancies. So, this is why we would expect wages to start increasing or perhaps we hope that they will. I think they probably are. We’re certainly seeing well, the sign- on bonuses that have been reported, there’s a story about McDonald’s. Possibly, who knows whether that’s true or not, it’s hard to know whether McDonald’s would be paying $1,000 sign-on bonuses, but that was the Perth Now report. I believe it in the mining sector though.

Randall Evans  34:12

Yeah, I could fly to Perth for like 400 bucks, have a job for a week and I’ll pay for my holiday.

Gene Tunny  34:20

You probably have to serve at some time. I’m sure they’ve got something or their agreement to cover that. So, I think the unknown is just how the economy will react as interest rates increase and just how much people will cut back their spending and whether you know, we had a boom and then we’ll have a burst. One of the challenges is going to be; and this is a big issue for the new government. You will recall that the previous government cut the fuel excise in half, so it’s down at about 22 cents a liter now, and what’s going to happen is that that’s going to go up to, it has to be 44 cents because they cut it in half, at the end of September. People will notice that unless petrol prices come down a bit more, they’ll really notice that and that’s going to come at a bad time, because we know interest rates are still going to go up. They’ll go up half a percentage point next week.

Randall Evans  35:38

What are your thoughts on how the Albanese government is going to shake up the economy? I guess some of the things that are promising, like, I guess the government backing certain home loans by 40%, and things like that. Does anything about his election promises stand out to you that will have a big impact?

Gene Tunny  36:06

Not really. They wouldn’t implement policies that I would probably implement at the moment to try to get inflation under control, they wouldn’t do that, they wouldn’t go that far. There was a discussion that we had? Well, I think we have to massively reduce his budget deficit we’ve got now. So, Jim Chalmers, the Treasurer, he’s talking about the need for savings. One of the reasons they’ve got to find savings; they need to get the debt under control – the trillion-dollar debt, but also because the government at the moment is contributing to the inflation problem we’ve got by running these large budget deficits. Still large, what you call a structural budget deficit. so that they’re still running these large structural deficits of 3 to 4% of GDP, if you look at the budget documents. So, what that means is that if you adjust for the state of the economy, you take into account the fact that the economy has been doing very well. At this point in time, the government should be running much smaller deficits or surpluses than they actually are, and they’re not. They’re still running reasonably sizable deficits. So, there’s this structural deficit, and that’s contributing to inflation. They’re adding to the demand in the economy, they’re contributing to the overheating. So, what this federal government has to do is to really cut back on their spending. Or, one alternative, I don’t know whether they’ll do it or not, because they promised that they would follow the stage three tax cuts. I think in stage three. There’s another tax cut coming through, that’s going to knock out one of the marginal tax brackets, if I remember correctly. And so, there are some people on the left who are arguing that the government shouldn’t go through with those, those tax cuts that are programmed in.That’s one possible thing they could do. To address that structural deficit. I’d probably prefer that they cut their spending, because they’ve got some big spending programs that are really getting out of control. So, NDIS, it’s well intentioned; I think a lot of people support the principle of it. But it’s growing, it’s tens of billions of dollars, or 30 billion, or whatever it’s going to overtake Medicare, in terms of the amount of money that’s spent on it over the budget estimates, over the next four years. 

So, that’s something they’ve really got to get under control, but that’s going to be difficult for them. I think it’s a well-intentioned program. The challenge is, where do you limit it? That’s the problem. There’s the desire to keep expanding it and to make it to provide as high level of service as possible and I think yeah, that’s just financially unsustainable at the moment, we need to really fix that up. 

That’s what I think needs to happen. There needs to be the expenditure restraint, or you know, the larger cuts than anything Jim Chalmers would be contemplating. I’m former Treasury, the Treasury would have provided some list of the things that should be cut. And knowing how these things work, Treasury have this huge book full of potential savings that could occur. And the government will probably pick a handful of them, because they look at most of the things Treasury’s proposing and they go, how could you ever contemplate cutting all of these things? Politically naive, so that that’s what will happen, that’ll be the reality. 

Randall Evans  40:38

Well, one of my questions is that, I know the RBA is supposed to be a separate entity, but allowing the RBA to increase interest rates to such a level that’s going to hurt your voter base. It’s almost political suicide. And I know they don’t really have a say, but, there was that kind of situation where I think it was Roosevelt who grabbed one of the members of the Federal Reserve by the scruff of his neck and was like, you’re destroying my presidency. So, is there a situation where the Australian Government can effectively halt the interest rate rise for political reasons? Or do we have enough kind of checks and balances to stop that happening?

Gene Tunny  41:31

Okay, they actually could, there’s, they have the power to do that. I’m trying to remember this is a point that Nick Growing often makes, I’m trying to remember correctly, I think there’s a provision in the Reserve Bank Act that the treasurer can table something in Parliament and tell the RBA what to do, right. So, the Treasurer could direct the RBA. And I don’t know if you remember, back in the 80s, we had a treasurer of Paul Keating, the Labor treasurer at the time, and he gave a famous or probably infamous speech. It was in the lead up to his challenge to Hawk when he said, I am like the Placido Domingo of Australian politics. And I’ve got the Treasury in this pocket, I’ve got the RBA in the other pocket. That was a great speech; it was not a modest man, it was a very coveted man. But yeah, Keating thought he ran the RBA. So, back in the day, the government had a lot more control over the RBA. The problem then is that, you don’t want monetary policy set by the government. Because for that reason, because the government’s going to want to have it more well, looser, they probably want to have the economy more prosperous in time for their reelection. And they’re not thinking longer term about what the inflationary consequences of that are. 

So, what economists have learned from that problem, the problem that if you have a Central bank politically influenced and you can get you can get higher inflation is we need to have Central banks independent of the government. So, we need to give them some independence. And so, what our governments have done is that they’ve struck an agreement with the Reserve Bank, there’s an agreement on the conduct of monetary policy. That was first, I think it was first formalized by Peter Costello, and in the fall, and in the 90s, in 96. And what that did was that codified in an agreement, the inflation targeting goal that we have now. So, the Central bank, the Reserve Bank, is targeting inflation between 2 to 3%, on average, over the economic cycle, so it’s of which means that they don’t have to be zealous or they don’t have to solely target inflation, if they’re going to crash the economy, they could ease up a little bit on interest rate increases, but ultimately, their goal is to get inflation under control, get it 2 to 3%. That’s what they’re accountable for. So, they’re going to be doing everything they can without crashing the economy to get inflation under control. But look, who knows? We hope we’re not in a situation that the Americans or that we were in the late 80s or the Americans were in the sort of early 80s and Britain too when you really had to increase interest rates a lot to get inflation under control because you had double digit inflation. Now we’re not there yet, hopefully we’ve moved in time to prevent that from occurring. But if you get to a situation where you’ve got double digit inflation, then you might have to increase interest rates much more than the economy can bear and then you end up in a crash. 

I’d like to think that we haven’t left it too late. And we’ll need to resort to those measures. But, let’s wait and see. So, I guess the answer is that, the government could direct the RBA. But then, the bad press they would get over that would be incredible. You’d have all the financial journalists around the country, criticizing them over compromising the independence of the RBA, Jim Chalmers wouldn’t be able to finish a press conference.

Randall Evans  45:52

You’re acting like they answer the presses questions. I think Anthony Albanese is the fondest to just brush off questions. But I understand completely what you’re saying. And I wasn’t suggesting; just for my viewers that the government should do that. I was just putting the thought out there. As a former Treasurer, what do you think the current government values most when it comes to the economy? Because everything seems to be a trade-off, right? It’s either we can get inflation under wraps, or we can have high job growth or, we can have housing affordability, so what do you think that they’re actually going to? Because you can’t have all of them or maybe you can? What do you think their focus should be, moving forward?

Gene Tunny  46:49

Well, I think the focus should be on the overall health of the economy. So, it should be about making sure that we’ve got the right tax policy settings or we’re spending on the right things, we’re not wasting money. We’re not contributing to the inflationary situation. We’re not enacting silly policies. 

One thing I have been encouraged by is the fact that they’re not doing really silly things, or they’ve knocked back this idea from the greens that we should have a moratorium on coal and gas projects, right? At a time when the coal price has been; well, that’s what Adam Danza saw, right. And at a time when the global coal prices being up at 500, or 400 US a ton for thermal coal, that’s extraordinary. 500 a ton for metallurgical coal, for coking coal. The idea that you’d actually wouldn’t develop any new coal mines when the world is crying out for it, because there’s no gas. We’ve got a global conflict and Europe’s worried about their gas supplies and whether they’ll have enough gas in the winter. Yeah, it’s a bit crazy. Full credit to the prime minister for knocking that back. 

I think there’ll be broadly sensible, but what you’ll see with a labor government is that they’ll be more aligned to what they perceive as the workers. Okay, and they won’t care as much about the costs they impose on business. Okay. And so, you’ve seen that recently. The problem we’ve got is that there are a lot of well-intentioned policies and so it’s hard to argue against a lot of these things, but they are costly to business. This government will probably do more things like this, we saw that there was that recent decision about from about, what is it? Paid leave for if you suffered domestic violence, or family violence? I can see what why that would be a good thing to have, at the same time, there is already paid leave available, you get four weeks if you’re a full-time employee. And this is an additional cost to employers. And you’d have to be a pretty nasty employer if you didn’t look after an employee of yours who was in that situation. I wonder why this sort of move is necessary from the government. Maybe they think it’s not going to have much of a cost because your employers would probably do the right thing, to begin with. 

I guess it’s a signal that this government is probably going to be more focused on the workers, it’s going to be less concerned about the impacts of its policies on employers. One thing that worried a lot of people, a lot of economists and financial commentators, John Keogh wrote a great column on this in the Finn review was when Anthony Albanese in the lead up to the election, talked about how the Fair Work Commission should just agree to wages going up at the rate of inflation. And there was a concern that, well okay, that’s a good thing that just leads to that wage price spiral where, if prices go up, oh, let’s increase wages by the same amount. And then that increases the cost to employers, they pass it on in prices. And then oh, let’s have wages go up again, prices go up again. And they just sort of gradually creep up a little, not gradually, they can increase, they can go up very quickly. And organizations such as the Bank for International Settlements and various other economic agencies around the world have warned about this wage price spiral, and one of the quickest ways to get there is to have automatic indexation of wages to inflation. 

So, there were people concerned about what the PM said there back in the election campaign. Ultimately, it was up to the Fair Work Commission, the Fair Work Commission recommended an increase that wasn’t complete. It was just a bit; I think it was a bit lower than the inflation rate. For non-minimum wage workers is about 4.6% or something, if I remember correctly.

So, that would be my take on it. I think they won’t do anything too crazy. They’ve resisted that crazy proposal from the greens, so, good on them for that. Sorry, go ahead.

Randall Evans  52:15

I follow a few greeny pages on Facebook just to see what they’re yapping on about. And I did see a lot of angry people today about that very thing you’re talking about. Saying, you can’t be for sustainability, but then allow coal mines to open. 

Gene Tunny  52:42

Yeah, well, just on that. it’s a real threat to labor. So, it was the coalition that got smashed on the climate change issue, last election, they ended up losing some of the blue-ribbon seats. But labor’s similarly threatened, right. Labor got what was it? 31% primary vote. So, labor was lucky to, it’s just the way that it played out in terms of the seats that were that were lost. And it managed to be able to form government, even though it ended up getting fewer votes than the coalition. But yeah, it’s in trouble from the greens as well.

All of these inner city seats are turning green. So, I’d be interested to see what happens in the future, whether Labor has to; how it survives, it’s under threat, as well as the coalition. So, I think that’s one thing that’s going to be fascinating to watch in the next few years.

Just on housing, the government’s policy isn’t going to do much for affordability because it was only going to apply to 10,000 people or so. It was it was limited in the amount of people that would apply to and it has to apply to hundreds of thousands of people to really make any sort of impact. The reality is there’s not much the federal government can do because the states are more relevant when it comes to housing because well, one, they’ve got responsibility for social housing. Now, my view is they’re just never going to be able to build enough of that. One of the problems with social housing is that they’re aiming to offer it at below market rent. The challenge there is you’re going to have a huge demand for your social housing because you’re offering something that’s cheaper than what the market is able to provide right? So, you’re never going to win there. You’re always going to be attracting more people, than you’re going to be able to build houses for. 

So, that’s probably not the answer. I think the answer is having a more liberal approach to development, allowing more development, particularly in the inner cities where we have heritage restrictions. There are all sorts of zoning rules around our capital cities. And even across the whole metro area here in Brisbane, for example, where I am, there’s a ban on townhouses in low density neighborhoods. And that’s just really silly. Because, that’s constraining the supply of housing. And there was research by Peter Tulip, at the Reserve Bank when he was there at the Reserve Bank, that showed that these zoning restrictions, they’re massively increasing the cost of housing, like 50, or 60%, something like that. So, that’s up to councils, but state governments, they possibly could do something like that with some of their planning legislation. But the commonwealth really can’t do much about housing. So, even though it’s an issue, it’s a big issue. I’m not sure they really can do much about that. 

The big issues the Commonwealth is facing; there’s the general economic management issue, what its budget deficit is doing for the economy, what its budget deficit means for the accumulation of debt and risk to the credit rating in the future and our ability to service that debt. And so therefore, that’s why Jim Chalmers is having to trim the budget where he can. He’s going to find it difficult though, just because that reason we discussed. Labor sees itself as the party of the workers, it also sees itself as more socially caring, more compassionate than the conservative side of politics. And so, it’s going to be very hard for them to make the substantial budget savings that are necessary.

Randall Evans  57:15

Well, we’ll touch base with you again, in a couple of months’ time and see where we’re at as a nation. And if people want to watch, we’ve had Gene on before, so you can just search for it in the little YouTube bar and watch that episode too. But apart from that, make sure you check out his website. It’s on the screen right now. If you want to have some more in-depth conversations.

Bye Gene. Thanks for your time. Thanks for being here.

Gene Tunny  57:42

Pleasure. Thanks. Thanks, Randall and thanks to everyone listening. Yeah, glad to be to be connecting with you. So, it’s been great. Thank you. 

Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com And we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Thanks to Randall Evans for letting us borrow the audio from his latest Deactivist show for this episode. Also, thanks to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.auPlease consider signing up to receive our email updates and to access our e-book Top Ten Insights from Economics at www.economicsexplored.com. Also, please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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Podcast episode

Reserve Bank of Australia being reviewed after big mistakes w/ Peter Tulip – EP149

The Reserve Bank of Australia has allegedly made some bad calls in recent years and now the Australian Treasurer has commissioned a major review. This episode’s guest, Dr Peter Tulip of the Centre for Independent Studies, has long pushed for a review of the RBA. Peter, a former RBA and US Fed economist, thinks the RBA can learn from other central banks such as the Fed and Sweden’s Riksbank, and it can avoid future bad policy decisions which cost hundreds of thousands of jobs. 

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcasts, Spotify, and Stitcher.

Here’s a video clip of Peter’s conversation with show host Gene Tunny to give you a flavour of what is covered in the episode.

About this episode’s guests – Dr Peter Tulip

Peter Tulip is the Chief Economist at the Centre for Independent Studies, a leading Australian think tank. Peter has previously worked in the Research Department of the Reserve Bank of Australia and, before that, at the US Federal Reserve Board of Governors. He has a PhD from the University of Pennsylvania.

Peter’s twitter handle: @peter_tulip 

Links relevant to the conversation

Peter’s previous appearance on Economics Explored: https://economicsexplored.com/2022/04/11/the-high-cost-of-housing-and-what-to-do-about-it-w-peter-tulip-cis-ep134/

Australian Treasurer’s 20 July 2022 announcement of RBA review:

https://ministers.treasury.gov.au/ministers/jim-chalmers-2022/media-releases/review-reserve-bank

Peter’s CIS paper on the RBA: https://www.cis.org.au/publication/structural-reform-of-the-reserve-bank-of-australia/

Kevin Warsh’s review of the Bank of England Monetary Policy Committee: https://www.hoover.org/sites/default/files/transparency_and_the_bank_of_englands_monetary_policy_committee.pdf

This is the 2010 Statement on the Conduct of Monetary Policy that Peter refers to at the end of the episode:

https://www.rba.gov.au/monetary-policy/framework/stmt-conduct-mp-5-30092010.html

This is the most recent statement:

https://www.rba.gov.au/monetary-policy/framework/stmt-conduct-mp-7-2016-09-19.html

Transcript: Reserve Bank of Australia being reviewed after big mistakes w/ Peter Tulip – EP149

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Peter Tulip  00:01

Coming up on Economics Explored. Many of us, including me, think that the Reserve Bank has been making big mistakes and is in need of structural reform.

Gene Tunny  00:15

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host, Gene Tunny. I’m a professional Economist based in Brisbane, Australia, and I’m a former Australian Treasury official. This is episode 149 on the review of Australia’s Central Bank, the Reserve Bank of Australia, or RBA. This review was announced by Australia’s new Labour government on the 20th of July, 2022. 

My guest this episode, is Dr. Peter Tulip. Peter has long pushed for a review of the RBA, and he’s been extensively quoted in local media on what needs to change. Peter thinks that the RBA has made some big mistakes in the past, and it could learn from other central banks, such as the US Federal Reserve, and the Bank of England, as he explains in this episode. 

Currently, Peter is the Chief Economist at the Centre for Independent Studies. And before that, he’s worked at the RBA, and at the US Federal Reserve Board of Governors. So, he knows how central banks work on the inside, and his perspective is a valuable one. 

This is Peter’s second appearance on the show. He previously appeared in Episode 134 on the high cost of housing. So, if you haven’t listened to that yet, please listen to it after this episode; it’s great. 

In the show notes, you can find relevant links and details of how you can get in touch with any questions, comments or suggestions. Please get in touch and let me know your thoughts. I’d love to hear from you. 

Righto. Now for my conversation with Peter Tulip on the review of the Reserve Bank of Australia. Thanks to my audio engineer Josh Crotts for his assistance in producing this episode. I hope you enjoy it. 

Peter Tulip, Chief Economist at the Centre for independent studies, welcome back to the program.

Peter Tulip  02:01

Good, Gene, how are you? 

Gene Tunny  02:03

Good. Thanks, Peter. It’s great to be chatting with you again. I’m keen to speak with you about the review of the Reserve Bank of Australia that was announced earlier this week by the treasurer, Jim Chalmers. One of our colleagues, Steven Kirschner; Stephen has been on the show before too. He wrote that the RBA review is; he wrote about it that everything is on the table, and that’s good. So, it is a very expansive review. The only thing it looks like they’ve left off the table to me, is that they’re not reconsidering the split in responsibilities between the Reserve Bank and the Australian Prudential Regulation Authority. They obviously still see a role for that as a separate entity, rather than rolling, prudential regulation back into the RBA. But other than that, it seems like a very broad ranging review. Are you generally happy with what’s been announced?

Peter Tulip  03:02

I’m delighted. Many of us have been calling for something like this for a long time. And the terms of reference are fairly deep and broad. The people running the review, first class, and there’s a good mix of people too. I mean, they’ve got a central banker, an academic and central bureaucrat. And any substantial reform, the RBA is going to require integrating those three perspectives. So, that’s useful also.

Gene Tunny  03:41

Right, okay. So, we’ve got an international expert, someone who’s been on the committee, the Monetary Policy Committee in the UK;

Peter Tulip  03:49

The Financial Policy Committee, slightly different. That’s financial stability rather than monetary policy.

Gene Tunny  03:55

All right. Okay. But she’s had a senior position in the Canadian Central bank, is that right? Caroline Wilkins? 

Peter Tulip  

Yeah, sure.

Gene Tunny  

And also, Renee A. Fry-McKibbin, who is an academic at the Australian National University, so highly regarded macro Economist, and also Gordon Brewer, who I worked with in the Treasury many years ago. And I mean, I think Gordon’s an excellent choice for that. So, yeah, it looks like;

Peter Tulip  04:24

And before that, Gordon worked at the RBA, so it’s good to have some internal experience.

Gene Tunny  04:31

Right, okay. But it wasn’t exactly what the RBA wanted, was it? Even though it looks like the RBA has had some role in shaping the terms of reference, I saw an interview with Jim Chalmers on, was either Coffee show or the Today show here in Australia. And he was saying that the RBA said some input in the terms of reference, but originally, they just wanted to review themselves, didn’t they? Which would have been a great idea if you think about it.

Peter Tulip  04:58

To be credible, it needs to be external and independent. They’ll have a secretariat, which will be largely staffed, I think, from Treasury and the RBA. So, they’ll be able to call on the resources of the bank, and it’ll be informed by the bank by insiders, but the ultimate judgments will be independent and external, which I think they need to be.

Gene Tunny  05:26

Well certainly will, particularly if they’ve got Rene on the review committee. So, Rene is the editor of the Economic Record here in Australia, which is the top Economics journal here, and she’s well known in the economics profession and her husband, Warwick McKibbin, is actually a former board member, isn’t he? I mean, she’s obviously a separate person to Warwick. But I mean, I’m wondering if this is a way that Warwick’s views are actually getting inputted into the review in some way, even though obviously, she’s her own individual.

Peter Tulip  06:03

Yeah. His views will clearly get a lot of weight. But Rene is an expert in her own right. Yes.

Gene Tunny  06:09

Yeah, along with other economics colleagues. So, it’s not going to be something that the Reserve bank is going to necessarily get its way on, which is good. There’s going to be input from a broad range of sources, including yourself, I mean, I’m guessing you’ll be making a submission to the review.

Peter Tulip  06:26

I’ve already written my submission. I mean, so I did a big paper calling for reform of the RBA, just a few months ago. In the context that this review has been called for. And I set forward my views on what I was hoping the review would look at and what it would conclude. So, I’ve done my bit, and now it’s up to them.

Gene Tunny  06:48

Great., I mean, you’ve certainly been one of the most influential people in in this discussion so far. And you wrote a fascinating AFR piece earlier this year, which was titled Reserve Bank must be made accountable for inflation mistakes. So, might chat about that in the moment. But to begin with Peter, could you tell us why do you think this review was necessary in the first place? Is it because of those inflation mistakes?

Peter Tulip  07:14

Can I give a long answer to that? So, there are three levels of an answer in increasing areas of being controversial. The first and simplest answer is that, it’s just good practice to regularly review your monetary framework every few years, in the light of new research and new experience. People are writing about these frameworks all the time, and you need to, every now and then have a stock take of that. And this is what all of our foreign, not all, most other Central banks do. It’s standard amongst foreign central banks to have regular reviews. And the format of those varies, and we’ll talk a bit about that. Some of them are external, some of them are internal. Some of them have a heavy academic focus. Some of them are on; the Bank of Canada does is on a regular five years schedule. Others are more ad hoc. So, that’s one thing. It’s just regular practice. 

