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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.

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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.

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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.

Female speaker  16:57

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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.