The second bigger argument is that the Reserve Bank has been missing its targets that prior to the pandemic, the inflation rate was well below the target of 2 to 3%. And the unemployment rate for an even longer period was well above estimates of its sustainable or full employment level. And so, particularly with the inflation rate, which is the reserve bank itself describes as a key performance indicator, when you’re persistently failing to hit your targets, there is there has to be a presumption that a review is necessary that otherwise there’s just no accountability at all. 

And then the third layer of arguments I gave, which is more controversial, is that many of us, I mean, including me, think that the Reserve Bank has been making big mistakes, and is in need of structural reform. And it’s great to have a chance to hear those views. And these are arguments that part of them are related to the composition of the board that these are decisions for the government and parliament often, rather than for the bank itself. And so, you need some kind of external review to evaluate this widespread argument.

Gene Tunny  09:53

Yeah, I think they’re good points. Peter, can ask you about that inflation target of 2 to 3%. Now, there could be two possibilities couldn’t there? It could be that either the 2 to 3% target doesn’t make sense, or we should review that target; we should, maybe we could downgrade it or just set it at 2% or have it at 1 to 2%? Or another possibility is the Reserve Bank; I mean, it was derelicting its duty. So, is that right? There are two possibilities there, there could be; and this is why a review would be desirable because you’d either look at the appropriateness of the target, and also whether the Reserve Bank is actually doing what it would need to do to achieve that target.

Peter Tulip  10:36

Correct. So, the reviews that other Central banks have had, often have had a strong focus on the specification of the targets. And that should be part of this review. And there are many people that would prefer a different target to the 3%. There are some people who think the inflation target should be lower, there are some people who think it should be higher. There are respectable arguments for both that the review should be considering. And that should be an important part. In my view, those arguments are really secondary, oh sorry, I should also say, there are other people who want to target a different objective completely, such as nominal income. And we’ll talk about that later on. 

In my view, those arguments are really secondary. That for most of the past decade, the bank has not been hitting its targets, it hasn’t even been trying to hit them. So, it’s a bit pointless specifying worrying about how you exactly define the target. If the bank isn’t just going to ignore. The most important question is governance, and how can we change the incentives of the RBA so that it actually does hit the targets it’s given? And you need to get that right before you worry about what that target actually is.

Gene Tunny  12:04

Okay, a bit of follow up on that. Peter, you’re saying that it hasn’t even been trying to achieve those targets?

Peter Tulip  12:11

Sorry, I’m wording that too strongly. You’re right.

Gene Tunny  12:13

I think I understand the point you’re making. I want to just explore that a bit. 

Peter Tulip  12:18

Can I give you an example? 

Gene Tunny  

Yes, please.

Peter Tulip  

So, in November 2019, just before the pandemic came along, the Reserve Bank issued a set of forecasts, and it had underlying inflation staying outside the target range for the whole horizon. And it had unemployment exceeding the bank system, it’s a full employment for the whole horizon. 

Gene Tunny  

So, inflation was below 2%?

Peter Tulip  

Yeah. Unemployment was I think, being forecasted 5% or higher, varying depending on the horizon. And despite what you would think is an obviously unsatisfactory outlook. The Reserve Bank didn’t change interest rates, either at that November meeting or subsequent meetings until the pandemic came along. And it did so because it was worrying about other things, in particular, financial stability. So, there was a disregard, or at least down weighting the bank statutory responsibilities in the legislation that says, the objectives stability of the currency, which we interpret is 2 to 3% inflation, and full employment, which we would interpret now as the preferred terming, that other Central banks uses, maximum sustainable employment, which were estimated about four and a half percent. So, there was a down weighting of those objectives in favor of this new objective that the bank invented about indebtedness, and we’ll talk about that later on too.

Gene Tunny  14:01

Okay, so shouldn’t central bank be concerned about indebtedness and the related issue of financial stability? I mean, that’s ultimately what they’re concerned about, isn’t it that if they’re worried that monetary policy, if it’s too loose, if it’s too accommodative, then households could take on too much debt and then get into trouble at a later date and that could have adverse economic consequences.

Peter Tulip  14:28

Sure. So, we know from the global financial crisis, that if your banks start failing, then it’s catastrophic for the economy. Australia had a similar experience in; when was it? In the early 1990s. When several of our small banks failed and some of our big banks came close. And again, that that was one of the worst recessions Australia’s had in living memory. So, yes, financial stability matters a huge amount. The question is how you deal with that? And what’s the appropriate instrument for that? And there’s a very large volume of research saying that it’s not interest rates or monetary policy, it’s prudential policy. And they were in particular, about the capital requirements that banks are required to have. And the way to avoid a repetition of the GFC is not to put 270,000 people unemployed, is to raise your capital requirements. So that if in the event of losses, banks making losses on their loans, banks have sufficient equity to cover that. And so, the important objective is, yes, we do very much want to avoid a repetition of the GFC. The way to do that is with high capital requirements.

Gene Tunny  16:04

This 270,000 jobs number Peter, is this from an analysis by, is it Andrew Lee and?

Peter Tulip  16:15

And Isaac Gross. So, Andrew Lee is now an assistant Treasurer, he’s a government minister. And Isaac Gross is an academician at Monash University of Economists. And they, just recently, published a paper in the economic record, which you were referring to before. That’s the journal that Renee A. Fry-McKibben edits. Where they found that, yes, the reserve bank kept interest rates too high, between 2016 and 2019. And because of these worries about debt, and because of that, unemployment was 270,000, higher than it should have been.

Gene Tunny  17:08

Yeah, it’s interesting. I mean, I’ll take the point there about; if you do run that simulation, and I think they use the Reserve Bank’s own macro-economic model Martin, I think they’d call it. And so, look, yeah, good point. I mean, if I were on the board, I’m probably one of those who wouldn’t have minded them having kept the rates where they are. I probably wouldn’t have supported cutting them, as that model would suggest, given that I would have those concerns about financial stability. But I do recognize that there are a variety of views. And I’ve been interested to learn about that literature that you’ve written about, and also Steve Kirschner talked about when I spoke with him on nominal GDP targeting. And I want to have a closer look at that. 

Peter Tulip  18:00

I’m happy to argue the merits of that particular argument further if you want, but what’s maybe a more important point to make here is that the process was bad. Yes, the bank never really explained or defended its position in public, that there seems to have been a real lack of scrutiny of the decision. So, there are people such as yourself, who were sympathetic to what the bank did. But those arguments, I would say, the large majority of expert opinion is on the other side, which is that you should regulate these considerations with prudential policy, not with monetary policy, that the most direct instrument is almost always the most efficient, and involves the least collateral damage? Yeah. 

And even though, a majority of expert opinion in a majority of other central banks were explicitly opposed to the bank, there was no real defense of that position in the bank’s documentation. Beyond a few brief sentences. The bank never quantified its concerns, was never actually very precise, even about whether it was really worried about the level or the growth rate of indebtedness. It didn’t even say what; no discussion of what’s the best way to measure this, no real clear discussion of the consequences of this. But maybe even more important, even though most expert opinion was against the bank, there was no; counter arguments were never addressed. 

So, in the paper I wrote that earlier this year, I mentioned another half a dozen arguments against the bank’s focus on indebtedness, any one of which I think would be fatal. And none of these were publicly addressed. Just to give one, a lot of research studies find that low interest rates don’t actually have almost negligible effect on indebtedness, that the debt to GDP ratio has a numerator and a denominator. And low interest rates will encourage both. And a lot of research says that actually, you have a bigger effect on GDP than you do on the debt. So, low interest rates have a greater effect on the capacity to repay, or to bear a burden than on the actual burden itself. Insofar as what the bank was doing, it was counterproductive. And there are more arguments and people; rather than going through succession of arguments on it. Yeah, actually, this is the paper. It’s called structural reform of the Reserve Bank of Australia. I mentioned a lot of further reasons as to why the bank was wrong in targeting indebtedness at the expense of its core objectives.

Gene Tunny  21:35

Yeah. I’ll put a link in the show notes to that paper for sure. Peter, in fact, I’ve got it in front of me, it’s a Centre for Independent Studies analysis paper, 36, April 2022. And in that paper, I mean, you, I mean, it’s Frank and fearless for sure. You’re someone who used to work at the bank. And you’ve probably still got a lot of friends there at the bank. But you mentioned or you talked about their poor communication and poor process. Now, I mean, you’re talking about that before. What do they need to do better? How do we improve it? I’m guessing this would be one of your hopes for what the review recommends. But how do we improve the process in the communication?

Peter Tulip  22:27

So, let’s start with this particular issue, the bank needs to fully explain itself, that it needs to outline the pros and cons of its arguments and address obvious counter arguments. And preferably, if something is important, you need to say what’s the evidence, both consistent with the bank’s position and how do we address evidence that people think weakens the position? And some kind of quantification of these effects is, well, I mean, some of these things can be measured, and there is substantial research on aspects of this question. And that really needs to be discussed and its relevance to policy explained. 

So, that’s dealing with one specific error, and why that’s important, is, unless you do that, mistakes will happen. And so, regardless of your position, on this particular question of indebtedness, the process was clearly flawed. That if you keep making big decisions that slip hundreds of thousands of people out of work, without a full, open public discussion, sometimes you’re going to make mistakes. And when you make mistakes, they will persist. An open discussion is the best antidote to making serious mistakes. Because this was not just a one off, the bank has a record of very controversial decisions that run counter to mainstream economics. For example, Warwick McKibbin, we mentioned earlier, was pushed out of the bank when he objected to its policy. This is back in the late 80s, early 90s of targeting the current account deficit. The bank had interest rates far too high, because it was worried about the current account deficit. Warwick McKibbin said that that was wrong. And essentially, he was told he wasn’t welcome. So, he left.

So, this is a cultural problem within the bank, its resistance to criticism and to scrutiny, even internal scrutiny.

Gene Tunny  25:09

Peter, can I just ask what are they doing now? So, at the moment, they do publish; there’s a decision, there’s a monetary policy decision every month regarding what they do with the cash rate, there’s a page or so of, you know, discussion of where the economy’s at and some sort of; all they make clear what their decision is, you’d like to think there’s some logical connection with their analysis of the economy in that decision. The governor does make himself available to give speeches, he appears that I mean, parliamentary committees, from time to time. So, what more needs to be done? And are there any examples around the world of how it’s done better?

Peter Tulip  25:54

Yeah, I think most Central banks are clearer and more transparent than the RBA. Where it matters most is in reasons better decision. So, where transparency, I think is most necessary is for the banks to say why it made a decision, and why its choice was preferable to alternatives. So, for example, at the moment, the bank with the rising rates, the market expects to be going up about 50 basis points a month, the next few months. It would be very useful, in fact, I think it’s necessary for the bank to say, what would be the consequences of alternative choices? Suppose interest rates were to rise slower, and interest rates could rise higher, and what would be the unemployment and inflation consequences of those alternatives? My guess is that a faster path of increases would give us lower inflation and higher unemployment, in both cases, bringing those variables closer to the bank’s targets. 

So, why is that not the preferred choice? That strikes me as the central requirement for transparency, explaining why you’re not doing something different, and the bank doesn’t really do that. It certainly doesn’t quantify it. But other central banks do. The Federal Reserve, the Risk bank are prominent examples. I mean, all it takes is just a little four panel chart to show; again, this is the Goldilocks path in the middle, and this is too high and this is too low. And these are the consequences and we pick the path, the Goldilocks path with the best outcomes. Other central banks do that as a matter of routine, so should the RBA.

Gene Tunny  28:05

Right, so you’re talking about the Federal Reserve and the Bank of England? Okay. 

Peter Tulip  28:09

The Bank of England does it in a slightly different way with scenario analysis. That would not be my preferred model. Either the Riksbank or the Fed approaches, or just very clearly convey the central issues in the monetary policy position.

Gene Tunny  28:27

Yeah. In preparing for our chat, Peter, one thing I noticed was a review that was done of the Bank of England’s Monetary Policy Committee by Kevin Walsh, 2014. Actually, I may have learned about that from you. I’m trying to, I can’t remember exactly, but I thought that was very good. If I’m reading one of his tables correctly, it does suggest that we have very low transparency here in Australia relative to those other countries. I think that’s.

Peter Tulip  28:57

So, about Kevin Walsh, he used to be a governor of the Federal Reserve and went to the Bank of England. This is an example of the kind of external reviews we were talking about, specifically to review their processes for transparency and openness. And it ended and it’s a very good thoughtful report, and anyone interested in that issue, I strongly recommend it. As part of his review, he looked up the Central bank practices and then yeah, the RBA was terrible. And the RBA is partly rectified. It as been more opened since that report was done. And in particular one, one of his glaring findings was that Australia was the only country he looked at where the Central bank didn’t give regular press conferences and and other countries find that a very useful way of explaining that as decision, and in particular, having important decisions challenged and defended. But since then, Philip Lowe has started getting press conferences, so, that’s a great thing. I’d still like them to be more frequent. He only does them occasionally, I would think you should do them, at least quarterly.,

Gene Tunny  30:34

Yeah. They certainly need to improve their communication. I’ll have to think myself about what that would best look like. I quite like the idea of having scenarios or having different, you know, looking at what different policy parts could mean for inflation and unemployment, but also being honest about what’s the uncertainty around that. And I mean, one of the things that our Governor, Philip Lowe has got into trouble for in the last few months is just the fact that their forecasts appear to have been just so bad. Perhaps, if they’re more honest about just how unreliable economic forecasts can be, given that the economy is hit by shocks all the time, and I mean, we’re not even sure we’re properly modelling the underlying mechanisms. Perhaps that would have; he would be held in high regard now. But everyone’s mad at him because he was, people were taking his word for it, that interest rates would stay where they were until 2024. And so, he’s in a heap of trouble now.

Peter Tulip  31:37

If I can comment on that. So, I think people exaggerate how bad these forecast errors were, and in particular, their relevance to the review. You have to remember that Jim Chalmers came out in support of a review of the RBA, over a year ago. So, before inflation took off, in fact, back a year ago, inflation was below the target. So, what’s happened? There are these unusually large forecast errors, but they’re not the reason we’re having a review. And forecasting is difficult, and in particular, if you’re forecasting in the middle of a pandemic that you’ve never been through before, you’ve got no historical experience to go by. And as it turned out, vaccines came on stream very much quicker than expected. And they worked much better than they’re expected. And the RBA got that wrong. You know what, no one can forecast accurately. I’ll be impressed with criticisms about the bank’s forecast record from people who actually do forecasts better than the bank. Hearing a lot of criticisms that we’re forecasting for people that don’t actually present forecasts themselves makes me roll my eyes a bit. Yeah, fair point. And the bank will always make forecast errors. And it has processes to improve its forecast performance and it does reviews of its models and this and the databases and things like that. The review will probably look at that. I’ve actually been involved in that process. I don’t see great scope for change or even questioning what the bank is doing there.

Gene Tunny  33:48

Okay, we’ll take a short break here for a word from our sponsor.

Female speaker  33:53

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Gene Tunny  34:22

Now back to the show. 

Okay, can I ask you about this transparency, like how we improve that? One of the suggestions that came from a panel member at the conference of economists last week when we’re in Hobart, you were there? I can’t remember. Sorry, Peter, were you in that session? You were in that session, weren’t you? There was that recommendation that I forgot who made it. But that part of members of the board of the Reserve Bank that their deliberations or their decisions are published or someone’s got a dissenting opinion that’s published. So, we get more communication from the board members. And so, we understand that there is a difference of views and that could help the public understand the deliberations and realise that the Reserve Bank isn’t this all-seeing, all-knowing entity that’s fully in command, or maybe that’s the wrong way of putting it. But maybe that would make people realise that they’re human, and mistakes can be made. And so, when we have a governor who says, oh, interest rates will remain this, at this level until 2024, we should realise, well, he’s talking about based on these assumptions. I mean, you can never guarantee anything. But what do you think about that idea of having more information about what different board members are thinking?

Peter Tulip  35:51

I think that’s a great idea, partly to improve the incentives have individual board members, that individual board members should be accountable for their decisions. And at the moment, there isn’t any individual accountability, these decisions are presented as decisions of the board. And so, I think there’s no incentive for a board member to say, I think this decision is wrong. The research says opposite. We need to pursue an alternative course of action. So, partly, there’s inadequate challenge within the board process, as and as a result, less need for the bank to defend itself. But also, it means the public is not brought into these highly consequential debates and decisions. And that would improve things. And where a board is divided on a particular course of action or a particular piece of analysis, this is where external research and external opinions are most valuable. But no one knows that. So, people talk about monetary policy, including you and me, but we’ve got no idea whether we’re talking about something that the board regards has completely settled, or as a 50-50 decision. And so, a lot of what we say is not relevant. And there are big questions on which further evidence would be useful. That we don’t know about.

Gene Tunny  37:30

Right. On the members of the board, you’ve been quite prominent in the media recently, and in the commentary on this RBA review, you’ve made the point that the level of expertise of board members is not really where it should be. I mean, obviously, there are some that have the expertise. But are you arguing for more economists on the board rather than business people? Is that correct?

Peter Tulip  38:01

Yes. And to be precise, more monetary policy experts. And this would be my number one recommendation for reform of the RBA. We talked earlier about the bank making mistakes, the first place that they should be caught and challenged is at the board level. But at the moment, the board seems to be operating as a rubber stamp for the governor, and that’s not good. I mean, so Phil Lowe is a very talented economist who gets lots of things right. But he is human and he’s just one person and he makes mistakes. You’ll have you will have fewer mistakes, if the decisions were instead, made by a committee of experts.

Gene Tunny  39:04

And is that what they’ve got in the States or in England or in or in the UK?

Peter Tulip  39:09

Yeah. So, I mean, that’s an interesting comparison. So, in 1959, when the RBA board was being set up, it was actually common to have non economists making monetary policy decisions. But since then, other Central banks have decided these are technical questions on which research is relevant and needs to be apply. So, they’ve moved to monetary policy committees, overwhelming, really comprised with monetary policy experts. Actually, it’s not just experts, but they have some of the leading economists in the world on monetary policy, sitting on their monetary policy committee. These the people that wrote the textbooks I learned my monetary policy from are often on the FOMC, or the Monetary Policy Committee of the Bank of England. So, whereas other countries have stars making their monetary policy decisions, we have part-time amateurs.

Gene Tunny  40:19

Yeah. Well look at who’s been the Federal Reserve Bank Governor in the US. You’ve had Ben Bernanke. You’ve had, I mean, he’s made huge contributions to macroeconomics. Janet Yellen.

Peter Tulip  40:33

The deputy of Stanley Fischer.

Gene Tunny  40:35

Right. And he’s the person who wrote the textbook;

Peter Tulip  40:39

And Bernanke and Frederick Michigan. Yeah, they’ve written textbooks on how to do monetary policy.

Gene Tunny  40:48

Okay. Yeah, good point. That’s a very good point,

Peter Tulip  40:52

Let’s say a bit more about the composition of the board. So, there are two parts of it, you would get better decisions with more experts on the board. And it’s just like, any other technical decision being made by a government bodies on immunisation or building a bridge or whatever you want. You don’t want business leaders making these decisions, you want experts in the field. Within that, you want a diversity of views. So, you want a mix of hawks and doves, for example, some empirical people, some theoretical people. Instead of that diversity of expertise, sorry, that diversity of views, we have a diversity of expertise, that there are some members of the board that are capable of challenging the governor, but most are not. And that results in groupthink and status quo bias and other flaws in decision making that we see in our monetary policy decision.

Gene Tunny  41:59

Yeah. So, look, I agree with you on that, Peter. And I think the government will find it, I mean, I don’t think that I’ll accept a recommendation along those lines, unfortunately. They’ll probably want to have a trade union member on the board. I think there’s going to be a push for that. Some people pushing for, let’s have a regional representative on the board. I mean, I don’t necessarily think we should be selecting people for the board for that reason. But what you’re going to have is, you’re going to have; there are people who are sceptical of experts, because there’s this general view out there now in western economies, that look, experts have led us down. And you know, people are upset about things that happened during the pandemic, and even before then. So, there’s a larger scepticism about experts. And there’s this issue of democracy, isn’t there? I mean, so, there could be an objection. Well, we don’t want all these technocrats running things. We think there should be some democratic element there. But then I think the issue there is that if you don’t have an independent Central bank, then you get worse inflation outcomes.

Peter Tulip  43:15

See, you’re raising several issues there, Gene. So, think about the other big important decisions that have been made in the news lately. I’m going to say public health. Do you want doctors and Epidemiologists making decisions on whether vaccines are approved? Or do you want business leaders?

Gene Tunny  43:36

I want the doctors and the Epidemiologists for sure. 

Peter Tulip  43:41

If a bridge is being built, you want that decision to be made by engineers or by business people? I mean, so in other areas, government policy, we rely exclusively on people that prompt eminent experts with technical expertise, and monetary policy is the same. It used to be that the values of monetary policy and even the objectives were vague and not clearly decided. And so, the board had a lot of discretion as to why monetary policy should be set but that’s no longer the case. Central bank has moved to a world of clearly defined objectives, essentially set by the government by the elected representatives. So, they decide that the objectives of the RBA are full employment and inflation of 2% to 3%. And it then becomes a technical question as to how to best achieve that, and that’s the decision that should be made in the national interest. It should not be made by representatives of sectional interests. Excellent point. And this interacts with the other recommendation we’re talking before about public votes. 

So, if you have a representative of say, the mining industry or the agricultural industry; industries that are heavily exposed to the exchange rate, do you want them making decisions that affect the exchange rate for the national interest or that will affect their sectional interests? I mean, if it’s the sectional interest one, they’ll always be voting for lower interest rates, and a depreciation of the exchange rate, and their constituencies will be expecting and demanding that. So, if you do have so called sectional interests, but you want the vote to be a national interest, you would need to keep the votes private. And this is an unusual way of dealing with a conflict of interest. Normally, we think conflicts of interest are best dealt with by transparency, not by secrecy.

Gene Tunny  45:58

Okay, what about the banks themselves, the staff on the banks themselves? Do you have views on how our reserve bank, how it compares with its peers with the Federal Reserve or Bank of England in terms of its ability to analyse the economy and to provide the advice to the board?

Peter Tulip  46:20

Yes. So, as background to that, before I worked at the Reserve Bank, I worked with the Federal Reserve Board of Governors, I was on the staff there for 11 years. I also worked at the OECD, on monetary policy, going on around the world talking to Central bankers about how they were sitting, making their decisions. And so it’s interesting, I mean, that background shows real differences in character and culture between different Central banks. I mean, have you noticed that just in government departments, different cultures, but even with Central banks, where they’re technically doing the same decision from different countries, they vary enormously. The RBA tends to be much less interested in research, and much less interested in technical modelling than other Central banks. And most clearly, with the Fed where the Fed has 400 PhDs on his staff, essentially putting together its forecast. The RBA has a very different human capital model, where academic qualifications and less important promotion and research is not ending, external research is not expected of most staff. And again, that is something that the review could look at a lot of people. I mean, there are differences on views as to whether that’s appropriate, and reflects lots of reasons that I mean, culture and history is a lot of it.

Gene Tunny  48:08

Yeah. So, your big recommendations for this review, or what you hope to get out of this review, improvements in transparency and communication.

Peter Tulip  48:18

Can I list them in order? Yes, please. 

Number one, we want more monetary policy experts on the board. 

Number two, we want those members to be individually accountable. That means public votes and public explanations of decisions. 

And third, the bank needs to be more open and transparent. And in particular, needs to do clear reasons for its decisions, and why alternatives are not taken. They would be my three main recommendations.

Gene Tunny  48:53

Okay. So, no changes to the inflation targeting regime, this flexible inflation targeting regime they talk about?

Peter Tulip  49:00

That’s why I have views on that. But as I said before, I think they’re secondary. So, the main changes I would make is, first of all, every time there’s a change in government or change in governor, there’s a new agreement between the bank and the government called the agreement on the statement of conduct of monetary policy. And that is where the target is specified in detail, which I think is appropriate. Currently, that says the main objective of the bank is inflation 2 to 3%. In my view, it should also specify full employment, or to be precise, maximum sustainable employment as an objective of equal status to the inflation rate. So, in legislation, the bank has a dual mandate that’s not reflected in the agreement on the statement of conduct and I think that causes a lot of confusion. People think that when people read the bank’s explanations of what it does, they often think that the bank is an inflation nutter. Which it’s not, it takes its unemployment objective very seriously. And it does it in this vague way, because flexible, inflation targeting, which should be specific about what flexibility is required and what isn’t. There would be other changes, but that would be the main one I would make.

Gene Tunny  50:31

Do you think there’ll be any changes to that framework? There seems to be a view from the RBA, and I guess from others that the inflation targeting approach seems to have worked pretty well in keeping inflation low over the last few decades, I mean, you mentioned, there is that issue of the times it might have meant we had higher unemployment than otherwise.

Peter Tulip  50:56

No, that was because they abandoned their inflation target. They had inflation too low, accompanied by excess unemployment, you would have sold both of those problems with lower interest rates. It didn’t do that, because it did invent this other objective of indebtedness that it should not have done. And it certainly shouldn’t have done it without a more open, transparent and accountable process. So, I think the main proposal for a change in the framework is for nominal income targeting, which Warwick McKibbin and Steve Kirschner and numerous other monetary policy experts think would be preferable. I think that’s a minority position. And I think you’re right, that the consensus of informed opinion doesn’t think that the framework needs to change much. I mean, I think there are some minor tweaks that shouldn’t be implemented. 

Nominal income targeting is not popular, partly because no other Central bank does it. So, there’s no example to show that it works. And the RBA is not a pace setter in these things. It’s a follower, not a leader, which is useful in a lot of ways. But also, the American literature on nominal GDP targeting some phrases in terms of nominal GDP targeting, which would just be inappropriate for Australia, because we have such volatile terms of trade. And we don’t want monetary policy being jerked around to target the coal price. Which just would mean big dislocations for most households. Not much apparent benefit.

Gene Tunny  53:02

Yeah. There seem to be some recognition of that in that panel discussion in;

Peter Tulip  53:08

So, Warwick McKibbin has said, you would target a slightly different variable, maybe some measure of nominal income. And that makes more sense. Warwick keeps contrasting his arguments for nominal income targeting with inflation targeting, which is what the bank says it is that it’s not what the bank is, in practice. In practice, the bank has a dual mandate. And we’re its main argument, as I take it is that inflation targeting is wrong, because activity is an appropriate objective of the Central bank and being explicit about the dual mandate would avoid that confusion.

Gene Tunny  53:50

Yeah. Okay. I’m just thinking about the tweaks; one tweak that seems clear to me that needs to be made is clarification on this point about what do you do about indebtedness? So, one way or the other, make that clear. Is the bank targeting financial stability or not?

Peter Tulip  54:09

And in my view, I mean, it’s the bank as an institution needs to worry about financial stability, but primarily, it should be dealt with, with prudential policy, not monetary policy.

Gene Tunny  54:23

And by that, you mean the Prudential Regulation Authority, which is looking at the banks and, you know, in looking at their balance sheets and making sure that they don’t make a bunch of risky loans.

Peter Tulip  54:34

Well, the nature of banking is you make risky loans. The big question is whether you’ve got an equity buffer to deal with those risky loans in the event that they all go sour at once. I mean, there are arguments about lending controls. That’s another controversial argument. But for this review, what’s going to be relevant is the status of financial stability within monetary policy. And in my view, I liked the wording. I think it was the 2009 agreement that the government had with the RBA, which said financial stability is an objective of the RBA, but it’s secondary, it’s subordinate to the core objectives. Or it should be said to be subordinate to the core objectives of full employment and stable inflation.

Gene Tunny  55:39

Okay. I’ll look that up and put in the show notes. Right, Peter, that’s been great. I mean, there are so many other aspects of this, I guess we could explore but we’ll probably have to wrap up because you’ve been generous with your time so far. Any final thoughts before we go? Anything we missed that you think is important to convey?

Peter Tulip  55:58

Oh no. I think it’s been good discussion of the key points. People who do want more, again, a lot of it is in my earlier paper.

Gene Tunny  56:11

Yes. You’ve been incredibly influential on this, Peter. So, well done. I saw you on ABC the other day, and it’s terrific that you’ve had this impact. And let’s say we get a really high-quality review with some recommendations that improve monetary policy in the future. 

Peter Tulip  56:34

Thanks for that, Gene. That’s great.

Gene Tunny  56:35

Pleasure. Thanks, Peter.

Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com and we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Thanks to the show’s audio engineer Josh Crotts for his assistance in producing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au

Please consider signing up to receive our email updates and to access our e-book Top Ten Insights from Economics at www.economicsexplored.com. Also, please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

Categories
Podcast episode

Stagflation: be alert, not alarmed – EP143 + transcript

In early June 2022, the World Bank downgraded its global economic growth forecast and warned of the rising risk of stagflation, the uncommon combination of high inflation and high unemployment, or falling GDP growth. Stagflation is a portmanteau word, combining stagnation with inflation. Economists first noticed stagflation in 1970s USA (see the chart below) and other advanced economies, when it was triggered by the 1973 oil price shock, which pushed up prices and reduced industrial output as input costs soared.

A simultaneous acceleration of inflation and an increasing unemployment rate in the mid-1970s surprised many people at the time, because it was contrary to the Phillips curve trade-off between unemployment and inflation.

In Episode 143 of Economics Explored, show host Gene Tunny and his colleague Arturo Espinoza discuss how the current global situation is similar and dissimilar to the 1970s, including consideration of recent perspectives from the World Bank and BIS.  While we also have a commodity price shock, associated partly with the war in Ukraine, it is less in proportionate terms than in the 1970s, and we also have better macroeconomic policy frameworks (i.e. explicit inflation targets) than in the 1970s. So the takeaway of the episode is that, while we should be alert to the possibility of stagflation, at this stage we shouldn’t be alarmed.

You can listen to episode 143 using the embedded player below or via Google PodcastsApple PodcastsSpotify, and Stitcher, among other podcast apps. A transcript and relevant links are also available below.

Links relevant to the conversation

Is a US recession imminent? w/ Michael Knox, Chief Economist, Morgans Financial – EP142 – Economics Explored (Previous episode with Michael Knox)

Jobs report May 2022: Payrolls rose 390,000 in May, better than expected as companies keep hiring 

https://trends.google.com/trends/explore?q=stagflation&geo=US (Google Trends for stagflation)

The Fed must act now to ward off the threat of stagflation | Financial Times

Are major advanced economies on the verge of a wage-price spiral? (BIS Bulletin 53)

Commodity market disruptions, growth and inflation (BIS Bulletin 54)

Robert Heller’s paper on International Reserves and Global Inflation (from p. 28)

Stagflation Risk Rises Amid Sharp Slowdown in Growth (World Bank report) 

Stagflation danger prompts  World Bank to cut growth outlook (Washington Post article)

EP59 on the Natural Rate of Unemployment (re. Milton Friedman’s AEA presidential address)

Friedman’s presidential address

Chart of the Week – The real price of crude oil – Callum Thomas

Clarification

Australia’s wage price index increased 2.4% through the year to March 2022 (see Wage Price Index, Australia, March 2022 | Australian Bureau of Statistics

Transcript of EP143 – Stagflation: be alert, not alarmed

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:01

Coming up on Economics Explored. My personal feeling is that; and this is informed by my conversation with Michael Knox last week. I don’t think we’ll end up with stagflation similar to the 70s or rather, I hope not. I don’t see at the moment.

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host, Gene Tunny. I’m a professional economist based in Brisbane, Australia, and I’m a former Australian Treasury official. This is episode 143 on Stagflation.

Joining me this episode is my colleague at Adept Economics, Arturo Espinosa. Arturo, good to have you on the show again.

Arturo Espinoza Bocangel  00:44

Thank you, Gene. I am glad to be here.

Gene Tunny  00:48

Excellent, yes. It should be a good conversation because we know that this issue of Stagflation is topical with the recent World Bank report that we’ll get into in this episode. But before we do that, I just thought I’d provide an update on last week’s episode.

So, in Episode 142, I spoke with Michael Knox, who is the Chief Economist at Morgan’s, which is a major Australian wealth management and stock broking firm. And Michael and I chatted about the prospects for the US and Australian economies and what’s been happening with monetary policy. And Michael made a bold prediction in that episode, on where the Australian cash rates, so the policy rate that’s controlled by the Reserve Bank of Australia, so that’s the equivalent of the Federal Reserve in the US or the Bank of England. And he forecast that they would lift it by 50 basis points. So, half a percentage point from 0.35%, he forecast that they would increase it to 0.85%. He was the only economist in Australia who was forecasting there, and he explained why he thought that was the case in the episode.

So, if you’re in the audience, you haven’t listened to that episode yet, please, think about having to listen to it because Michael, I think is one of the best economic forecasters out there. He looks at the global economy, he looks at the Australian economy. And it turned out that the Reserve Bank did increase the cash rate by 0.85%. And it surprised all of the other market economists, all the commentators, and now there’s all this talk about what does this mean for the economy?

Will people now have trouble paying their home loans? Will they get into financial trouble? And there’s a huge conversation about that now in Australia; well done to Michael Knox for forecasting that correctly.

And we were also chatting about this idea or this concern that there could be a recession coming up in the US. So, there’s been a lot of commentary about that. It’s associated with all of this commentary, all this discussion at the moment about stagflation, which we’re going to get into. But Michael is very optimistic about the US economy as we talked about, and just after that episode was published, there was some new data that came out from the Bureau of Labor Statistics; at the BLS. And they reported better than expected, employment numbers in the US for May, CNBC reported that the US economy added 390,000 jobs in May, better than expected despite fears of an economic slowdown and with a roaring pace of inflation. The Bureau of Labor Statistics reported Friday, at the same time, the unemployment rate held at 3.6% just above the lowest level since December 1969.

Okay, so that’s an update on last week’s episode. Okay. Any questions or thoughts on that, Arturo?

Arturo Espinoza Bocangel  04:04

No, let’s start discussing about the topic.

Gene Tunny  04:09

Yep, about stagflation, absolutely. So, I want to devote the bulk of this episode, or the rest of this episode to talking about stagflation. This is something that I asked Michael about last week in our conversation. And I mean, this is something we haven’t; it’s a term that, that I remember, you know, I learned in when I studied Economics, and as you did, we would have learned this term stagflation about what happened in the 1970s. But we haven’t really heard it in the economic commentary for a while. So, there were decades when no one was really talking about it. And then there was this revival of interest in it, I think, from around late last year.

And if you look at the Google Trends Data, and I’ll put this chart on the show notes, so you can see, when interest in the concept of stagflation has picked up again. And that was from around, I think it was around September, 2021. And we’ve had various commentators talking about the risks of stagflation. So, on 25th of May this year, Martin Wolf; so Martin Wolf is one of the leading financial economic commentators in the world. He writes for The Financial Times. He wrote a column; “The Fed must act now to ward off the threat of stagflation.” And we know from the 1970s, the time to throttle an inflationary upsurge is at the beginning. And is there going to be a recession in the US and other leading economies? This question has naturally arisen among participants at this year’s meeting of the World Economic Forum in Davos. So, you probably saw, I think that meeting, they had their World Economic Forum meeting in Davos, Switzerland last week.

Martin Wolf wrote that this is however, the wrong question, at least for the US. The right one is whether we are moving into a new era of higher inflation and wage growth, similar to the stagflation of the 1970s. If so, what might this mean? That was one of the motivations for having this conversation today.

And almost as if I forecast that the World Bank would produce this study on stagflation, they released it overnight, or it came overnight our time. And so, we’ve just been looking at this morning, this new report, from the reserve; sorry, not the Reserve Bank, that’s our bank here in Australia, the World Bank. And the press release; June 7, press release, I’ll put this in the show notes. So, if you listen, and you’re interested, you can find that; stagflation risk rises amid sharp slowdown in growth.

So, you had a look at this earlier, Arturo, didn’t you? What were your main takeaways from this report from the World Bank?

Arturo Espinoza Bocangel  06:59

Well, I think these are very good reports, where they dedicate special focus on globalist inflation. And there is a section which they talk about similarities to the 1970s. They mentioned that they are three of them. The first is that supply shocks after a prolonged monetary policy accommodation, the existence of weaker growth. Also, there are some significant problems or inabilities in emerging economies. Those three things can be similar from 1970s to the current period.

Gene Tunny  07:51

This is because these supply side shocks really hurt those emerging economies more than the richer economies; is that the idea? Because they generally have lower incomes in those countries. And so, they’re going to be very badly affected by increases in oil prices, increases in food prices, and that can bring not only economic turmoil, but political turmoil as well.

So, what we might do is; we might revisit those, those similarities. Again, in the podcast first, it just occurred to me that we probably should, or I probably should just talk about what Stagflation is, what does it mean? And I couldn’t find any or there’s no strict definition of what it is. It’s a combination of unemployment and inflation or low GDP growth and high inflation. But there’s no agreed definition of it’s stagflation, if unemployment and GDP growth are x and y and inflation is there; there’s no quantitative definition as far as I can tell.

So, stagflation; it’s a pretty horrible word, if you think about it. I mean, it’s one of these, what do you call it? A portmanteau word. So, it’s a word that is a combination of other words, to try and convey a particular meaning, the combination of themselves. So, it’s a combination of stagnation, plus inflation. Glenn Hubbard’s introductory Economics textbook. So, Glenn Hubbard was the chair of the Council of Economic Advisers for President George W. Bush, in the early 2000s. In his textbook, they define it as a combination of inflation and recession, usually resulting from a supply shock. Okay, and like with everything in Economics, we’ve defined a concept by referring to another concept, we have to define a lot of times. So, supply shock. What do we mean by that? We mean, something that increases the cost of inputs; it’s a shock on the supply side of the economy, our ability to produce.

It’s not like a demand shock, where there’s an increase in spending or an increase in the amount of money. It’s a shock to our productive capacity. So, this concept, I think, originally came into Economics, or it became prominent in the 1970s, when there was the huge spike in oil prices in 1973, when OPEC, because of the Arab countries are upset with the West because they were backing the Israelis in the war, I think it was the young people war. That meant that the cost of inputs increased. And when those inputs increase, we use oil, well for petrol and, you know, across the economy. And so, it’s pushing up costs of production and produces; firms will try and pass that on to customers. That can be inflationary. Okay.

And you mentioned supply shocks before, didn’t you? In terms of the similarities with the 70s? So, we’ve had that,

Arturo Espinoza Bocangel  11:10

Yeah, we have the impact. However, there is a difference there in the case of the World Bank report, they say that the current shocks or current supply shocks are smaller, compared to those shocks in 1970s.

Gene Tunny  11:33

That’s right. I should have checked the numbers before I came on to record. But if you look at the real oil price back in the 70s, that was in proportionate terms, that was a huge increase, wasn’t it? I mean, it was multiples of the then current price, and it really shocked people. It was a huge shock to face those price rises.

So, I’ll have to dig out what that stat was and put it in the show notes. But that’s what they’re driving out there, aren’t they? They’re saying, well, okay, we’ve seen some big increases in commodities prices, but they’re, they’re smaller still than what we saw in the 1970s. So, they may have a chart and that report that we can refer people to in the show notes. Okay.

So, just on this definition of stagflation again, that was one definition. Now, note, there’s no quantitative; there aren’t any numbers in that definition. Dornbusch and Fisher; so, that was the textbook I use when I studied macro Economics back in the 90s. Rudy Dorn, Bush and Stan Fisher, so very prominent, US macro economists, I think are at MIT. They wrote that stagflation occurs when inflation rises, while output is either falling or at least not rising. And on well, actually, there’s probably no point me giving textbook page references, because this is sort of the 1994 edition. But in that edition, they wrote that during periods of stagflation, such as 1973, 74, 1980, and 1991. There are articles in the newspapers that the laws of Economics are not working as they should, because inflation is high or rising, even though output is falling.

So if we go to the, the data for the US, so I’ll put this chart in the show notes as well. We look at what happened in 1973 – 74. And this was a huge shock, I think at the time. We see that inflation went from a rate of 2 to 3%. And it ended up at a rate of over 10%. I think it looks like nearly 12½ % on this chart, I’ve pulled up. And so, we had those two years; well, after the ‘73 oil shock, so 74, 75 inflation is accelerating. And unemployment is also increasing, and it’s increasing from about 5% to nearly 8 to 9% or so. I’ll put this chart in, and I’ll just check those numbers. And this came as a big shock, because there was this concept of the Phillips Curve wasn’t there? There was this idea that there was this tradeoff between unemployment and an inflation, that if you had high unemployment, then at the same time, you should have low inflation. Or if you had high inflation, you’d have low unemployment. There was this idea that there was this trade off; because empirically, if you looked at the data for the 50s and 60s in the States, or for the UK or other advanced economies, it looked like there was this trade off. It looked like there was a menu from which economic policymakers could choose.

The typical story about the Phillips Curve was that, you could get unemployment down by stimulating your economy, a bit of Keynesian fine tuning, a bit of pump priming. You could reduce unemployment, but if you get unemployment; if you if you do reduce that, that puts more power in the hands of Labor relative to capital, you can tell stories about unions, you can tell stories about people being more aggressive in their wage negotiations, because Labor is scarcer, and that leads to higher inflation.

So, there’s this idea of a tradeoff. And this Phillips Curve was something that was found by Bill Phillips, who was a professor, Bill is from New Zealand originally. And he ended up being a professor at the London School of Economics. Have you heard about that? This is a bit of a tangent, but he built that hydraulic, economic model. Have you ever heard of that, ever heard of LSE?

Arturo Espinoza Bocangel  16:08

No, I haven’t heard about it.

Gene Tunny  16:11

And he developed this hydraulic, economic model in the 50s and 60s. They built a representation of the economy; they’re essentially modelling the circular flow of income with using water and mechanical parts. And this was a model that London School of Economics; I just remember that because she gave a lecture at the University of Queensland in 2016, Mary Morgan, she’s a professor at LSE, London School of Economics. She wrote a great book on the World in a Model. So, she’s done some great work on the history of economic modelling. Her first job, she said, was looking after that hydraulic computer.

So, Bill Phillips, one of the great economists, he discovered this correlation between all this trade off; the Phillips Curve, the relationship that ended up being influential in economic policy in the 60s until it broke down in the 70s. As we are talking about, he looked at UK wages growth, so wages, inflation and unemployment data. Even though what he did was look at wages data, well, it soon transferred as a concept to a tradeoff between price inflation and unemployment, because well, there is obviously a link between wages and prices, because employers will try and pass on those increases.

Does that all make sense? I was just trying to explain why this idea of this stagflation came as such a shock in the 1970s.

So, what was wrong with that Phillips Curve concept? Why didn’t it work out? Well, it was because of this supply side shock, wasn’t it? This was something that wasn’t really anticipated in that Phillips Curve story. And the other problem was that when you have high inflation, the expectations of people in the economy of workers and businesses, your expectations of inflation increase. You essentially, come to expect inflation and inflation becomes a self-fulfilling prophecy, because every time there’s a wage negotiation, or a contract negotiation, you essentially allow for the future inflation, you expect it. And you have things like cost-of-living adjustments, you essentially build it into contracts and under wage bargaining. So that’s one of the reasons why the traditional Phillips Curve breaks down. And there was a very famous speech by Milton Friedman; the presidential address to the American Economic Association in 1968. And I’ve talked about this in a previous episode – Episode 59, on the Natural Rate of Unemployment. And Friedman argued, well, in the long run, there’s really no Phillips Curve, you might think that there’s some sort of tradeoff in the short run, that you can get unemployment down if you pump-prime; if you stimulate your economy, and you’ll get some inflation as a result of that or you could go the other way and try and contract the economy to reduce inflation.

But in the long run, there is no trade off; there’s no Phillips Curve to speak of this. The economy should gravitate towards a natural rate of unemployment. And inflation can be whatever is consistent with people’s expectations.

There’s a big problem if you don’t get inflation under control, and people come to expect inflation, and then you can just have persistently high inflation, and you can have that with high unemployment as well.

Have you seen those diagrams of the Phillips Curve, with the vertical long run Phillips Curve? And then if you start off at a point on that Phillips Curve, so say you’re at your natural rate of unemployment, and you’ve got high inflation expected, then what can happen is, there some sort of shock that increases unemployment. And so, you start off at that high point with high inflation already. Maybe, it eventually has some sort of; it does contribute to a reduction in inflation somewhat, but you still at that higher level of inflation. And so, you can have higher unemployment or high unemployment and high inflation still.

So, that was probably a bit more technical information than we needed. If you have a look at an intermediate or advanced macroeconomics textbook, they’ll have some diagrams; I have some models that go over, that we probably don’t need to look into that. But the main point is that this Phillips Curve, discovered by Bill Phillips; people thought it was this stable tradeoff between unemployment and inflation, didn’t hold in the long run. And if your economy is subject to the supply side shocks, so increase in the price of oil, for example. And then if people come to expect inflation, then you can get high levels of inflation. And they can be very persistent, and you can have the economy slow down, you’re going to have high unemployment, and inflation can still persist for a long time.

And if you did want to get that inflation down, you really need a change in monetary policy, you need a much more aggressive monetary policy, and you need a credible Central bank that can deliver it. And I think this is what Paul Volcker in the US did in the early 80s. And this is what when they massively tighten monetary policy, high interest rates, crunch the economy, but they did get inflation under control. And I think this is related to this point that the World Bank made. There was a point about better monetary policy frameworks. Is that right?

Arturo Espinoza Bocangel  22:37

Yes, that’s right. After that economic event occurring 1970s, most of Central banks started to control prices, try to target inflation. Also, they incorporated the old thing related to these rational speculative in order to take into account potentials proven that pulling golden, been analyzed before 1970s since the Phillips Curve wasn’t explained correctly, the prequel evidence, as you mentioned. In the short run, that Phillips Curve is playing well, but in the long run, they didn’t account other factors, and relationships was different. So, I think most of the Central bank started to work better in terms of expectations.

Gene Tunny  23:45

Yeah. And so, this is this point, that Central banks, they need to have a credible monetary policy. And one way of having a credible monetary policy is to have an explicit inflation target that you’re judged on. And that’s why our Reserve Bank of Australia has a 2 to 3% inflation target, and the Bank of England and the Federal Reserve, they’re aiming for, I think it’s 2%. I’ll put that in the show notes. But they sort of; all of these Central banks tend to have inflation targets in 2 to 3%, which is a recognition that you’re going to have some inflation, but what you want to avoid is higher rates of inflation or double-digit inflation, or even worse, that’s what you really want to avoid, because that really causes a lot of misery. People can sort of, live with inflation of 2 to 3%.

So, that was this point about monetary policy; another thing that helps signal a credible monetary policy. So, by credible, we mean that people in the economy, businesses and workers know that if inflation starts to accelerate, the Central bank is going to squash that inflation as soon as it can. And that helps keep inflationary expectations down so people don’t come to expect higher inflation.

Okay, and one other thing that does help with the credibility of a Central bank is having an independent Central bank, who the worst thing you can have is if your Central bank is influenced by politicians; if it’s controlled by politicians, because, say they’re coming up to an election, there might be inflation increasing, but the politicians don’t want the Central bank putting up interest rates just before an election.

Arturo Espinoza Bocangel  25:43

That’s right. In the world, we have seen many examples. For example, Peru is a good example of a thing that would the government shouldn’t do. For example, in the middle of 80s, Peruvian government, had a high level of debt. That moment, government Allan Garcia took place, and he didn’t recognize the debth. So, they didn’t want to pay. And also, in the government, they started to print money because the other Central bank, was subordinated to the current government. And that was the world’s respond for [unclear] because Peru initiated a stage of hyperinflation. And also, Peru faced a recession period.

Gene Tunny  26:52

So, hyperinflation; there is a quantitative definition of hyperinflation. It’s when you have inflation running at about 50% a month or something. It’s a very high rate, and you can end up with annual inflation rates of over 1,000% or something, which is just mad. What they had in Germany in the 1920s. But also, we’ve seen it in South American countries in the;

Arturo Espinoza Bocangel  27:18

Most South American countries, experience periods of hyperinflation.

Gene Tunny  27:23

So, you are highlighting one of the; when it gets really bad when you don’t have that independence. And because the Central bank is the bank for the government as the government just commits to making all of these payments, and it might not actually have the money, but the Central bank just prints the money. It just pays the bills for the government; the money is just created. So yeah, what they call modern monetary theory nowadays; bad results.

We’ve chatted about the Phillips Curve, why it’s not reliable. I’ll put links to all of these things I’ve mentioned particularly to Milton Friedman’s presidential address, which is just brilliant.

Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny  28:47

Now back to the show.

Okay, now, one of the things Central banks are essentially wanting to avoid is this idea of a wage price spiral. So, we’ve talked about inflationary expectations, you want to avoid inflation becoming expected, and then it becoming a self-fulfilling prophecy. So, one of the concepts that disgusts is a wage-price spiral.

Okay, so in early May 2022, the Reserve Bank of Australia; this was a report in the Australian Financial Review. The Reserve Bank of Australia has warned of a wage price spiral if unions exploit the low jobless rate to push for higher pay rises to compensate for an inflation rate to peak at a higher than expected 6%.

So, what is a wage-price spiral? The Bank of International Settlements in Basel in Switzerland; it’s defined a wage price spiral in the following way, and this is in a bulletin that they produced, BIS bulletin number 53 on Major Advanced Economies on the verge of a Wage Price Spiral.

A wage price spiral entails feedback in both directions between wages and prices. Inflation then rises persistently on the back of such a spiral. Once the economy enters the spiral, workers bid up nominal wages more than prices, prompting firms to raise prices further, the likelihood of an economy entering the wage price spiral depends in part on macro-economic conditions.

Workers bargaining power is typically greater when Labor demand is strong and Labor supply is tight. Similarly, firms may have more pricing power when aggregate demand is strong. Labor market institutions also influenced the likelihood of a wage price spiral emerging.

Automatic wage indexation and cost of living adjustment. So C-O-L-A or COLA clauses make wage price spirals, more likely.

And this was important in the; well, it became an issue in the Australian election campaign, because the then opposition leader now Prime Minister, Anthony Albanese; did you see his comments when he was saying that, if we were in government, we would support workers being getting a wage rise in line with inflation. Inflation was rising at well; inflation was 5.1%. That was the last reported estimate from the Reserve Bank, which was higher than expected. And then, Anthony Albanese came out and said, yes, workers, their wages should increase by at least 5.1% To make up for that. And then, the then Prime Minister, Scott Morrison tried to make a big thing out of that and he said, Anthony Albanese is a loose unit, because this could then lock in inflation permanently.

So, this is his concern about a wage price spiral and the BIS was arguing that, this sort of thing; there’s automatic wage indexation, which is almost what well, it’s essentially what Anthony Albanese, our current prime minister here in Australia was almost hinting at. I think he regretted making that comment, because they really don’t want to do that. And if I think they’ve walked back a bit from that position, I mean, they put a submission to the Fair Work Commission, ultimately, it’s up to the Fair Work Commission to decide the increase in minimum wages in Australia.

There was some criticism of the opposition leader at the time, because it could have; there were commentators who were saying, this is a sort of thing that risks a wage price spiral. And you could take that BIS note as supportive of that position. Ultimately, I don’t think that mattered much in the election campaign. So, who knows? I mean, it could have even increased support for Anthony Albanese. People think, well, that sounds fair enough that we’re compensated for inflation. Most people are wage earners as more wage earners than business owners in the country. So, it could have been a popular thing. The PM at the time was trying to say, well, he’s a loose unit, who knows how much impact it had on the election campaign?

Ultimately, I think the election was decided over concerns about climate change. There was this general perception out there that the government wasn’t doing enough on climate change, rightly or wrongly. And that was the dominant consideration.

Do you remember that whole debate or that whole discussion around the opposition leader’s comments?

Arturo Espinoza Bocangel  33:43

I remember that. I saw some news about it. I also reviewed some comments from some Australians, And some people or some citizens mentioned that the proposal is not correct for the current situation in the global economy. Because of course, if you want to raise salary, that will be loads, let’s say factor, or determinant to boost inflation pressures in Australia.

I remember that I checked some economic paper; it’s okay to raise the wages, but it could be implemented gradually. Or maybe you can target some sectors in order to improve the salaries but it’s not a good policy response to increase generally, the wages in the whole Australia.

Gene Tunny  35:01

Maybe limited to the lowest paid workers, rather than have at across all of the wage agreements in the economy so that; fair enough. Okay, we might have to come back to this whole issue of how wages are set in a future episode.

So, what did the BIS conclude about whether major economies are on the verge of a wage price spiral? Well, with most economic issues, they weren’t able to reach a firm conclusion. I mean, none of us has a crystal ball. I mean, I’m always very reluctant to give firm or precise forecast, because you just can’t, because there’s so much uncertainty.

So, my reading of what the BIS was saying in that wage price spiral bulletin, is that, well, they’re not really sure. The key things that they noted in their analysis were that while inflation is returned, it’s reached levels not seen in decades, whether inflation enters a persistently higher regime will depend on labor market developments and on whether a wage price spiral emerges. To date, evidence for a broad acceleration in wage growth is mixed. It’s picked up significantly in the US, but it remains moderate in most other advanced economies. So, it’s certainly still moderate in Australia, it is picking up a bit, but it’s not near what arguably, we’d like to have. And this became an issue in the election campaign to you probably remember this. Well, this is why Albanese made those comments to begin with. Because if you looked at wage’s growth, which was, 2.7 or maybe it was a bit lower through the year, compare it with inflation of 5.1%, then you get a real wage decline of 2.6%.

I will put the exact numbers in the show notes. It must have been about 2½%. If we’ve got a 5.1% inflation rate, I think they were saying the real wage decline was 2.6 or 2.7%, that it must have been a 2½% wage price index increase. I’ll put the right data in the show notes.

That became an issue in the recent election campaign.

Here is where the BIS basically admits; we really don’t know:, Extrapolating behavior from low inflation periods is problematic if inflation remains high, households may ask for higher wages to make up for lost purchasing power and firms may raise prices to protect profit margins. And stubbornly high inflation may lead to institutional changes, such as automatic indexation and cost of living adjustment clauses. So, that’s the sort of thing we want to avoid. And that’s why people were worried about what our current Prime Minister was saying, because there was a concern that we could effectively do that sort of thing, if he followed through on what he was saying.

Did you have any thoughts on that wage price spiral article? You had a looked at that today, didn’t you Arturo?

Arturo Espinoza Bocangel  38:17

Yes. I think, in the report, they also mentioned that some condition must be complied to be under these kinds of wage price spirals. But from my point of view, I think is quite complex to determine if all the countries are going to face that wage price spiral? I think that depends on the particular condition from each country.

Gene Tunny  38:50

Yeah, that’s the problem that the World Bank and the BIS, or the IMF have, because they’re trying to produce forecasts, or do analysis for the whole world or all major economies, whereas there are differences in the institutions within those economies; a very good point.

Okay, so let’s get back to the central question. I mean, all of these things we’ve been talking about, are related to because if we have a wage price spiral, and then we have some shock or the economy goes into a downturn, then we could end up with stagflation. So, it’s all related.

We’ll talk about now, the prospects for stagflation. So, is this something we should be worried about? And it turns out the BIS looked at this last month, so before the World Bank, so this is obviously something that economists in these major institutions are concerned about, and the BIS had to report commodity market disruptions, growth and inflation.

We’ve talked about the broad base supply shock increasing inflation, food and energy prices spilling over to other components of inflation, and possibly; well contributing to a reduction in global economic growth. And we should talk about the World Bank’s forecasts because the World Bank now is forecasting a reduction in global growth, isn’t it? That was one of the major things in that latest report. I’ve got it here.

The bank slashed its annual global growth forecast to 2.9% from January’s 4.1% and said that subdued growth would be likely to persist throughout the decade because of weak investment in most of the world.

And so, the BIS was saying that this is the sort of thing that would happen. It was saying this last month, and I guess, I mean, a lot of other economists have been concerned about that. There’s a recognition that what’s happening with Ukraine, what’s happening with commodity prices, that is going to compromise, global economic growth.

Now, it looks like the BIS; they’re saying similar things to the World Bank and the World Bank, probably. I mean, I’m sure it read what the BIS analysis is pretty much; I think they reach the same conclusions almost. So, let’s go over what the BIS says, and then we’ll compare it with what the World Bank says. So, the BIS has concluded, recent shocks have been smaller than the 1970s oil shocks, but broader based encompassing food and industrial commodities as well as energy. Nonetheless, structural changes, as well as stronger policy frameworks and nominal anchors.

So, by a nominal anchor, they mean, something that’s keeping prices down. They’re talking about inflation targets. So, they make stagflation less likely to return. But this is where they acknowledge that.; we’ve said that, but ultimately, things can happen that derail the economy that can mean our forecast is incorrect. And they know commodity price increases in the wake of the war in Ukraine are likely to weigh on global growth and add to inflation. While lower energy dependence and stronger policy frameworks make a repeat of the 1970s stagflation unlikely, high and volatile commodity prices could still be disruptive. This puts a premium on restoring low inflation quickly before it becomes ingrained in household and corporate decisions.

Absolutely. I think that’s a very good point to make. So, that’s what the BIS said, That’s pretty similar to what the World Bank said, isn’t it?

We might have a look at that now, again. Let me just go back to the media release. They also got a comprehensive report and that chapter, the focus on stagflation, which I’ll link to in the show notes, which is worth reading. I’m just going to consult their media release, which is a really good summary and well written.

Let’s just talk about how the current situation resembles the 70s. And why? What are the reasons why we might think that we could end up with global stagflation?

The current juncture resembles the 1970s in three key aspects: persistence supply, side disturbances, fueling inflation, preceded by a protracted period of highly accommodative monetary policy and major advanced economies, prospects for weakening growth and vulnerabilities in emerging market and developing economies face with respect to the monetary policy tightening that will be needed to rein in inflation.

Let’s have a look at what they’re talking about there. We’ve talked about the persistent supply side disturbances, preceded by a protracted period of highly accommodative monetary policy. By accommodative, we mean, loose, we mean, ultra-low interest rates, we mean lots of money printing, that sort of thing; credit creation, due to the low interest rates. And that’s what we’ve seen in Australia, we’ve seen in the US, we’ve seen it in other advanced economies. So, there’s no doubt about that. And the argument is that buildup of that additional money, that additional liquidity will end up with too much money chasing too few goods, accelerating inflation, right. We’ve talked about that on the show before.

They also talked about vulnerabilities that emerging market and developing economies face with respect to the monetary policy tightening that will be needed to rein in inflation.

So, let’s have a think about what they’re driving out there. I mean, as the western economies increase interest rates, that’s going to mean; this is just one aspect of it. That will attract investment capital, portfolio investment to the US or to other major advanced economies. And if those developing economies don’t put up their interest rates, then that will lead to a depreciation of their exchange rates, which means that the cost of imported goods in those economies will be compromised, or if they’re trying to fix their exchange rates, it puts pressure on their balance of payments. So, it’s a bad situation for those emerging economies.

And also, the thing is, when you have situations like this in the world, when there’s concerns about volatility, there is this flight to safety and money can flow to the advanced economies where there’s a perception, it’s safer, and that could compromise these emerging economies. I wouldn’t be forecasting this yet, but things can happen unexpectedly or rapidly. We know that there can be crises in emerging economies that are difficult to predict, such as the Asian crisis in the late 1990s.

 Any thoughts on any of those key aspects, Arturo? About how, how there are similarities with the 70s?

Arturo Espinoza Bocangel  46:19

No. Your explanation was very clear.

Gene Tunny  46:23

Okay, well, then we should; before we conclude this episode, we should talk about how the ongoing episode also differs from the 1970s. The dollar is strong, a sharp contrast with a severe weakness in the 1970s, the percentage increases in commodity prices are smaller, and the balance sheets of major financial institutions are generally strong.

More importantly, unlike the 1970s, Central banks in advanced economies, and many developing economies, now have clear mandates for price stability. And over the past three decades, they have established a credible track record of achieving their inflation targets.

And they go on to conclude as the World Bank global inflation is expected to moderate next year, but it will likely remain above; I think I’ve missed the words there, it must be above average.

And they talked about; something’s gone wrong with my printout. They do talk about, you know, there is a risk of stagflation. So, stagflation risk rises amid sharp slowdown in growth, okay, so, there’s going to be some moderation in inflation, but it’s likely to still remain high or higher than the normal. And you couple that with the fact that there’s a risk of a slowdown, and they’re talking about a slowdown in global growth. That’s what they’re forecasting, then, yes, certainly, stagflation of some kind is a risk.

My personal feeling is that; and this is informed by my conversation with Michael Knox last week, I don’t think we’ll end up with stagflation similar to the 70s, or rather, I hope not. I don’t see at the moment. I think the US economy based on the indicators I’ve seen in my conversation with Michael, I think, at least for the next year or so, the prospects for the US economy are very good. Likewise, for Australia, I mean, there are always risks. We’ve got some heavily indebted households; we’ve got interest rates increasing. That’s one of the great unknowns at the moment. But if you look at the indicators, such as job vacancies, you look at the fact we’ve got a 3.9% unemployment rate. You look at what’s happening with commodity prices, which were in net terms benefiting from, because we’re a net exporter of energy and minerals to the world. Like, our coal prices have been $400 – $500 US a ton.

Queensland is a huge producer of coal; and that’s benefiting our state and budget. I mean, there’s ultimately; there may have to be a transition out of coal because of concerns over climate change. But at the moment, it’s something that is beneficial to the state economy. So, I think in Australia, I’m not concerned about stagflation at the moment, but as always, I need to say, I don’t have a crystal ball.

Any thoughts, Arturo? I mean, what’s your general feeling on stagflation? Is this just the latest thing that we’re worried about? Perhaps for no really good reason? I mean, it certainly; I haven’t seen this interest in the concept for a long time. And yes, is it something we should be worried about? What do you think?

Arturo Espinoza Bocangel  49:35

I think the case is; it’s good to have these discussions and it’s good to know that most of the Central banks are considering these potential, let’s say, this potential event. If they are well prepared, they can avoid that kind of situation for some countries. As I mentioned this thing, if a cure isn’t going to be general, so some countries perhaps are going to face stagflation. In some cases, if they don’t manage properly their monetary policy and some fiscal responses.

But of course, there are many risks that are out there, for example, as the World Bank report mentioned, if the supply disruption proceeds or the commodity prices continue to climb, inflation could remain above Central bank’s target. So, I think those are potential risks, the Central bank must consider giving good response.

Gene Tunny  51:00

Yeah, good point.

One other point I wanted to make is; and this is related to the other thing that differs from the 70s, which is, the World Bank set out a few ways that the economy is not the same as the 70s. And, one of the important ones, I think, is they talk about the US dollar, don’t they, the dollar is strong. Now, this is a very technical issue, it’s a hard one to sort of get your head around, because you have to go back to the situation in the 60s and the early 70s, before the era that we’re now in, in advanced economies of floating exchange rates. When we had the Bretton Woods system.

Michael Knox referred to the growth in international reserves, he talked about the growth of foreign currencies, held by Central banks in the early 70s that just massively increased in the early 70s. Because what was happening were because of the issues in the US and higher budget deficits and concerns about inflation, people around the world were trying to get out of US dollars. And because of the Bretton Woods system, they were trading their US dollars for their own currency or other currencies, or for European currencies, because there was the strong; well, in those that post-war recovery in Europe and Europe was becoming more prominent. And so, there was a move out of US dollars and to buy those US dollars, the Central banks essentially printed money, they created new money.

So, these changes in international reserves that Michael was talking about, I think was like 80%, over from the end of 1972, sometime in 1972. It was a huge growth in these international reserves, that led to a big increase in domestic money supplies, and that fueled inflation.

This is a great article by Robert Heller, that was in one of the IMF journals; might have been finance and development. I put a link to it in the show notes before, I’ll put it again, because it’s just well worth reading. But I think for us to do that justice, we will probably have to come back and talk about Bretton Woods and the whole international financial system pre 1970s. And look, that’s going to be a lot of work.  

This shows the complexity of the issues that we’re dealing with. In the economy, so many moving parts, it’s all interconnected. And yes, but what we’re trying to do, I think on this show is to simplify it as much as possible. And really make sure we understand those mechanisms because in a lot of economic discussion, there’s just too much that’s assumed in terms of the knowledge of the people reading or listening. There are too many concepts explained by reference to other concepts without explaining those concepts. And I want to try to make sure that we’re as clear as possible.

I think we’re probably in a position to wrap this up. Arturo, any final words? Thoughts?

Arturo Espinoza Bocangel  54:18

I think this conversation was pretty clear. And you’re to understand what is going on globally, in terms of inflation, potentially stagflation problems that some country may face. So, I think let’s stay alert. I think that Central banks are going to react properly in order to address that problem.

Gene Tunny  54:56

Okay, so you said, be alert, I like that. As our Former Prime Minister John Howard once said, Be alert, not alarmed. We will be alert to the prospects for global stagflation. But we’re not going to be alarmed at the moment.

You may not have been in Australia when he said that. That was something that people had amusing. There was about a serious issue is talking about international terrorism, which was, of course, a serious issue. And he said, be alert, but not alarmed. And then that sort of prompted all of these sorts of jokes about, what does that exactly mean to be alert, but not alarmed? I mean, how worried should we be?

And there was the old joke in Australia. Be alert, Australia needs Lurtz. I don’t know if you’ve heard that one. So, I think people would probably; as soon as John Howard said, Be alert, not alarmed. People were instantly sort of thinking, this is a bit of a funny thing to say. But maybe because I remembered that all joke about being alert.

Thank you, Aturo, I really enjoyed that conversation. And if you’re in the audience, and you’re listening, and you’d like to know more about these issues, I’ll put links to everything we chatted about in the show notes. I’ll also make any corrections. If I’ve got anything wrong I discover, in terms of numbers. I generally think the concepts and the facts; I think we got that right. But it’s possible some of the numbers I may have misremembered. So, we’ll put clarifications links in the show notes. And thanks again for listening. Arturo, really appreciate your time today. Thanks so much.

Arturo Espinoza Bocangel  56:43

Thank you again. Thank you very much.

Gene Tunny  56:46 Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com And we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Big thanks to EP143 guest Arturo Espinoza and to the show’s audio engineer Josh Crotts for his assistance in producing the episode and to Peter Oke for editing the transcript. 

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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Podcast episode

Nominal GDP targeting w/ Stephen Kirchner – EP135

Market monetarists such as Stephen Kirchner argue nominal GDP targeting would be better than inflation targeting and could help central banks such as the RBA and the US Federal Reserve get back on track. Stephen is Director of the International Economy Program at the United States Studies Centre at the University of Sydney. 

Stephen spoke about nominal GDP targeting with Economics Explored host Gene Tunny in episode 135 of the show, recorded in April 2022. Among other details of nominal GDP targeting, Stephen discussed the potential role of a nominal GDP futures market and for blockchain and Ethereum in such a market and in financial markets more broadly. You can listen to the conversation using the embedded player below or via Google PodcastsApple PodcastsSpotify, and Stitcher, among other podcast apps.

About this episode’s guest – Dr Stephen Kirchner

Dr Stephen Kirchner is Director of the International Economy Program at the United States Studies Centre at the University of Sydney. He is also a senior fellow at the Fraser Institute in Canada, where he has contributed to research projects comparing public policies in Australia, Canada and New Zealand.

Previously, he was an economist with the Australian Financial Markets Association, where he worked on public policy issues relating to the efficient and effective functioning of Australian financial markets and Australia’s position as a regional and international financial centre.

Stephen has been a research fellow at the Centre for Independent Studies, a senior lecturer in economics at the University of Technology Sydney Business School and an economist with Standard & Poor’s Institutional Market Services based in both Sydney and Singapore. He has also worked as an advisor to members of the Australian House of Representatives and Senate.

He has published in leading academic and think-tank journals, including Public Choice, The Australian Economic Review, Australian Journal of Political Science and The Cato Journal.

His op-eds have appeared in publications including The Wall Street Journal, Straits Times, Businessweek, The Australian Financial Review, The Australian, and Sydney Morning Herald.

Stephen holds a BA (Hons) from the Australian National University, where he was awarded the L. F. Crisp Prize for Political Science, a Master of Economics (Hons) from Macquarie University, and a PhD in Economics from the University of New South Wales.

Stephen posts regularly on his substack: 

https://stephenkirchner.substack.com/

Links relevant to the conversation

Stephen’s papers on nominal GDP targeting:

Reforming Australian Monetary Policy: How Nominal Income Targeting Can Help Get the Reserve Bank Back on Track

The RBA’s pandemic response and the New Keynesian trap

Transcript of EP135: Nominal GDP targeting w/ Stephen Kirchner

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:01

Coming up on Economics Explored.

Stephen Kirchner  00:04

If you want to avoid, you know hitting the zero lower bound or expanding your balance sheet by a significant amount, the way to do that is to respond quickly and aggressively upfront. If you don’t do that, then you fall behind the curve and then monetary policy has to work a lot harder to stabilise the economy.

Gene Tunny  00:23

Welcome to the Economics Explored podcast, a frank and fearless exploration of the important economic issues. I’m your host, Gene Tunny. I’m a professional economist based in Brisbane, Australia and I’m a former Australian Treasury official. This is Episode 135 on nominal GDP targeting. My guest this episode is Dr. Stephen Kirchner, who is Director of the International Economy Programme at the United States Studies Centre at the University of Sydney in Australia. In this episode, Stephen tells us why nominal GDP targeting would be better than inflation targeting and how central banks such as the Reserve Bank of Australia and the US Federal Reserve can get back on track. Please check out the show notes for relevant links and for details of how you can get in touch with any comments or suggestions. I’d love to hear from you. Righto, now for my conversation with Dr. Steven Kirschner on nominal GDP targeting. Thanks to my audio engineer Josh Crotts for his assistance in producing this episode. I hope you enjoy it. Dr. Steven Kirchner of the US Studies Centre. Welcome to the programme.

Stephen Kirchner  01:36

Thanks for having me, Gene.

Gene Tunny  01:37

It’s a pleasure, Stephen, keen to chat with you about a paper you wrote last year on Reforming Australian Monetary Policy: How Nominal Income Targeting Can Help Get the Reserve Bank Back on Track. So there’s a lot to talk about here. And I think this is of general interest to people in other countries, as well, other than Australia, because this idea of nominal income targeting, it’s been raised in other countries, I know that you’ve appeared on David Beckworth’s podcast, Macro Musings, and I know that David Beckworth is a proponent of this in the United States. So I’d like to ask about, essentially, what is this nominal income targeting compared with how we normally, or how central banks have been running monetary policy? Would you be able to give us an overview of that, please?

Stephen Kirchner  02:38

Sure. I think nominal income targeting is actually not a huge change from where we are at the moment. So most central banks do what they call inflation targeting. And as part of an inflation targeting regime, they’re typically adjusting their monetary policy instrument, usually an official interest rate in response to deviations in inflation from target. But also responding to deviations in output from its full employment, or potential level. And the reason you have output as part of your reaction function is the output gap is predictive of future inflation outcomes. So if you’re running an inflation targeting regime, you want to respond to both deviations inflation from target, and output from potential.

Well, if you think about those two things, inflation on the one hand, and output on the other, if you put those two things together, then you’ve got nominal income, or nominal GDP. So in some respects, nominal GDP targeting or nominal income targeting is just a really weighting of that standard central bank reaction function. So if you think about a Taylor rule, which is just an empirical description of how the interest rate responds to deviations and inflation from target, and output from potential, all nominal GDP targeting is doing is saying you want to put inflation output together and weight them equally in terms of the interest rate response.

Gene Tunny  04:14

Ah, right. Okay. Yeah, that’s a good way of describing it. Yeah, please go on.

Stephen Kirchner  04:18

Yeah, so in that sense, it’s not a huge leap from where we are at the moment. But what it does mean is that the central bank is a bit more agnostic about its response to inflation, and deviations in output from potential. So it’s saying really we want to stabilise both, and the reason you want to stabilise both is if you’re just focusing on inflation, one of the problems you face is not all of the deviations in inflation from target are reflective of aggregate demand shocks. As we know, especially at the moment inflation can deviate from target due to supply shocks. Supply shocks have the effect of lowering output. And so this creates a dilemma for a central bank in how do you respond to a supply-driven inflation shock, or deviation from target. Because if you respond to the deviation in inflation from target and raise interest rates, then that’s going to compound the reduction in output you’d get from a supply shock.

Gene Tunny  05:28

Right. So one example, I’m just thinking, Stephen, is one example of this, did this occur, arguably a policy mistake? Was it 2008 when the European Central Bank put up its policy rate? Not long before the financial crisis? Because there was a supply shock? Or was there an increase in the price of oil? I’m trying to remember, is that one of the examples I give?

Stephen Kirchner  05:55

Well, I think the canonical example here is what happened in the 1970s, when you had very significant increases in oil prices giving rise to higher rates of inflation. And central banks did respond to those oil price shocks through tighter monetary policy. And so there’s an influential paper by Ben Bernanke, Watson and Gertler in 1997, which showed that the propagation of the oil price shock to the US economy was essentially through the monetary policy reaction. And so it was the central bank that actually put the stag into stagflation.

Another example of this would be if you go to September 2008, the FOMC meeting took place a couple of days after the failure of Lehman Brothers. And this was at a time when inflation expectations were collapsing and nominal GDP expectations were collapsing. At that meeting, the FOMC incredibly left the Fed funds rate unchanged, and cited inflation pressures arising from higher oil prices as the reason for keeping monetary policy steady. So this is a very good example of monetary policy being led astray by inflation outcomes that are being driven by supply shocks rather than aggregate demand shocks.

And so what we want is the central bank to respond to inflation pressures to the extent that they’re reflective of aggregate demand shocks, not aggregate supply shocks. And nominal GDP lets you do that without actually having to take a view on what’s driving inflation. So nominal GDP outcomes will tell you the extent to which your inflation issues are being driven by aggregate demand rather than aggregate supply.

Gene Tunny  07:51

Okay, so yeah, a few things to try and explore here. Stephen, inflation targeting. So it’s typically going for something around well, in Australia, it’s 2 to 3%, we’ve got a target band for inflation. And in the US, is it 2%? Or I remember thinking of Bank of England? But the different countries have just slightly different targets.

And what’s fascinating is that when these things were first formulated, we had much higher inflation. And I think no one ever expected we’d be getting consistently, we’d inflation outcomes consistently lower than those targets. And it makes it difficult to think about what’s the appropriate monetary policy response.

I better make sure I understand your argument about why you think the Reserve Bank needs to get back on track. Are you suggesting that the fact that Australia is similar to some other advanced economies, who’ve had inflation outcomes below the target for a substantial amount of time, that would imply that the Reserve Bank, the central bank had scope to expand to have a more expansionary monetary policy which could have pushed the economy closer to full employment? Is that the argument, broadly?

Stephen Kirchner  09:14

Yeah, that’s certainly true of the sort of pre-pandemic period basically, the period in which the RBA was undershooting from approximately 2014 through to the onset of the pandemic and even into the pandemic. So it’s certainly in the last couple of quarters that inflation has returned to target. I mean, I think the specification of the inflation target inevitably is a little bit arbitrary. What matters most is not the exact target range, but the fact that you hit that target more often than not over time and thereby establish your credibility in relation to that target. So ultimately, what you’re trying to do is condition the expectations of price, and wage setters in the economy should be consistent with that target. And so whether it’s a 2% target or 2 to 3% target, it’s less important than the fact that you have one and that you actually stick to it.

But the case for nominal income targeting is to say if you’re only targeting inflation, and this creates a bit of a presentational problem and a sort of implementation problem, which is that what happens in the context of a supply shock when inflation might be above target? How do you explain to people the fact that you’re not hitting your target, even though there’s probably a very good reason why you’d want to look through that supply shock.

If you’re expressing your monetary policy target in terms of nominal GDP, that task becomes a lot simpler, because yes, you may be above target on inflation, but in the context of a supply shock, output is going to be lower. And so you don’t get the same sort of deviation from target under a nominal GDP targeting regime than you would under an inflation targeting regime. Policymakers are less likely to be led astray, because by focusing on nominal GDP, they don’t have this issue of trying to figure out whether inflation outcomes reflect demand shocks or supply shocks.

Gene Tunny  11:23

Okay, so how would this work in practice? So in nominal terms, so by nominal, you’re talking about, we’re not talking about a real GDP measure where we adjust for inflation, we try and get things in consistent dollars, you’re just talking about the total value of the economy, in GDP in nominal terms, so what it is in current dollars, and say that it’s over $2 trillion in Australia annually. And so would the Reserve Bank have a target? They would have an expectation of what that nominal income for Australia should be in 2022, what it should be in 2023. So it should be 2.3 billion by this date or something? Is that Is that how it’s formulated? A trillion I meant, not billion. Sorry,

Stephen Kirchner  12:16

You can’t express it in level terms. So with a nominal GDP target, you can express it both as a growth rate or an implied path for nominal GDP. But I think it’s important to emphasise that, just as with inflation targeting, you don’t target inflation outcomes, necessarily. What you’re targeting is actually the inflation forecast. So what you’re saying is, in future, you’re going to be realising inflation outcomes consistent with target, or with nominal GDP targeting, it’s exactly the same thing. So you want to specify a target path for the future evolution of novel income or novel output. And you want to adjust your monetary policy instruments to be consistent with that target path.

So if in any given quarter, your level of nominal GDP is a little bit above or a little bit below the target path, that’s not necessarily a problem. Again, what you’re trying to do is conditions people’s expectations in relation to what future nominal income will be. And I think that has very useful properties from the point of view of stabilising the economy, because if you think about things like wage and price contracting in the economy, people borrowing and lending, all those activities are conditional on expectations for future normal income. And so if you can stabilise both expectations for that future nominal income path, and by implication, also nominal GDP outcomes, then I think that’s a recipe for macroeconomic stability, more so than if you’re targeting inflation without regard to whether inflation is being driven by demand or supply shocks.

Gene Tunny  14:13

Right. Okay. Might go back to that Taylor rule. So you mentioned the Taylor rule. And you mentioned you can actually think of nominal GDP targeting in a, you call it a reaction function, so how the central bank reacts to the macroeconomic variables. And you said this gives equal weight to deviations of inflation from the target end of real GDP from the target. What does the Taylor rule typically do? Do ou know, what sort of normal parameters there are in that reaction function and what that means?

Stephen Kirchner  14:53

So the Taylor rule was due to John Taylor, who in the early 1990s sat down and said, well empirically, how do we characterise movements in the Fed funds rate. So he regressed the Fed funds rate on various macroeconomic variables. And the empirical description that he came up with for the Feds reaction function was to say, well, the Fed responds to deviations in inflation from target, and had estimated a weight of about 1.5 on that deviation, and also response to deviations and output from potential. And he estimated a weight of .5 on that.

But to sort of round out that empirical description of the Fed funds rate, you also needed an estimate of what the neutral Fed funds rate would be. So in other words, what happens when inflation is a target and output is a potential? What is the Fed funds rate consistent with that? And so that just ends up being a constant regression.

One of the big issues that sort of comes out of that is that’s obviously a historical estimate. What happens if your equilibrium real interest rate changes over time. So you then have the issue of, if you’re responding based on those historical relationships, but the actual equilibrium interest rate changes, and you may end up with monetary policy being miscalibrated. And I think that arguably happens in the United States, and to a certain extent here in recent years, where I think the equilibrium real rate probably fell considerably. And that meant that monetary policy ended up being tighter than central banks intended.

Gene Tunny  16:53

Okay, we might come back to that, I just want to go back to the Taylor rule that you mentioned 1.5. So that means for every percentage point that inflation would be above the target, so if the target’s 2%, and inflation is 3%, the central bank would put up the policy interest rate, the overnight cash rate or the federal funds rate by 1.5 percentage points. And the idea is there that you’re trying to engineer an increase in the real interest rate. So you want to make sure the interest rate increases more than the inflation component of it. Actually, yeah,

Stephen Kirchner  17:41

Yeah, that’s right. So this thing actually has a name, it’s called the Taylor principle. And the Taylor principle says that you want to move your nominal interest rate by more than one for one with the deviation inflation from target, because if you just do a one for one or a less than one point move, then you’re not going to move the real rate, you’re not going to move it in the desired direction. So it has to be a move that is more than the change in inflation. So that’s why you get a parameter estimate of a little bit more than one.

For some central banks, you get higher responses to inflation. So the BOJ, Bank of Japan, the ECB, depending on what sort of model that you look at, sometimes their reactions will be up around two. But yeah, the basic Taylor principle is that you want a response to inflation that is greater than one. But essentially, nominal GDP targeting says that you want to combine inflation and output in the form of nominal GDP, and you want to respond to that.

Gene Tunny  18:46

So I guess one of the points that you make, and I think it is a good point, that to do this Taylor rule properly, you need estimates of these unobservable variables, such as this equilibrium real interest rate. And as you rightly point out, I mean, this is something that… Interest rates are much lower now than we ever expected. You compare historically, it’s quite extraordinary what we’ve seen since the financial crisis in Australia, and the US and UK, and even before then in Japan, since the ‘90s. Absolutely extraordinary.

So I want to make sure I understand the logic again. You mentioned that this means that monetary policy was not as aggressive or as accommodative, or however you describe it, because the equilibrium real interest rate, whatever that is, whether it’s… Say it was 4% and now it’s much lower than that. How does that logically work, Stephen? Can you take us through that logic? I just want to make sure I understand how it would lead a central bank to go astray.

Stephen Kirchner  20:00

Actually, the problem is a bit broader than that. So there are potentially three unobservable variables it would impact. Taylor rule style reaction function, and potentially monetary policy Australia. So one is the real equilibrium interest rate, as we’ve discussed. It’s not directly observable. And it could be higher or lower than we think. But I would say it’s probably been lower than policymakers have thought. In terms of the output gap, then you have the problem that we don’t directly observe potential output either. And so that could be higher or lower than we think. And so policy can be miscalibrated on that basis.

An alternative way of thinking about the output gap is to think in terms of an unemployment gap. So the deviation in unemployment from its full employment level, and this is of course where we get the NAIRU from. So the idea that there’s an unemployment rate that’s consistent with the stable interest rate. And both the Federal Reserve and the RBA have conceded in recent years that the NAIRU has actually been a lot lower than they realised. So they have downwardly revised their estimates of the NAIRU.

And so for much of the post financial crisis period, I think both the Fed and to a lesser extent, the RBA were conditioning monetary policy on a view that the unemployment rate was pretty close to the NAIRU, when in fact, it was probably sitting quite a bit above the NAIRU. And so what that meant was we had monetary policy that was two tight. They could have actually pushed the unemployment rates lower. And done it in a way that would have meant that inflation was more consistent with target as well.

So you can see that the problem with a sort of Taylor rule type approach is that embedded in the Taylor rule, you’ve got at least two unobserved variables.  You’re trying to estimate what those unobservable variables are and condition policy on it. So what nominal income targeting says is well, in fact, you don’t need to take a view on either the equilibrium real rate or the NAIRU or potential output, because nominal GDP in and of itself is a complete description of the stance of monetary policy. And in the long run, nominal GDP is fully determined by the central bank. So the central bank can both influence the long run level of nominal GDP, and the level of nominal GDP tells you whether monetary policy is too easy or too tight at any given time.

You don’t need to do what’s sometimes called navigating by the stars, which is, in macroeconomics, when you write this stuff down in the form of equations, the equilibrium values,  the real interest rate, the NAIRU and potential output, those variables denoted with an asterisk or a star. And so we were first and policy that sort of conditions on those variables as navigating the stars. This is what leads monetary policy astray. It’s the problem that nominal GDP targeting seeks to address

Gene Tunny  23:24

Okay, so by NAIRU, N-A-I-R-U, which stands for non-accelerating inflation rate of unemployment, such a horrible expression. We use it all the time. Okay, we’ll take a short break here for a word from our sponsor.

Female speaker  23:45

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Gene Tunny  24:14

Now back to the show. So how’s this gonna work in practice, Stephen? I’m wondering, and does that mean the main thing the central bank is looking at it in their deliberations, so the board meeting of the Reserve Bank or at the Federal Open Markets Committee, or the Monetary Policy Committee, in the UK, or in the FOMC and in the US, they’re just looking at what the latest data are telling them about GDP, about nominal GDP? They’re trying to forecast that themselves based on a range of indicators, I suppose. Have you thought about how it’s going to work in practice?

Stephen Kirchner  24:55

I think central banks should basically look at all the information that’s available to them in forming a view. So the question is more in terms of what their target is and how they specify that target. And, importantly, also how they describe their policy actions in relation to that target. And so, the purposes of adopting a nominal GDP target, one way to do that is to specify a target path for the future evolution of nominal GDP. So you can do that out a few years in advance. And you would then explain your changes in your operating instrument in terms of an attempt to hit that target path.

So for Australia, for example, it would be a simple matter of rewriting the agreement with the treasurer, what we call a statement on monetary policy, which basically sets out what the RBA is trying to achieve through its conduct of monetary policy. And you would specify that in terms of a path, the future path for nominal GDP.

One of the things I do in my paper for the Mercatus Centre is to estimate an implicit forward-looking nominal GDP targeting rule for the Reserve Bank. So I basically do for the RBA, what John Taylor did for the fed back in the early 1990s, and say, How would an empirical description is nominal GDP targeting of how the RBA has actually changed the cash rate in the past?

And as it turns out, it’s actually not a bad empirical model of what they’ve been doing historically, because even if you’re thinking of monetary policy material type framework, you know, you’re still trying to stabilise nominal GDP. You’re just putting different weights on those two components of inflation output. But if you think of monetary policy as just responding to the nominal GDP, well, to some extent, the RBA is already doing that. Where I think nominal GDP targeting is helpful is, at the margin, I think it would lead to better monetary policy decisions, for the reasons that we’ve already talked about that. At the margin, they would be focusing more squarely on nominal demand shocks and looking through supply shocks, which I think is where monetary policy has run off track in the past.

Gene Tunny  27:34

Okay, so I want to ask about the RBA. So you want to get the RBA back on track. And one of the areas or one way you think that it’s off track is that over the last decade or so, or maybe over the last five years, or maybe a bit longer than that, it’s paid too much attention. Am I getting this right? You think it’s paid too much attention to financial stability risks, and this is called leaning against the wind? I think it’s denied that it actually does lean against the wind. Is this one of your criticisms of it, Stephen? And if so, what’s wrong with taking financial stability risks into account when setting monetary policy?

Stephen Kirchner  28:15

So there’s a long running debate about the role of financial stability, inflation targeting framework, and to what extent you should take financial stability concerns into account when doing inflation targeting. And one conception of this is to say that if you are doing inflation targeting, and you’re underpinning nominal stability in the economy, that this in itself is conducive to financial stability. And so, you want to prioritise nominal stability and that is the way you get financial stability.

And to the extent that financial instability becomes a problem, then monetary policy can always address that ex post. So the way the debate is sometimes characterised is between leaners and cleaners. So if your reaction to financial instability is ex post, then you’re cleaning up after you get a financial stability problem. If you’re a leaner, then you’re trying to sort of anticipate those financial instability problems. And to that extent, you’re going to potentially sacrifice your inflation target in order to head off some of those concerns.

So central banks will always obviously have to respond to financial instability after the fact to the extent that it creates problems for the macro economy. The real question is, to what extent do you try to do that preemptively. And I would argue that we don’t have enough information about financial stability risks to really do that successfully, preemptively. And traditionally, that was kind of the view that the RBA took. So if you look at the 2010 statement on monetary policy agreed between the treasurer and the RBA governor, that statement was the first to incorporate financial stability as a consideration. So it was the first statement after the financial crisis. And so it’s no surprise that that statement took on financial stability concerns.

And in that 2010 statement, it says very explicitly that, yes, the Reserve Bank should take account of financial stability, but without compromising the price stability objective. So financial stability concerns were made explicitly subordinate to price stability. And so that reflects the view I talked about before where you view nominal stability as being the most conducive way to address financial stability risks. So that would be the way that I would tend to formulate that relationship between price stability and financial stability.

What happened when Philip Lowe became governor in 2016 is there was a change in the wording on the statement on the conduct of monetary policy, which essentially turned that relationship on its head. So that statement explicitly provided for short-term deviations in inflation from target in order to address financial stability risks. So that agreement was essentially saying that there may be times when in the short run, we’re going to allow inflation to deviate from target in order to address financial stability concerns. And those concerns were explicitly nominated as a reason why you might look at the inflation target.

Gene Tunny  31:51

They might accept lower than the target inflation, because they don’t want monetary policy so stimulatory that it means that there’s a big growth in housing credit and house prices. Is one of the criticisms of what the RBA is doing now. I mean, I’m interested in your views on what it’s done during the pandemic, because we’ve had very aggressive monetary policy response. And this has arguably contributed to the boom in housing credit and house prices where we’ve got double digit, we’ve had house prices increase by over 20% In some cities. And I mean, to me, I mean, it looks like monetary policy has been too aggressive during this period. But yeah, I’m interested in your view on that, Stephen. And I mean, how does what they’ve done, how do you assess that given you’re an advocate of this nominal income targeting? How compatible is what they’ve done with that, please?

Stephen Kirchner  32:58

So if you look at the period from 2016, through to the onset of the pandemic, that changed, and the wording of the statement in the conduct of monetary policy ended up then being a very good description of monetary policy under Governor Lowe. So, through that period, the RBA very explicitly traded off concerns around, in particular the household debt-to-income ratio, and said, Well, the reason why we’re letting inflation run below target is we’re worried that if we provide more stimulatory monetary policy settings, then that would trigger more household borrowing, and potentially create risks in in the housing market. And the concern was that by the household sector taking on increased leverage, that this would increase the household sector’s exposure to a shock. So essentially, you’re trying to fight the last war in terms of the 2008 financial crisis. They were trying to mitigate what they saw as the risks that led to that particular event.

Now, one of the criticisms of leaning against the wind, I think, and this is a criticism that’s been made very persuasively, I think, by Lars Svensson, Swedish economist, is to say, well, if you’re conducting monetary policy on the basis of an apprehended financial stability, its annual trading off inflation and output against those risks, then in a sense, what you’re doing is you’re setting yourself up to have a weaker starting point if and when a financial crisis does occur. So the starting point for the economy is actually going to be weaker because you’ve been running monetary policy, it’s been too tight. And so this is a mistake that the Swedish central bank made In the early 2010s, and which led Lars to sort of formally model leaning against the wind and coming up with that characterization.

Peter Tulip who was a former Reserve Bank economists, when he was at the bank. He also did some work, basically applying Svensson’s framework to Australia and showing that in terms of the trade-off between the central bank’s objectives and financial stability risks, the RBA was basically incurring costs anywhere from three to eight times the benefit in terms of mitigating financial stability risks. So the cost in terms of having unemployment, for example, higher than would have been otherwise, you know, more than offset any gain in terms of reducing financial stability risk.

So essentially, I think this is a hierarchy in knowledge problem that the central bank really does not have enough knowledge about the economy to be able to successfully lean against the wind. This explains why the RBA undershot its inflation target for the better part of seven years. And it was an explicit policy choice, you know. This wasn’t an accident.

Going into the pandemic, I would say that the initial monetary policy response was inadequate. And this was essentially a function of the RBA trying to conduct monetary policy within its traditional operating framework. So they were still trying to use the cash rate as their main operating instrument, even though the cash rate was constrained by the zero lower bound on a nominal interest rates.

Gene Tunny  36:43

So we had a cash rate of, was it .25% going into the pandemic?

Stephen Kirchner  36:49

Going into the pandemic, it was point .75.

Gene Tunny  36:52

Oh, right. Yeah, sorry.

Stephen Kirchner  36:54

In March of 2020 they lowered it by 50 basis points in 2 increments of .25. And that took it down to a quarter of a point, which they argued at the time was an effective lower bound inasmuch as the RBA operates a corridor system around that target cash rate. And so the bottom of the corridor would have normally been at zero, if they had maintained that system. Subsequently, of course, the RBA did lower the cash rate below .25. So it turned out that it wasn’t a lower bound after all. It was very much a self-imposed constraint.

But going into the pandemic, they tried to conduct monetary policy very much within that conventional operating framework with the cash rate as the main operating instrument. And I think, because they allowed the level of the cash rate to determine how much stimulus they would provide… And initially, monetary policy was way too tight. So even though they had lowered the cash rate, what we saw between March 2020 and November 2020, when they finally adopted QE, was that the Australian dollar appreciated significantly. So the Australian dollar outperformed all of the other G10 currencies over that period. The appreciation on the trade-weighted index was about 10%.

And so what this is telling you is that in relative terms, we were not doing nearly as much as other central banks. And we were paying a penalty for that on the exchange rate. The other element of this, of course, was the macroeconomic policy mix, so the relative weight on monetary and fiscal policy. So our fiscal policy response was one of the strongest in the world. But our monetary policy response wasn’t.

Gene Tunny 38:52

Initially, yeah, gotcha.

Stephen Kirchner 38:54

At least up until November 2020. And so this is a recipe for the open economy crowding out effects that you discussed with Alex Robson, when you talked about Tony Makin’s work on open economy crowding out. So if you have a fiscal policy response, if you’re overweighting on fiscal policy relative to monetary policy, you’ll pay a penalty for that exchange rate. And that’s exactly what happened. And that was a pretty strong indication that monetary policy of this period was too tight. The RBA could have done more but didn’t because it was trying to conduct policy within its traditional operating framework.

Gene Tunny  39:33

Right, and by more you mean quantitative easing or large scale asset purchases, creating new money, printing money electronically and then using it to buy financial securities bonds, for example?

Stephen Kirchner  39:48

Yeah, so there are two alternative operating frameworks that they could have used. One is negative interest rates and the other is large scale asset purchases or QE. And so by November 2020, the RBA conceded that other central banks had done more to expand their balance sheet. And they needed to do the same. They also lowered the cash rate target from .25 to .1. And they lowered the bottom of the cash rate corridor from one to zero. So effectively, they conceded that they could have done more and needed to do more, and they finally delivered. And at that time, they did adopt a very aggressive asset purchase programme because they were playing catch up to other central banks. And so by the time we’ve got to the end of 2021, in fact, the RBA had expanded its balance sheet as a share of GDP by an amount that was broadly equivalent to what the Fed had done.

So one of the ironies here is that the RBA’s attempt not to expand its balance sheet actually ended up being a balance sheet expansion that was comparable to that of the Fed. And I think this is an important lesson for monetary policy generally, that typically, if central bank is using its policy instruments aggressively, and over a very extended period of time, that’s usually an indication that it didn’t do enough upfront. So in fact, if you want to avoid, you know, hitting the zero lower bound or expanding your balance sheet by a significant amount, the way to do that is to respond quickly and aggressively upfront. If you don’t do that, then you fall behind the curve, and then monetary policy has to work a lot harder to stabilise the economy. And I think that’s what ended up happening in Australia in response to the pandemic.

Gene Tunny  41:42

Right, okay. You’ve written another fascinating paper on this, Stephen. The paper’s titled The Reserve Bank of Australia’s Pandemic Response and the New Keynesian Trap. So this was published in Agenda, which is a journal put out by the Australian National University. And I want to ask you what you mean by New Keynesian trap. But I think I sort of know, I think you’re sort of alluding to the fact that a new Keynesian policy approach would be inflation targeting, but you can correct me on that. But the point you make, and I think this is fascinating, you want to explore this and make sure I understand what you mean here, you write, “A monetarist conception of the monetary transmission mechanism would have encouraged more rapid adoption of alternative operating instruments.” So could you explain what you mean there, please?

Stephen Kirchner  42:33

Yeah, so the New Keynesian trap was exactly what I was describing in terms of the monetary policy response to the pandemic. The New Keynesian framework for monetary policy analysis relies excessively on an official interest rate as not just the central bank’s only operating instrument, but also the only way that you get monetary policy into that model. And the problem with this is that if the central bank thinks of monetary policy implementation and monetary policy transmission exclusively in terms of an official interest rate, then that’s going to be a problem when your official interest rate hits the lower bound, because at that point, your model basically blows up, because if you can’t lower the nominal interest rate, in a situation which is calling for easy monetary policy, then that’s a recipe for macroeconomic instability. And in fact, it becomes a downward spiral because the economy deteriorates and you can’t respond through your conventional monetary policy instrument.

And in the sort of New Keynesian literature on monetary policy, there are all sorts of ways in which they try and sort of solve this problem. So in some of that literature, for example, there’s just an assumption that  fiscal policy steps in to bail out the central bank. And to some extent, that’s what we saw with the pandemic response, which was that you might have noticed during the early stages of the pandemic, the Reserve Bank Governor was begging the federal and state governments to do even more with fiscal policy than they were actually doing, even though the fiscal policy response is quite large. And so really what he was saying was, my hands are tied, you need to do more to stabilise the economy.

Now, were the central bank’s hands tied by its operating framework? Well, only in the sense that they perceive that framework to be binding on their decision making. If you go back to November 2019. Governor Lowe gave a speech in which he addressed the issue of negative interest rates and quantitative easing. And he was arguing that it was very unlikely that the central bank would have to go there. And if you read that speech, you can see he’s very reluctant to contemplate using either of those policy instruments. So for me, the New Keynesian trap, it’s a self-imposed constraint on monetary policy. It’s because of the way you’re conceiving both the monetary policy instrument and the monetary policy transmission mechanism, it leads you to pull your punches in an environment where you need to adopt a new operating frame.

And for me, the fact that the RBA walked away from that framework in November of 2020 basically concedes the point, they realised that their traditional operating framework was not adequate in responding to a massive shock when the interest rate was hitting the zero bound, and so they needed to think of monetary policy in an alternative framework. And so this is where an RBA officials started giving speeches about the role of quantitative policy instruments and quantitative transmission mechanisms in the monetary policy implementation. If they had done that back in March of 2020, I think we would have had a more timely, more effective monetary policy response and avoided what I’ve called the New Keynesian trap.

Gene Tunny  46:22

Yeah, yeah. Okay. I mean, I think you’ve been rightly critical of the RBA. If they eventually had to adopt these measures, and arguably, they should have done them earlier. So very good point. I want to make sure I understand why it’s a monetarist conception, why that would have led to more rapid adoption. Is that because a monetarist would have been looking at the monetary aggregates, they would have been thinking about, well, how, how could we make the monetary aggregates grow at the rate that would be optimal? Is that what you’re thinking? And you’re just not thinking in terms of a cash rate? You’re thinking in terms of the money supply?

Stephen Kirchner  47:03

Monetarists have always been very critical of the idea that an official interest rate is both the best characterization of what monetary policy is doing, but also the idea that it’s a complete representation of the role that monetary policy plays in the economy. So it’s true that, you know, in equilibrium, you could say that an official interest rate might be a good representation of the contribution of monetary policy.

The way monetarists tend to think of the long run evolution of the price level is in terms of the long run supply and demand for real money balances. And so they tend to think of the evolution of monetary policy in a quantity framework rather than a price framework, the price being the interest rate. So you can think of monetary policy instruments either working through a price, which is the interest rate, or quantity, which is the supply and demand of real money balances. I think both modes of analysis have their place, and they’ve clearly linked. But the focus on official interest rates, I think has been very misleading, because you know, of itself, the level of the cash rate, tells you very little about the stance of monetary policy.

I think one of the mistakes monetary policymakers have made internationally and in Australia has been to assume that because the nominal cash rate is low, monetary policy must be stimulatory. And one of the points that Milton Friedman made repeatedly was to say, if the nominal interest rate is low, then that’s probably indicative of tight monetary policy because that probably means that inflation is very low as well, if you think of the contribution that inflation makes to the nominal interest rate. So if you’ve got very low nominal interest rates, that’s probably an indication that monetary conditions are too tight, rather than too easy. And I think it’s a mistake that monetary policymakers have repeatedly made.

Milton Friedman warned against it in his 1968 presidential address to the American Economics Association. And throughout his life, he tried to impress upon policymakers the significance of this. But it’s something that’s still eludes policymakers, I think, and you can see it in some of the comments that the RBA and Governor Lowe has made in recent years where they often emphasise the low level of the cash rate as being self-evidently indicative of an easy monetary policy stance when, in fact, if anything, it’s probably an indication that monetary policy is too tight.

By the same token, if you go back to say, the late 1980s, in Australia, when we had double digit inflation rates, well, we had double digit interest rates as well. At that time, very high level of interest rates was in fact indicative of the fact that the RBA had run monetary policy in a way that was way too easy, giving us high inflation.

Gene Tunny  50:34

Yeah. And it was that experience that did prompt the adoption of inflation targeting because we weren’t inflation targeting back then. They had some checklist approach or whatever. This was just after they had the brief experiment with monetarism, and then they had a checklist or something and they didn’t have an explicit inflation target until the early ‘90s. I mean, Stephen, would you agree that arguably, inflation targeting was a good thing to adopt at the time? I mean, did it actually improve? Do we get better monetary policy for a while with inflation targeting? Was it better than what we had before?

Stephen Kirchner  51:09

I think inflation targeting was a very important and helpful innovation. They’ve got central banks focused on nominal stability, which is what you want them to do. And I mean, I’m still a defender of inflation targeting as much as I think you could make the current inflation targeting framework work better. And the way in which you would do that would be to focus on as you’re looking through supply shocks, so in other words, not responding to increases in inflation that are clearly driven by supply side constraints, like some of the inflation pressures that we’re seeing at the moment. Where nominal income targeting is helpful I think is helping you to do that.

So one way of thinking about nominal income targeting is you could think of nominal income as an indicator variable or an inflation variable, which tells you when you need to respond to inflation with monetary policy and when you shouldn’t. So that would be one way in which you could improve an inflation targeting regimen would be to sort of look at both variables and use that to help you sift through what inflation shocks you want to respond to, what inflation shocks you want to look through. I don’t think we have to necessarily give up on inflation targeting but we probably do need to change the way we do it, because I think inflation targeting in recent years has failed on its own terms, because central banks have said, well, we’re targeting inflation, but in fact, they’ve missed the target. So if you’re missing the target, you’re not doing it properly. So clearly, you need to change the way you’re doing it.

Gene Tunny  52:49

So as an implication of what you’ve said, are you implying that there’s a risk of the Reserve Bank could increase the cash rate too much, because it’s reacting to CPI data that partly, the inflation is going to be driven by this supply shock? Is that a concern of yours?

Stephen Kirchner  53:12

Yeah, I mean, we’ve certainly seen that in the past. So we talked before about the Fed, and the ECB in 2008 I think clearly made that error. And I think it’s a risk at the moment. At the moment, we have both supply and demand shocks driving inflation. So there’s been a huge dislocation in the supply side of the global economy due to shifts in demand, so that the speed of the recovery has basically caught the supply side of the world economy short. It’s struggling to keep up. And so there’s a big supply component to existing inflation pressures.

In the United States, I’d say there’s also a demand component inasmuch as one of the things that Mercatus Centre has done has been to develop what they call an NGDP gap, which is basically a measure of the deviation in nominal GDP from long-run expectations. At the moment, we have a positive nominal GDP gap in the United States. And so consistent with the nominal GDP targeting framework, that’s saying that there are excess demand pressures in the US economy. And so you would want monetary policy to respond to that. And so I think this is why the Fed is tightening at the moment. It’s appropriate that they do so because there is excess demand in the US economy, and GDP expectations are a good guide. But at the same time, there’s a very significant supply side component to this. And that is something you probably want to look through.

So one way to think about US monetary policy at the moment is the Feds should be tightening with the views of closing that nominal GDP expectations gap on the Mercatus measure. That would require some tightening of monetary policy but not nearly as aggressive as if you were trying to fully stabilise consumer price inflation.

Gene Tunny  55:13

Right. So nominal GDP in the US by that Mercatus measure, it’s higher than that path that long-run path. Is that right?

Stephen Kirchner  55:25

Yeah, that’s right. So on their measure, the level of nominal GDP is running at about, I think, 3% above the path implied by long-run expectations for nominal income. So from a nominal GDP targeting framework, you would certainly want to respond to that.

Gene Tunny  55:41

Right. Now, this is one thing I’ll want to just make sure I understand. In your paper, you talk about how it’s good to correct for deviations from that target path, that nominal path. Why does a target path in nominal terms? Why is that relevant? I think one of the points you make is that, traditionally, central bankers wouldn’t really worry about the nominal path, or they if you did have low inflation for a period, and that meant that you were below that nominal level, it’s not as if you’re going to ramp up, they wouldn’t have a more stimulatory monetary policy just to try and hit a particular GDP number in nominal terms, say two and a half trillion or something, because well, what does the actual nominal value of it matter? What matters is what’s the real value of it and how many people are employed, that sort of thing? I want to understand that. Are you saying that we should try and get back to some sort of the nominal GDP number that was implied by the path we’re on?

Stephen Kirchner  56:54

Yeah, I would say that nominal GDP stabilisation is still implicit in what the RBA and the Fed do today. So if you’re stabilising inflation around target and output around potential, then that will certainly be conducive to stability in nominal GDP. It’s just that we’re not explicitly framing monetary policy in those terms. So at the moment, we frame it in terms of the cash rate responding to deviations in the inflation target, or deviations in output or the unemployment rate from their assumed equilibrium values. All I’m saying is you want to reframe the way in which you implement monetary policy in terms that are currently implicit, but arguably should be explicit.

So really, I’d say monetary policy is trying to stabilise a path for the future path of nominal GDP. Were just not explicit about it. So it’s really reframing monetary policy in those terms, to bring out those relationships. But I think it does it in a way that’s less conducive to monetary policy running off track, for all the reasons that we’ve talked about, that you’re no longer making guesses about the equilibrium interest rate, the equilibrium unemployment rate, or the equilibrium level of real output. You can abstract from all of those things and just ask the question, How is nominal GDP evolving relative to, A, expectations, or B, in my sort of operating framework, you know, where you want monetary policy to be. So just be explicit about that and nominate a target path.

One of the advantages of doing that is in fact, I think, better financial stability outcomes, reason being if you think about the decisions that lenders and borrowers are taking in credit markets, whether it be in relation to housing or business lending or any other type of credit, the serviceability of those contracts depends entirely on the future flow of nominal income. So putting yourself in the shoes of a holder of a mortgage, for example. The amount I borrow is very much a function of what I think my future nominal income is going to be. And the lender is making the same assessment, right? They’re saying, Does this person have the capacity to service a mortgage? Well, that’s a function of what’s going to happen with their normal income in the future.

So by stabilising both expectations for nominal income and actual outcomes for nominal income, I think that’s conducive to financial stability because then the economy is going to evolve in line with the expectations embedded in those credit contracts. So I think you’re less likely to run into financial stability concerns in that context.

So this is essentially Scott Sumner’s critique of US monetary policy in response to the global financial crisis. So what Scott Sumner argues is that the recession in the United States was made deeper by the fact that nominal GDP and expectations for nominal GDP in the early stages of the crisis were allowed to collapse, and that more than anything affected the ability of people to service their mortgages.

Gene Tunny  1:00:42

That’s an interesting argument. I’ll have to have a look back over his work. I’ve seen it in the past. But have you got time for two more questions or do you have to get going? Because there are a couple –

Stephen Kirchner  1:00:52

Oh no, absolutely. Take all the time in the world.

Gene Tunny  1:00:55

Great. There are a couple other things I want to chat about. On page 27 of your Mercatus Centre paper you write, “There’s a growing empirical literature on the advantages of NGDP targeting relative to inflation targeting and other policy rules. I’m interested what that literature is. What does it comprise of? Is it cross-country regression studies, or how do they determine that, that this actually is superior to what we’re doing at the moment?

Stephen Kirchner  1:01:23

So there’s a long history is who the literature on monetary policy rules. And it really goes back to a Brookings Institution project back in the early 1990s. And it was as part of that project that John Taylor published his Taylor rule estimates. And Warwick McKibbin, the Australian economist, was actually an early contributor to that literature as well. And I mean, one of the things I did, as part of that Brookings Institution project was to just simulate different types of rules. So on one hand, you can estimate empirically what the central bank response to macro variables is . But you can also do simulations, where you say, well, what would happen in a economic model if the central bank responded to nominal GDP or some other specification of the monetary policy reaction function.

And I think it’s fair to say that, in that early literature, both nominal GDP targeting, whether in level or growth rate terms, did not fare well, relative to the sort of more Taylor rule type specification. The problem with that literature was that it wasn’t taking account of the knowledge problems that we talked about earlier, which is the unobservability of some of the key conditioning variables, namely the real equilibrium interest rate, either potential output or an estimate of an error. Once you take account of those knowledge problems, then the Taylor rule literature becomes much less robust. And nominal GDP targeting becomes much more robust. So once you allow for the fact that there’s uncertainty around those assumed equilibrium values, then inflation targeting as it’s currently conducted in a Taylor rule framework looks a lot less attractive. So really, that early literature was conditioning on historical relationships, which, when you’re operating in real time, become much more problematic.

Gene Tunny  1:03:53

Okay. I have to ask you about an NGDP futures market. So this was mentioned in your Mercatus Centre paper. Why would that be useful? And what’s the role of Ethereum, so a cryptocurrency, isn’t it? What’s the role of Ethereum in that?

Stephen Kirchner  1:04:15

So if you’re targeting nominal GDP, then one of the things that would be very helpful in that context would actually be a market-based estimate of where nominal GDP is going. People like myself who call themselves market monetarists, the market part of that expression refers to the fact that we think that markets are in fact the best gauge, financial markets at the best gauge of the stance of monetary policy and also what effect any given policy change is likely to have on the economy.

So if you take that view, then what you want to do is get a market-derived estimate of where nominal GDP is going and then base your monetary policy response on that estimate, because that’s going to be your best guess of where nominal GDP is going. And there are various versions of this. Scott Sumner has a version where the central bank would actually tie its open market operations mechanically to prices in that nominal GDP market. So monetary policy would then basically become market-driven. But you don’t need to go quite that far. I mean, it would be sufficient, I think, just for the central bank to take account of what the nominal GDP market was telling you about the stance of monetary policy.

The beauty of this is that any macroeconomic policy measure that you might implement, the nominal GDP futures market will give you instant and real time information on what the market thought that was going to do to the economy. So for example, if you had a fiscal stimulus package, a nominal GDP futures market would tell you basically on announcement, what it thought the impact of that package would be. And my expectation would be that if we had a nominal GDP futures market and you announced a big fiscal stimulus, we would actually probably see very little movement in the nominal GDP futures market because most of the economy crowding out effects that we discussed before, I suspect that in a small open economy with a floating exchange rate like Australia, fiscal policy actually doesn’t do very much in terms of aggregate demand.

Gene Tunny  1:06:45

Right.

Stephen Kirchner  1:06:46

We see that a little bit already, because although we don’t get sort of very clean or discreet announcements of fiscal policy measures, typically when the budget lands every year, and they announce what the change in the budget balance the share of GDP is going to be, which is your sort of best measure of the impact that fiscal policy is going to have on the economy. The national markets very rarely move in response to that announcement.

So the case for a nominal GDP futures market is you want that market to basically inform monetary policy decision making. And it really goes to the issue of what paradigm do you want for monetary policy? The market monetarist paradigm is essentially to say central bank is a lot smarter than financial markets when it comes to assessing where the economy is going. And we should do away with the fiction that they know more than what’s embodied in financial crises. And so conduct monetary policy on the basis of the best available information, which is what financial markets are telling you about the evolution of the economy,

Gene Tunny  1:08:01

What does this instrument look like? And who sets up the market? Does the central bank set up the market? I mean, people are gambling, or they’re betting on what future nominal GDP is. But how’s the market actually work? Has anyone thought about how it would be designed? Does the central bank have to run out or could it be a privately owned market?

Stephen Kirchner  1:08:26

So this could be a conventional futures markets? So we have at the moment futures contracts available, various financial instruments, so there are futures contracts for 10-year bond yields for the Australian dollar. We effectively have futures contracts on inflation outcomes, which is the difference between the prices on bond yields and index bond yields, so that it’s bond yields adjusted for inflation. So we actually already effectively have a futures market in inflation outcomes. And that’s actually a very important input into monetary policy decision making.

So one of the things that the RBA pays very close attention to is what market prices are saying about the future evolution of inflation? So we already have one half of the equation. What we need is the other half, which is to say, a view on what’s going to happen with real output. But if we combine those two things, and what we’re saying is we want a financial market view on where nominal GDP has gotten. So it’s very straightforward to design a futures market contract that you would list on the Australian Stock Exchange, which would be traded by financial market participants.

And I think another thing that would be useful that comes out of this is it would be a very good hedging instrument. So we think of corporations, their top line revenues are in fact often largely a function of nominal GDP. So one of the things the company will look at when they’re forecasting their revenues is an assumption about what nominal GDP is going to do. So corporates could actually use a nominal GDP futures market as a hedging instrument. And that increases the information content of NGDP futures prices. It becomes highly informative of what decision makers in the economy are expecting in relation to the future evolution of nominal income. That information is very useful for policymaking.

And my argument to the Reserve Bank, when I’ve presented this work to them, is to say, Do you think that would be useful input into monetary policy decision making? And of course, the answer has to be yes. You know, you want more information, not less. And so my argument to them is, well, if that information will be useful, then it’s probably worth incurring some costs in order to get that information. So what I’ve suggested is they need to remove some of the regulatory barriers to the creation of a nominal GDP futures market.

A huge regulatory barrier to any sort of financial innovation in Australia is the fact that the costs of financial system regulation in Australia are paid for by the financial sector. So all of the costs of ASIC and APRA in regulating the Australian financial system is recovered from market participants, economic institutions. But that cost recovery framework has a public interest clause, which basically says you should be able to get relief from cost recovery if there’s a public interest in doing so. And so I like it that the creation of a nominal GDP futures market is a perfect application of the public interest case for relief from cost recovery. So basically, the institutions and the Securities Exchanges that would put together that market should basically get an exemption from regulatory cost recovery. I think that would give a huge boost to making that sort of market commercially viable.

Gene Tunny  1:12:37

It’s a fascinating idea, because occasionally, you do have these new financial instruments. I mean, I know in the US they have a market in… Is there a futures market for house prices based on the Case-Shiller Index?

Stephen Kirchner  1:12:51

Yeah, that’s right. There’s derivatives around house prices in the United States. The NSX tried to get a derivatives market in house prices up and running a few years ago. I would argue that, yes, we should have house price futures as well, for exactly the same reasons. It’s informative for policymakers, t gives them information that they would not otherwise have. It will tell you, for example, when APRA changes its regulation of financial institutions. A house price futures market would tell you straightaway what the implications for that are for house prices. It’d be useful hedging instrument as well. So yeah, ideally, I think we should have both markets.

I think the impediments to those markets, given that they are potentially so useful, are most likely regulatory in nature. And so we need to lower the regulatory barriers to the creation of those markets. And arguably, I think there’s a case for implicit public subsidies for those markets as well, so relief from regulatory cost recovery. I think the RBA could use its balance sheet to become a market maker in those markets. So not with a view to influencing the prices, but just providing, being a liquidity provider, which would lower costs for other people transacting in those markets and would help get them up and running.

Gene Tunny  1:14:25

I was just thinking, I was just trying to think, how would this actually start up? And, I mean, you’d need someone to actually develop the instruments, create the contracts and sell them, so that could be say, an investment bank, for example. It could be a Goldman Sachs or it could be a Morgan Stanley or one of those businesses. It’s a fascinating idea.

Stephen Kirchner  1:14:50

Yeah, I mean, in my Mercatus paper, I make the case that the council of financial regulators should jointly mandate the creation of a nominal GDP futures market. And I mean, when regulators mandate something in financial markets, it usually happens. So it’s not uncommon for the financial regulators to actually come out and say to financial market participants, okay, we’re doing this. If it becomes a regulatory mandate, then the financial market participants will cooperate with that mandate. And you know, I think it would be enthusiastic participants. So I think it’s really incumbent upon the RBA to say this is something that we want and need, would be helpful for policymaking and for hedging, as I’ve described. And so we’re going to sit down with financial market participants and make it happen

Gene Tunny  1:15:46

And just finally, you’ve mentioned that there could be a role for blockchain. So you talk about how US NGDP futures have already been implemented on the Augur blockchain. Did I pronounce that right? And then, Eric Falkenstein has also developed Ethereum-based derivatives contracts. These contracts could provide competitive alternatives to listed securities, okay, on existing exchanges and require little or no public support while still yielding useful information about monetary policy in the economy. So is there anything special about the blockchain in this context?

Stephen Kirchner  1:16:22

Well, the role for blockchain I think is just in terms of lowering the costs of doing it. So as we’ve already discussed, there are significant cost barriers to listing nominal GDP futures on our traditional securities exchange. I’ve argued that we should try and lower some of those costs. But another way of doing this is to implement it in blockchain space. There’s already been some interest in doing this in the US. I think, eventually, almost all financial derivatives will move off exchanges and onto the blockchain at some point, main reason being you can then do instantaneous clearing and settlement. So you no longer have trillions of dollars tied up in collateralizing clearing and settlement of financial derivatives. So if derivatives markets are going to move onto blockchain, then arguably NGDP futures should move on to blockchain as well. But I think there’s more scope for innovation in the blockchain space at the moment, just because it’s a different regulatory environment.

And so I’ve sort of argued for a two-prong approach where on the one hand, you want to go through sort of the conventional channel other listed securities market for NGDP futures. But at the same time, I think there’s scope for entrepreneurs to innovate in the blockchain space and do something similar. And hopefully, what we get out of this is a viable future market, not just in nominal GDP, but [with] other macro variables included. And I think it would not only provide policymakers with useful information, but it would really change the way people think about financial markets and monetary policy, because you can’t beat the sort of real-time financial market verdicts on what policy is doing.

It would eliminate a lot of arguments about the implications of various types of public policy, because let’s say the government is proposing a change in some tax rate, and there’s an argument about what the implications of that tax change is for the economy. Well, a nominal GDP futures market will instantaneously settle that argument, because when the tax change is announced, you can observe what the change in the nominal GDP futures is. And that basically tells you what the economic impact is,

Gene Tunny  1:19:07

Assuming the market expectation is correct.

Stephen Kirchner  1:19:11

It doesn’t have to be correct. It’s probably our best guess.

Gene Tunny  1:19:15

Best guess, gotcha. Yeah. I agree. I was just wanting to –

Stephen Kirchner  1:19:19

Ex post it could be completely wrong. At the time of the announcement, it would be the best guess of everyone who actually has a real-time financial stake in that outcome.

Gene Tunny  1:19:31

Yeah, very good point. Okay, Stephen, this has been terrific. I’ve learned so much and it’s made me think about a lot of a lot of things that hadn’t been thinking about before. I love this idea of futures markets in economic indicators. I think that’s brilliant. So yes, I’ll have to come back and explore that in the future. So Stephen, you’ve got a sub stack, which I’ll put a link to in the show notes. I’ll also put links to your two fascinating papers on monetary policy. Any final words before we wrap up?

Stephen Kirchner  1:20:06

I think this has been a great conversation. I’ve really enjoyed it, Gene.

Gene Tunny  1:20:09

Thank you, Stephen. I’ve really enjoyed it too. I must admit, initially I don’t think I’ve really understood this nominal income targeting idea and its merits and what the problems with inflation targeting were as much as I do now, I think I’ve got a much better understanding. So absolutely, really appreciate that. So, again, thanks so much for coming on to the programme. And yeah, hopefully, I have you on again, sometime in the future. We could chat more about these issues. So thanks so much.

Stephen Kirchner  1:20:46

Thank you, Gene. It’s been a pleasure.

Gene Tunny  1:20:49 Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com And we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Big thanks to EP135 guest Stephen Kirchner and to the show’s audio engineer Josh Crotts for his assistance in producing the episode. 

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

Categories
Podcast episode

The high cost of housing and what to do about it w/ Peter Tulip, CIS – EP134

Property prices have been surging across major cities in advanced economies. In Australia, a parliamentary inquiry has recently investigated housing affordability, and it handed down a report with some compelling policy recommendations in March 2022. Our guest in Economics Explored episode 134 provided an influential submission to that inquiry. His name is Peter Tulip, and he’s the Chief Economist at the Centre for Independent Studies, a leading Australian think tank. Peter explains how town planning and zoning rules can substantially increase the cost of housing.  

You can listen to the conversation using the embedded player below or via Google PodcastsApple PodcastsSpotify, and Stitcher, among other podcast apps.

About this episode’s guest – Peter Tulip

Peter Tulip is the Chief Economist at the Centre for Independent Studies, a leading Australian think tank. Peter has previously worked in the Research Department of the Reserve Bank of Australia and, before that, at the US Federal Reserve Board of Governors. He has a PhD from the University of Pennsylvania.

Links relevant to the conversation

Inquiry into housing affordability and supply in Australia

CIS Submission to the Inquiry into Housing Affordability and Supply in Australia

Gene’s article Untangling the Debate over Negative Gearing

Missing Middle Housing podcast chat with Natalie Rayment of Wolter Consulting

A Model of the Australian Housing Market by Trent Saunders and Peter Tulip

Transcript of EP134 – The high cost of housing and what to do about it w/ Peter Tulip, CIS

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:01

Coming up on Economics Explored,

Peter Tulip  00:04

We know that zoning creates a huge barrier to supply. And it’s not clear that there are any other barriers that can account for distortions of this magnitude.

Gene Tunny  00:17

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist based in Brisbane, Australia and I’m a former Australian Treasury official. This is Episode 134 on the high cost of housing. Property prices have been surging across major cities in developed economies. In Australia, a parliamentary inquiry has recently investigated housing affordability, and had handed down a report with some interesting policy recommendations in March 2022. My guest this episode provided an influential submission to that inquiry. His name is Peter Tulip. And he’s the chief economist at the Centre for Independent Studies, a leading Australian think tank, which I’ve had a little bit to do with myself, over the years. Peter has previously worked in the research department of the Reserve Bank of Australia, and before that, at the US Federal Reserve Board of Governors. He has a PhD from the University of Pennsylvania.

Incidentally, here in Australia, we had a federal government budget handed down in late March 2022. But it didn’t take up any of the proposals in the housing inquiry report that Peter and I discuss this episode. The budget extended an existing housing guarantee scheme, which helps a limited number of first-time buyers avoid mortgage insurance. But the budget didn’t really do anything substantial to improve housing affordability. So we are still waiting for improved policy settings here in Australia, which would make housing more affordable. In my view, such policy settings would not include some more radical ideas that have been injected into the policy debate, such as the government itself becoming a large-scale property developer. That would be too interventionist and too costly policy for me to support. In contrast, what Peter is suggesting in this episode is a very sensible and well thought out set of measures that deserves serious consideration from decision makers.

Okay, please check out the show notes for links to materials mentioned in this episode, and for any clarifications. Also, check out our website, economicsexplored.com. If you sign up as an email subscriber, you can download my e-book, Top 10 Insights from Economics, so please consider getting on the mailing list. If you have any thoughts on what Peter or I have to say about housing affordability in this episode, then please let me know. You can either record a voice message via SpeakPipe, see the link in the show notes, or you can email me via contact@economicsexplored.com. I’d love to hear from you. Righto, now for my conversation with Peter Tulip on the high cost of housing. Thanks to my audio engineer Josh Crotts for his assistance in producing this episode. I hope you enjoy it. Dr. Peter Tulip, chief economist at the Centre for Independent Studies, welcome to the programme.

Peter Tulip  03:10

Hi, Gene. Glad to be here.

Gene Tunny  03:12

Excellent, Peter. Peter, I’m pleased to have you on the programme. So earlier this month, an Australian parliamentary inquiry chaired by one of the MPs, one of the members of parliament, Jason Falinski, released a report on housing in Australia. And it quoted you among other economists, and I was very pleased that you actually referred to a paper that I wrote a few years ago on a housing issue here in Australia. And that was in your submission. And yes, you got quite a few mentions in this report, which was titled The Australian Dream: Inquiring into Housing Affordability and Supply in Australia. Now, Peter, would you be able to tell us why is this such an important inquiry, please, and what motivated you to make a submission to the inquiry, please?

Peter Tulip  04:20

Sure. So the report’s huge. It’s 200 pages long. They had hearings for several months. And I think about 200 people or more made submissions to the inquiry. So there’s an enormous amount of information. And it’s motivated by these huge increases in house prices, that the cost of housing has gone up 20% this year, on the back of similar increases in previous years. So you go back a decade or two and the price of housing has tripled. And that’s having all sorts of huge effects throughout Australian society. It’s making housing unaffordable. And that’s reflected in homeowners can’t get into the market, because deposits are incredibly high, renters suffering a lot of stress. There’s an increase in homelessness. Because housing is one of the largest components of spending, the huge increase in housing costs is having a huge effect on household budgets, changing the way we live. 30-year-olds are living with their parents. Tenants are living with flat mates they don’t like. People are having to suffer three-hour commutes to work. Housing affordability is a real problem in Australia.

Oh, sorry. The other huge issue is that inequality dimension is enormous. So society is increasingly divided up into wealthy homeowners who are having very comfortable lives, and renters and future homeowners who are really struggling. And that’s becoming hereditary, because it’s very difficult to get into homeownership without parental assistance. The Bank of Mum and Dad, it’s often called. And so it’s the children of the wealthy that get a ticket, these enormous capital gains. And people without and less privileged, they’re really suffering.

Gene Tunny  06:38

Yeah. Now, you mentioned the big increases in house prices we’ve had in Australia so over 20%, or whatever, since the recovery for the –

Peter Tulip  06:48

Just this year.

Gene Tunny  06:49

Yes, yes. But we’ve seen big increases around the world and in capital cities around the Western world, from what I’ve seen. The Financial Times had a good report on that last year. Was it the case that our house prices were high relative to benchmark? If you look at things like house prices relevant relative to median income, they were high prior to the pandemic. There’s been this big surge since the pandemic with all the monetary policy response. Is that the case that they were already high and they’ve got worse?

Peter Tulip  07:28

Yeah. And there are a lot of different benchmarks. And the benchmark partly depends on the question you’re asking. But Australian house prices are high in international standards. So for example, one think tank, Demographia, put out a league table of housing affordability. And they looked at, what is it, something like, it’s 100 or 200 big international cities around the world. And Australian capital cities have 5 of the top 25 cities in terms of expense, in terms of price-to-income ratios. So that’s one of many possible benchmarks you can use. And by that benchmark, Australian cities have very expensive housing.

Gene Tunny  08:24

Yeah, yeah, exactly. Okay. Now I just want to talk about the inquiry and how it went about its job. I found the preface to it or the foreword written by, I think it was must have been by Jason Falinski, quite fascinating. He talked about two different tribes of people in the housing policy arena in Australia. The first tribe consists mainly of planners and academics who believe that the problem is the tax system, which has turned housing into a speculative asset, thereby leading to price increases. Okay. And then he talks about how the second tribe believes that planning, the administration of the planning system, and government intervention have materially damaged homeownership in Australia. I think I know the answer to this, Peter, but it’d be good if you could tell us which tribe do you fall into? Do you feel fall neatly into one of those tribes?

Peter Tulip  09:30

Yes, I’m in the second tribe, and as in fact, are almost all economists. I mean, this is one of those issues where you get a real division of opinion between economists and non-economists. And a lot of the most vocal of those non-economists are probably town planners. So there have been a lot of economic studies of the effect of planning restrictions on housing prices. And they find very big effects using a whole lot of different approaches. And that’s a result that’s been replicated in city after city around the world there, and dozens and dozens of papers, economics papers showing planning restrictions are a very big factor, explaining why housing is so unaffordable. And town planners don’t like that and complain and they don’t believe that supply and demand is relevant for prices. They will say that in varying degrees of explicitness. The general public doesn’t like to admit that result. They don’t take part in the academic debates.

Gene Tunny  11:04

So we’re talking about restrictions on what you can build in particular areas. So in Brisbane, for example, where I am, we have restrictions on to what extent you can redevelop these old character houses. A lot of these old character houses, these old Queenslanders, the tin and timber houses, they’re protected in the inner-city neighbourhoods. In other state capitals, you have similar restrictions for different types of properties. And so it ends up distorting the development that you see. In Brisbane, we end up with these horrible, tall apartment towers in just small pockets of where there’s some activity allowed because it was formally allied industrial or commercial area. But yeah, it seems logical to me that we are restricting the supply, because if we had fewer restrictions, presumably we’d see more medium density development, or at least that’s what I think. It doesn’t seem controversial to me that supply restrictions would lead to an increase in prices.

Peter Tulip  12:17

Oh, well Gene, now you’re sounding like an economist.

Gene Tunny  12:20

Well, I mean, I read Ed Glaeser’s recent – I think it’s Ed Glaeser.

Peter Tulip  12:25

He’s done a lot of stuff on the issue. In fact, he may be the leading expert in the world on this topic.

Gene Tunny  12:31

Yeah, yeah. He’s very confident in this impact. Now, you’ve done research on this, haven’t you, Peter? You did research at the Reserve Bank.

Peter Tulip  12:43

Before we get to that, Gene, just a comment on what you just said. There are lots of planning restrictions. They come in dozens of different variations. But there are two of them that are especially important, one of which is zoning as it’s strictly and conventionally defined, which is separation of different uses. Most of Australia’s cities, as in fact is the case for a lot of cities around the world, most of our cities are reserved for low-density housing. That’s single-family detached houses. And in most of Australia’s cities, as cities around the world, apartments, townhouses, terraces are prohibited. Where medium or higher density housing is permitted, there are height limits. And so even if flats and apartments were permitted at your local train station, there’ll be a limit on how high that building can go. Brisbane actually, what you mentioned, is not a very bad offender in this, and so particularly around the river in Brisbane, there’s been a lot of tall apartment buildings, and partly reflecting that, apartment prices in Brisbane are pretty moderate. But in Sydney and Melbourne, the height restrictions are really severe. And so as a result, apartment prices are much, much higher.

Gene Tunny  14:28

Yeah, yeah, absolutely. Okay, so you did research a few years ago, didn’t you, when you were at the Reserve Bank, on the magnitude of the impacts? Now these impacts could be even larger now, given prices have increased so much, but do you recall what sort of magnitudes of impacts you were getting, Peter, from these types of restrictions?

Peter Tulip  14:49

Yes, so the effects are huge. The way we looked at it was to compare the price of housing relative to the cost of supply. And in a well-functioning market, the price will equal the cost of supply. But planning operates as a supply restriction, sort of just in the same way as a quota or a licence to supply will. A lot of cities have taxi licences, and it’s the same thing, that you have a restriction on output, so the price goes much higher than the cost of supply.

And we found when you look at detached houses, the effects are huge in Australia’s big capital cities, I think 70%. Around 70% in Sydney, about 60% in Melbourne, was also very large in Brisbane and Perth. I can get into the details of how we actually estimate that. The more important figure for policy is for apartments, because that’s where the real demand for extra housing is. That’s where the big policy debates are. If we do want more dense housing, it will have to come in the form of urban infill. And again, we find very big effects there, especially for Sydney. I think the effect was about 60%, or a bit higher, it raises the cost of housing. In Melbourne, it was moderate, about 20%. And in Brisbane, actually, we didn’t find much of an effect. It was fairly small, just a few percentage points. But as you say, prices have risen very substantially in the, what is it, four years since our data was put together. So those effects will presumably be bigger.

Gene Tunny  16:52

Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny  17:26

Now back to the show. Okay, so we’ve talked about the views of one of the tribes, the tribe that you’re a member of. There’s another tribe, which it’s arguing, oh, it’s all to do with tax policy settings. And, look, we’ve got some quirky tax rules here in Australia. Well, to an extent they’re logical, and which is one of the arguments I made, but they’re different from what happens in some other countries. We’ve got this thing called negative gearing whereby if you lose money on your rental property, taking into account your interest costs and depreciation and the whole range of expenses that are eligible, then you can use that to reduce your taxable income. That reduces the amount of tax you have to pay. And that’s outraged many people in the… There are a lot of people who don’t like that as a policy and think that’s a big problem and leading to higher prices. And there’s also rules around capital gains, concessional taxation of capital gains.

Peter Tulip  18:48

So the whole tax of housing is one of the more controversial parts of this. So can we talk about that?

Gene Tunny  18:55

Yeah, go ahead. Yeah. I’m interested in your thoughts. Yeah.

Peter Tulip  18:59

In fact, you’re the expert on this. In fact, as you mentioned earlier, a lot of what I’ve learned on this topic comes from a paper you wrote in 2018, which was published by the Centre for Independent Studies. It might be easier if you give a quick rundown on what the key issues are. Actually, before that your professional background is probably really relevant here. So in the interest of disclosure, do you want to tell the listeners where you learned about all of this and your experience?

Gene Tunny  19:35

I was in the Treasury, so tax was one of the issues we looked at, but the main research I did on this issue, on the issue of negative gearing and capital gains tax, came from a consulting project I did for a financial advisory firm here in Brisbane, Walshs. Walshs, they clients who are – they have investment properties. And so they were very interested in what the potential impacts of the federal opposition’s policies regarding negative gearing, so changes to that. So basically limiting it and not only allowing it on new houses, if I remember correctly, newly bought properties. And they were concerned about what that would mean for their clients and then what it would mean for the market.

So certainly, negative gearing does make investing in a rental property more attractive. It does two things. So it does lead to more rental properties, and it does push down rents. And it also increases the price of houses to an extent because it does increase that demand. So look, there’s no doubt that it is impacting on prices, but it doesn’t seem to be a huge effect. I got something like 4%. Grattan when they looked at it got 2%. Some other market commentators, I think SQM Research, Louis Christopher thinks it could be 10 to 15%. It’s hard to know, It’s not a huge impact. So you’re not going to solve housing affordability by getting rid of negative gearing. At the same time, there are logical reasons why you’d have it.

Peter Tulip  21:43

Can I just butt in there, Gene? You’re underselling your research. What you said is all right. Everything there is correct. But, in fact, since your study, there have been a whole bunch of further empirical studies and academic studies on the effect of negative gearing, and, and they essentially get the same result as you, that these effects are tiny. So there was a bunch of Melbourne University academics. There was a study by Deloitte and a few others. They use actually different approaches. So the Melbourne Uni study is the big structural model micro-founded in assumptions about preferences and technology. And so we now have a range of different studies, all using different approaches. And they’re all finding the results, the effect on housing prices comes in between about 1% and 4%. So I think we can be more confident than you were suggesting about this result. It’s a big important controversial issue. So we need to talk about it. Listeners need to be aware that it just doesn’t actually matter for anything.

Gene Tunny  23:15

Yeah. So I think one of the main points that’s important, I think, in that whole negative gearing debate is that it is quite a logical feature of the tax system, and as the Treasury explained in one of their white papers, on tax issues, it’s important for having the same treatment of debt and equity if you’re buying an investment property. So I thought that made sense. So there’s some logic to it, and it certainly does improve the rental market. Now, look, there was a huge debate. It was all very political. I thought, well, certainly it would impact house prices. And then that ended up becoming a big story. And there was a lot of discussion about that and just what could the impact on the market be.

Peter Tulip  24:15

Is the problem negative gearing or the discount for capital gains tax? Because they interact.

Gene Tunny  24:21

Yeah, I think that’s part of it. But I think there is a logical reason to have concessional treatment of capital gains, particularly if –

Peter Tulip  24:33

Concessional taxation of real capital gains?

Gene Tunny  24:37

We don’t adjust them for inflation.

Peter Tulip  24:41

We do it both ways. My sense is you can argue that there is distortion, that an investor can put, I don’t know, $10,000 into a property improvement and write that off against tax with depreciation. But then that will increase the value of the property, presumably by about $10,000. And though they get the full deduction, they only have to pay tax on half the benefit. So there is an incentive towards excessive investment in housing for that reason.

Gene Tunny  25:30

Look, potentially, I think you could argue about those capital gains tax settings. Yeah, certainly, I think that was one of the things I acknowledged in the report, if I remember correctly. So yeah, I guess the overall conclusion is that I didn’t think negative gearing was the villain that it was being portrayed as, and if you did make changes to it along the lines suggested you could end up having some adverse impacts. If you look at what estimate I made of the potential impact on house prices, and you look at how much house prices have increased in recent years, you think, well, who cares?

Peter Tulip  26:15

It’s one week’s increase. I think you’re exactly right. And while I say I think there is an argument that it creates distortions, if you fix that up, you then create distortions elsewhere, as you said, between debt and equity, and there are distortions between investors and owner occupiers. And given that so many different aspects of housing are taxed differently, it’s impossible to remove all the distortions. You remove them somewhere, then create them somewhere else. And the bottom line is that this doesn’t really matter, the housing affordability. The effects on prices are small and positive. And there are offsetting effects on renters, which I think are often neglected. Negative gearing promotes investment in housing and is good for landlords. And because it’s a competitive market, the free entry, that gets passed on in lower rents.

Gene Tunny  27:21

Yeah, yeah, exactly. So I’ll put a link to that paper in the show notes. So if you’re listening in the audience, and you’d like to check that out, you can read it. Bear in mind it’s now over. It’s four years since I wrote that, and probably six years since I did that report for Walshs. I think the logic is all correct. And I think the analysis still makes sense because it was a static model in a way. Yes. It was a static model. I was just looking at how much does a change in tax policy settings affect the rate of return for an investment property? So you could argue it’s still relevant in that regard. But the whole political sort of imperative, it’s not as big, it doesn’t figure as much in the political debate now, of course, because the opposition has dropped it as a policy, because I think they’ve recognised that, look, it is unpopular, because there are a lot of people – there have been in the past – fewer people now with low interest rates, but there have been a lot of people in the past who have been negative gearing. So I think they accept that it’s probably not a policy that is popular with the public.

Peter Tulip  28:35

But also, it’s just a non-issue. It wasn’t going to deliver benefits in terms of housing affordability. So I think one of the reasons I dropped it, or at least the reason I would have told them to drop it, was it was just a red herring.

Gene Tunny  28:50

Yeah, yeah, I think that’s correct. That’s how I would how I would see it. Okay, we might go back to the Falinski report. I know it does deal with this issue in the… It is part of the conversation for sure. Where did the Falinski report come down on deciding which of these two tribes is correct? Did it make a judgement on that or did it –

Peter Tulip  29:17

It’s strongly on the side of economists, of those who argue that planning restrictions have large effects on house prices. The commission discussed it in a lot of detail. It’s all of Chapter Three, I think of the report. It’s the first substantive policy-oriented chapter of the report. It’s some of their lead recommendations. And they note that there were… I think they described it as the most controversial issue they dealt with, with very lengthy submissions on both sides.

Their assessment was that the weight of evidence is not balanced. It’s overwhelmingly on the side of those who think planning restrictions have big effects on prices. In fact, they cited our submission, which said there have been a lot of literature surveys of this research. I think we cite six of them by different authors, a lot of them very big names in the policy world. And all of those surveys conclude that planning restrictions have big effects on prices. And the commission recognise that even though it’s hard to tell in the noise on social media, if you look at the serious research, the weight of evidence very clearly goes one way.

Gene Tunny  31:01

Okay. What does that evidence consist of, Peter? You’ve done your own study. Was your study similar to what others have done around the world? And broadly, what type of empirical technique do you use?

Peter Tulip  31:17

So in fact, there have been dozens and dozens or more years of studies on this question, both in Australia and in other countries. The approach we used is… The reason we used it was we thought it was the best and most prominent approach to answer these questions. And it’s been successfully used with essentially the same results in a lot of cities in the United States, some focusing particularly on coastal cities, some on California, some on Florida. There’s a big study for the United Kingdom and a lot of European cities, another study in Zurich in Switzerland, studies in New Zealand, all using essentially our approach of comparing prices with the cost of supply. And they all come up similar results.

Other people have looked at planning restrictions more directly. So for example, we know that planning restrictions are very tight in California and very loose in a lot of Southern and Midwestern cities in the United States. And there, you get a very strong correlation with prices. California is incredibly expensive. Houston, Atlanta, places with relaxed zoning are relatively inexpensive.

Gene Tunny  32:46

So is there a regression model, where you’re relating the price of housing to cost of supply, and then you’ve got some… Do you have an indicator variable or a dummy variable in for planning restrictions? Is that what you do?

Peter Tulip  33:05

So there are lots of different ways of doing it. Yes, people have constructed indexes of the severity of planning restrictions. That’s one way of doing it. The most famous of these is what’s called a Wharton Index, put together by researchers at the University of Pennsylvania, in fact, my old alma mater. Our approach doesn’t actually – and this is a criticism that some people make of it – it doesn’t actually use direct estimates of zoning restrictions, because they’re just very difficult to measure. But when you have prices substantially exceeding costs, you need to find some barrier to entry. And just as a process of elimination, we know that zoning creates a huge barrier to supply. And it’s not clear that there are any other barriers that can account for distortions of this magnitude.

Gene Tunny  34:10

Right, okay. I better have another look at your study, Peter, because I’m just trying to figure out how did you work out what’s the cost of supply? You looked at what an area of land would cost, where it is readily available, say on the outskirts of a city, and then you looked at what it would cost to build a unit on that or a house on that site?

Peter Tulip  34:38

So where it’s simplest is for apartments, because there you don’t need to worry about land costs, and which is a big, complicated issue. But you can supply apartments just by going up. And so we have estimates of construction costs from the Bureau statistics, to which we add on a return on investment, interest charges, a few tax charges, developer charges, marketing costs. There are various estimates of those other things around, and they tend not to be that important. And the difficult thing is getting an estimate of the cost of going up, because as you increase building height, average costs increase. You need stronger foundations, better materials, extra safety requirements, like sprinklers and so on. You need more lift space. So a lot of it involves a discussion of the engineering literature in housing, where we can get estimates of things like that. And they exist both in Australia and in other countries, where the other people that did that. And that’s how we get our estimate of the supply cost.

Gene Tunny  35:59

Okay. That makes sense now.

Peter Tulip  36:03

That’s one way of doing it. There are other ways of doing it. So you can assume that’s the cost of going up. We can also do the cost of apartments by going out. And there you just make an assumption that it’s the average cost of land in that suburb or on that street or in that city, is the land cost. And then you get a cost of going out, which in some cases is a bit higher, some cases a bit lower.

Gene Tunny  36:33

Yeah, yeah. Okay. That makes sense to me. Can I ask you about the recommendations of the Falinski report? It looks like it’s come down. It supports the view that, yep, supply is a big issue. And also, there’s this issue of now we’ve got this issue of young people having this deposit gap, haven’t we, that it’s difficult to save up for a deposit? So that’s another issue. And I think it’s made recommendations that may help with that. I don’t know. But would you be able to tell us what you think the most interesting and the most important recommendations are of that inquiry, please, Peter?

Peter Tulip  37:13

So I think the most important recommendations go to the issues we were just talking about, the planning restrictions. A difficulty with that is that this was a federal government inquiry. But responsibility for planning regulations rests in state and local governments. And so there’s not a lot that the Commonwealth government can do, other than shine a very big spotlight on the issue, which I think it has done. It’s helped clarify a lot of the issues. And it’s putting more pressure on state and local governments to liberalise their restrictions. But I think the most important recommendations is it wants to couple that with financial grants, and in particular, provide grants to state and local governments in proportion to their building activity, so that neighbourhoods that are building a lot of housing get more support from the Commonwealth Government than neighbourhoods that are refusing to build anything at all.

his should help allay some of the local opposition. We get to housing developments, that a lot of neighbours and local residents understandably complain if new housing is going in, in their neighbourhood, without extra infrastructure, without transport, parks, sewerage, and so on. And what the Falinski report says is we’ll help with that, that we don’t want local neighbourhoods to bear the burden of increased population growth, it’s a national responsibility, and so the Commonwealth will help. So I think that will be the most important recommendation, that should improve incentives to local and state governments to improve housing. Want to go to some of the other recommendations that I think are interesting?

Gene Tunny  39:34

Yeah, I was just thinking about that one. They obviously haven’t put a cost estimate in the inquiry report. So they’ve just said, oh, this could be a good idea. But then we’d have to think about what this ultimately would end up costing.

Peter Tulip  39:47

So our submission put dollar figures on it, even though Jason Falinsky didn’t want to sign on to actual numbers. These conditional grants in terms of housing, good housing policies, could be in place of current Commonwealth programmes that are of less value. And one that’s just been in the news a lot the last few weeks is, I think it’s called the Urban Congestion Fund, which is essentially something like a slush fund that the government uses to channel money towards marginal seats. That’s about $5 billion the Commonwealth uses at the moment.

We could remove that invitation to corruption, and at the same time, solve some of our housing problems by instead, by making that conditional on housing approvals. And if you use that $5 billion, divide that by the, what is it, 200,000 building dwellings that get built in Australia every year, that works out at something like $25,000 per new dwelling. A grant like that will provide a lot of local infrastructure. It’ll give you a new bus route, it’ll give you a new park, it’ll give you some new shops. It’ll fix up the local traffic roundabout, and so on. You could do even more than that, if you start looking at state grants and other grants that are currently on an unconditional basis.

Gene Tunny  41:38

Right. So was the origin of this recommendation, was it from your submission, was it, Peter, the CIS submission?

Peter Tulip  41:44

In fact, a lot of people have been recommending a policy, something like this. We talked about it maybe a bit more detail. But the Property Council of Australia actually wrote a paper on this a few years ago, sorry, commissioned a paper by Deloitte, which discusses some of these issues. But in fact, it’s been proposed in a lot of other countries around the world. And so the original Build Back Better proposal from the Biden administration had substantial grants from the US government to local governments along these lines, and that’s been cut back a little bit in their negotiations. They’re still talking about substantial grants from the federal government, to local counties that are improving their housing policies.

Gene Tunny  42:43

Right. Okay. That’s fascinating. Now, I have to have a closer look at that. Yeah. On its face, it sounds yep, that could be a good idea. As the ex-Treasury man, I’d be concerned about the cost of it to the federal government, but you’re saying we’ve wasted all this money on various pork barreling projects anyway, we could redirect that to something more valuable.

Peter Tulip  43:13

And if you want to talk about really big money, you could change grant commission procedures, so that if housing were regarded as a disability, in the formula for dividing up, the GST, the fiscal equalisation payments with the states, then states that are growing quickly and providing a lot of housing should be able to claim money for the extra infrastructure charges that requires. I think that’s consistent with the logic of the Grants Commission processes. And they currently already do this, but something like this to transport. So there is a precedent, and that would substantially improve incentives for state governments to encourage extra housing.

Gene Tunny  44:08

Yeah, yeah. Okay. Just with the supplier restrictions, am I right, did they make a recommendation along the lines that local councils and state governments, they should look at existing restrictions with a view to easing those restrictions? Did they say something along those lines?

Peter Tulip  44:26

It’s not a formal recommendation, but that’s emphasised in several places in the report, and I think it might be… I can’t remember the exact wording. Recommendation one certainly discusses that issue.

Gene Tunny  44:43

Right. Okay. I should be able to pull that up pretty quickly.

Peter Tulip  44:49

It’s not something the Commonwealth can do something directing it. So the wording is a bit vague. That’s clearly the thrust of the report. Yes.

Gene Tunny  45:03

Right. Yep. So the committee recommends that state and local governments should increase urban density in appropriate locations, using an empowered community framework as currently being trialled in Europe. I’m gonna have to look at what an empowered power community framework is sometimes. I haven’t heard that before. I had Natalie Raymond on. She’s a planner here in Brisbane. And she got an organisation called YIMB, Yes In My Backyard. So I’ve chatted with her about some of these issues before, but I can’t remember hearing about this empowered community framework. Have you come across that concept at all, Peter?

Peter Tulip  45:45

It’s something that the report is very vague about.

Gene Tunny  45:50

Okay.

Peter Tulip  45:52

No, I’m not sure what that means either.

Gene Tunny  45:55

I’ll have to look it up.

Peter Tulip  45:57

Should we talk about some of the other recommendations?

Gene Tunny  45:59

Oh yes, please. Yeah, keen to chat, particularly about this idea of tapping into, well, they didn’t recommend allowing people to withdraw money for housing, for a deposit for a house. But they made some recommendation around superannuation. Would you be able to explain what that is, please, Peter?

Peter Tulip  46:19

This, I think, is one of the most interesting recommendations. And it wasn’t explicitly discussed in detail in any submissions they received. But it’s something that I and the CIS have been talking about in the past, so we were delighted to see it get up.

The argument is that people should be able to use their superannuation balances. But people outside Australia, that would be equivalent to something like a 401K or Social Security in the United States, or Social Security contributions in several European countries. People should be able to use those balances as security or collateral for the deposit for their house. And so lenders would reduce deposits, presumably by the amount of the collateral, by the amount of the superannuation balance.

The committee argued that the main obstacle towards homeownership in Australia is getting the deposit together. And this recommendation is directly aimed at making that easier, and it does it in a way that doesn’t cost the taxpayer anything. And it doesn’t jeopardise the retirement income objectives that superannuation is set up to solve.

So there have in the past been proposals that people should withdraw their money from their superannuation to pay their deposit. And the objection to that is that will just undermine retirement income objectives. And in particular, the compulsory superannuation system is set up on the assumption that people are short-sighted and will tend to fritter away their assets if they’re made too liquid. This objective, allowing withdrawals from superannuation is directly applicable to that argument.

But using superannuation as collateral doesn’t is not subject to that argument, that the superannuation balance will only be touched in the very rare and the unexpected event of foreclosure. Historically, that’s a fraction of a percent houses ever go into foreclosure. So it would be extremely unlikely to affect retirement incomes. But at the same time, people have saved this money, it’s their asset. So they should be allowed to use it in ways they want, that don’t jeopardise their retirement income. And using it as security helps in that.

Gene Tunny  49:35

Yeah. Do you have any sense of how the banks will react to this, how lenders will actually react to this? Is this something that will be attractive to them? Has anyone made any announcements along those lines?

Peter Tulip  49:51

Not that I’ve seen. You would hope and expect that if the policy is put together well, that deposits would be reduced by something like the order of the superannuation balance. And it could be a bit more or a bit less. It may be a bit less because the superannuation balances are risky. It may be a bit more because they’ll be growing over time with. We don’t know exactly how those things will factor in. You would hope and expect that deposits would be reduced by about the amount of the superannuation balance.

Gene Tunny  50:34

An interesting recommendation. I was wondering just how much of an impact it could have. But then the way you explained it, I think it makes it a bit clearer to me how this could potentially have some benefit. Yeah.

Peter Tulip  50:54

It’s not huge. The people that most want this are going to be young, first home buyers having difficulty. People having difficulty getting a deposit tend not to have huge superannuation balances. And there are a few numbers floating around. The average super balance of say, a 30-year-old tends to be, I think there was one estimate I saw, it’s about a quarter of the average deposit on a house for a first home buyer. So it doesn’t get you all the way there. It does get you a sizable bit of the way there so that instead of it taking eight years to save for a house, it’ll only take six years. And you use the super for those other two years. That doesn’t solve the problem. But I’m sure there are lots of first home buyers that will appreciate getting into their home two years earlier than would have otherwise been the case.

Maybe the other point to make in this is that I think superannuation is unpopular, particularly amongst young people, because it is an obstacle to homeownership, that people would like to be saving, but instead 10% of their income has gone off to this account that they wont see for 50 years.

Gene Tunny  52:22

Do we think they would be saving, Peter? I wonder. That was the reason we introduced the super system in the first place.

Peter Tulip  52:28

Exactly. Well, there are some people that would like to be saving for a house. Yeah, superannuation definitely makes that harder. And as a result, superannuation is unpopular. The effect of this policy is it changed it from being an obstacle to being a vehicle towards homeownership. And so I think it makes the superannuation policy more popular.

Gene Tunny  52:51

Yeah, yeah, absolutely. Okay, so I’ve got in my notes, and I must confess, I’ve forgotten what your paper… You wrote a paper with Trent Saunders in 2019. What was that about, Peter?

Peter Tulip  53:06

So that’s a big one in the housing area. We did a lot of empirical modelling of the Australian housing market, and trying to put together how the prices and interest rates affect housing construction, nd then how does housing construction feed back under prices and quantities. So there have been a lot of studies of individual relationships in the housing market. But there’s feedback between construction and other variables. So it was always difficult seeing what the full effect was, without allowing for that feedback. And the big result from that paper that got all the headlines was on the importance of interest rates. So partly interest rates are very important for construction. But even more surprisingly, they’re very important for housing prices. And in particular, the big decline in real mortgage rates that we’ve seen over the past 30 years or so, accounts for a very large part of the run-up in house prices over that period.

Gene Tunny  54:20

So with the cash rate, the RBA policy interest rate, it’s expected to go up, and then borrowing rates will go up. And there are some economists and market commentators speculating this could lead to falls in house prices, some double-digit falls, if I remember correctly, in some capital cities. So there’s that issue. I’m keen for your thoughts on that. Also immigration. If we reopen Australia as we are and we have net overseas migration running at 250 to 300,000 or whatever it was before we had COVID, what will that do for house prices?

Peter Tulip  55:09

Our paper tries to estimate. In fact, a big point of the paper is exactly to answer and quantify those questions. House prices are an interaction between supply and demand. And in the short run, the bigger effect on demand is interest rates. And that, for example, is why, we talked earlier, house prices have risen over 20% just in this past year. That was essentially a response to the record low interest rates that the RBA implemented just prior to the prices taking off. And you’re right, our model suggests that that’s going to go into reverse over the next few years as interest rates increase. Interest rates go up and down. And in the long run, you would expect them not to trend so they don’t explain trend changes in prices. The big trend increase in demand in Australia has been immigration. Our population doubles or so every generation or two. And so that creates an ever increasing demand for housing that we need to supply.

I don’t know if you’re about to ask this, but I’ll ask the question. How does this relate to our earlier stuff on zoning? Essentially, they’re asking different questions. Zoning is asking the question, how do we change process in future, how do we adjust policy? The previous paper is empirical. Policy is given, and asks, what explains changes in the past? And they’re slightly different questions. The effect of zoning is to make supply inelastic, like just a vertical supply curve. I’m sorry, I’m waving my arms around, and people listening on a podcast aren’t going to know what I’m doing. But the changes in interest rates and immigration increase the demand curve, shift the demand curve out to the right. And so it’s the interaction of supply and demand that drives house prices. So it’s a combination of rising demand and inelastic supply.

If we fixed up, if we had a better planning regime, that instead of being inelastic, the supply curve would be flatter, would be closer to horizontal. And then these big increases from immigration and low interest rates would result in extra construction instead of extra prices.

Gene Tunny  58:05

Yeah, yeah. Okay. So I’ll put a link to that paper in the show notes. I just realised Trent Saunders, he’s in Queensland now.

Peter Tulip 58:10

He’s at QTC.

Gene Tunny 58:11

Queensland Treasury Corporation, yep. He’s been doing some good stuff. So that’s terrific. Okay. Peter Tulip, chief economist at the Centre for Independent Studies. Thanks so much for the for your time today. That was great. I think we went over a lot of the economics. I’ll put plenty of links in the show notes for people because some of these studies, they’re fascinating studies and also, it’d be good to just… You may be interested in the empirical techniques and in more of the details. So Peter, again, really appreciate your time. Thanks so much.

Peter Tulip  58:56

Thanks, Gene. It was great to talk.

Gene Tunny  58:59

Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com and we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Big thanks to EP134 guest Peter Tulip and to the show’s audio engineer Josh Crotts for his assistance in producing the episode. 

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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EP68 – COVID and Wartime: Comparison of economic impacts

Economics Explored episode 68 COVID and Wartime features a conversation on whether COVID can be compared to wartime, which considers the different scales and scopes of the shocks, and what it all means for prospects for economic recovery. Economics Explored host Gene Tunny, an Australian professional economist and former Treasury official, speaks with businessman Tim Hughes, also based in Brisbane, Australia.

Gene and Tim conclude that a comparison of COVID to wartime isn’t valid. One reason is that World War II required a complete reorganisation of the economy to maximise production for the war effort, while COVID has involved restrictions that have reduced economic activity. 

Links relevant to the conversation include:

Comparing COVID-19 to past world war efforts is premature — and presumptuous

US Council on Foreign Relations Backgrounder on The National Debt Dilemma

Brookings on What’s the Fed doing in response to the COVID-19 crisis? What more could it do?

Australia’s Boldest Experiment (excellent book on Australia’s wartime economy)

Robert Gordon’s The Rise and Fall of American Growth (outstanding book by a leading US economist containing a great discussion of America’s wartime economy)

Aussies over-confident after being over-compensated by Gov’t for COVID-recession

Mint security lapse amazes judge (story about theft from the Australian Mint in early-to-mid 2000s)

Finally, the word Gene got stuck on at 6:55, irredentist, means, “a person advocating the restoration to their country of any territory formerly belonging to it”, according to Oxford Languages.

If you’d like to ask a question for Gene to answer in a future episode or if you’d like to make a comment or suggestion, please get in touch via the website. Thanks for listening.