Confidence in what?

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Economists do not make good psychologists, so when i hear my colleagues talk about ‘confidence’ my skin crawls.

If you feel the same way, and have that roller-coaster desire to make yourself (nearly-)barf, read this collection of ‘confidence’ abuse that Macrobusiness has collected.

This sort of talk is always around, but i blame the RBA Governor for feeding the frenzy with his ‘after the booms’ speech.

As economists, we are taught a framework — it’s a cost-benefit framework … let’s use it!

An axiom is that folks do things when the (expected) benefits exceed the (expected) costs. This framework has everything we need to speak meaningfully about why investment is depressed (expected returns are low relative to the cost of capital) or why consumption is low (expected future spending power has declined).

So what are the folks (Stevens included) saying when they talk about low confidence being the problem?

Are they saying that expected returns are unreasonably low? How could they know that? They couldn’t — no one can say that for sure. No one is any good at forecasting returns over the horizons that matter.

We can talk about the extent to which generally expected returns differ from our own — but would that tell us anything? There’s no information in this about confidence as an economic force. Perhaps it just says our forecasts are too high (or that we are over-confident).

A clue would be if there was nothing we could point to that explained pessimism … But that is not the case.

We are in the midst of a large terms of trade shock. It’s been big so far, and we are probably only at the start of a multi-year event. The mining investment drop off hasn’t even really started … That will happen in 2014.

Every terms of trade boom has ended with the terms of trade over-shooting to the downside. The terms of trade remain wayyyy above the long run average — so the pain isn’t nearly over.

What does theory say will happen as this nominal income shock spreads out across the economy?

The textbooks suggest we will see the return on capital in the mining sector fall, as the AUD is unlikely to fall by enough to offset the drop in export prices. As this sector retrenches, the normal input-output relationships mean that all sectors will experience weak demand and profitability.

There are two obvious consequences of this: a weak labour market and depressed government finances.

In the first case, sectors will shed labour and shutter output (or at least slow additional capacity) as demand from the mining sector falls back and they wait for interest rate sensitive sectors and the external sector to pick up the slack (via a weaker AUD). This will show up as a period of depressed investment, slow GDP growth, and higher unemployment — pretty much what we see just now.

In the second case, weaker company profits and a soft labour market (slower growth in both wages and hours worked) mean less government revenue and larger deficits.

This may feed back via fiscal policy — and is currently doing so. The government is responding by raising taxes and cutting spending, so firms are seeing less demand as both consumers (who are paying the taxes) and governments spend less.

So what’s the ‘circuit-breaker’? A lower AUD. The lower AUD will boost other sectors, and they will eventually pick up the slack.

Why should consumers be happy about this? A weaker AUD is a real wage cut for Australian households and consumers.

I think the weakening AUD will have a larger depressing impact on consumer confidence than usual, as an increasing number of Australians are exposed to a weaker AUD via purchases of online goods.

Ask a 25 year old about the AUD, and they’ll sound like they work in finance … at least they’ll know how much it’s gone down, over what period, and might even supply a quote as to what it’s done to their toy and clothing expenses …

… for the rest of us, there remains the price of the fuel we put into our cars — these complaints have picked up following the AUD’s ~15% decline over such a short period.

So there reasons to think that the returns on investment will be low in the future. If you think this terms of trade boom will end just like every other terms of trade boom, you would hunker down.

If the terms of trade just goes back to the pre boom average, investments will be less likely to pay off handsomely (although some will), jobs will be less secure, taxes will be higher, government services will be reduced, nominal wage growth will be slower, and real wages will fall (via the lower AUD).

We do not need myths about bad government (though we do have one), nor appeals to things that cannot be measured to understand what’s is going on.

So let’s leave the confidence fairies behind — we ought to talk about the real shocks that are hitting the Australian economy (and are likely to continue to do so).

Given these real shocks it is reasonable for folks to have lower expected returns. The RBA cam offset this with lower policy rates. Better regulation — both more predictable governance and more permissive regimes — would also help …

But let’s be clear that the terms of trade drop is a real shock and it is this real shock that is very reasonably lowering expected returns.


  1. I agree with you (and ‘Houses and Holes’ from MB) that ‘confidence’ is really a symptom rather than a cause of the current slow economy. Stevens has fed this, as have commentators like those on MB. But even McKibbin was on this bandwagon yesterday in the Fin, saying that confidence was low due to ‘political incoherence’ and rates shouldn’t be cut because it would not increase investment or stimulate demand but rather cause a misallocation of capital. Here is the guy who wrote papers on central bank NGDP targeting in the 90s now saying a looser monetary policy is neither effective nor desirable when NGDP growth is at 20-year lows! The mind boggles.

    But Ricardo, I disagree with you on the outlook. I don’t think the proximate cause of the hand-wringing is the mining boom; it is low NGDP growth (relative to the 1995-2005 period and especially relative to the unsustainable 2005-08 period) and the low average wages growth that has gone with it (preventing real wage adjustments in declining industries due to downward nominal wage rigidity), which has contributed to the rise in UnN. And the low NGDP growth is attributable to the RBA being too tight for too long. The RBA made ‘too much room’ for the mining investment boom, crushing other sources of demand and consequently overall demand. We should have been experiencing above-trend economic and jobs growth over the last 2-3 years, not below-trend. The RBA were too worried about repeating the 05-08 boom, ie, fighting the last war. What happens now will depend on how much they have learned from the past. Australia did very well in the late 90s (as well as in the mid-80s) despite falling – and record low – commodity prices because the RBA set rates to promote healthy levels of NGDP growth. People worry too much about ‘where the growth/jobs will come from’. This is a perennial concern that is never borne out when the central bank becomes determined to inflate. The AUD is part of it, but the RBA should treat movements in the dollar as exogenous and manage what it can manage. If that means the dollar doesn’t fall that far, but we end up at 1% or zero cash rates for a while, so be it. If and when the necessary monetary accommodation is provided, Say’s Law will operate and growth will arise wherever the market dictates. My guess is this will be partly net exports, but mainly housing investment and more consumption. Our cafes, restaurants and bars should get a boost, but it could well be household and personal services (eg cleaners, childcare, health, etc).

    1. I agree with most of this – i guess we part ways in that i think low expected and actual returns are due to the terms of trade shock.

      i do agree that the RBA can manage behaviour by lowering the user cost of capital (by cutting rates), and i do think it will work as it always has done when they do so.

      I even agree that the RBA has got it wrong this last cycle and is behind the curve. 2% inflation and rising unemployment means you were too tight 2yrs back — if you had known for sure about the coming ToT shock.

      They didn’t but i think they could have been more aggressive this past year.

      1. Yes, I probably hammed up the differences a bit to keep things interesting!

        I agree real wages might need to fall, but as UnN is rising, this has to happen one way or the other. However, I don’t think people will mind too much, so long as nominal wages keep rising and we have more jobs. I also think the RBA can increase expected returns by stimulating more, as you say as well. Given that now we all know the boom is ending, the RBA has no excuse not to go harder over the next couple of years, so expected returns could rise fairly sharply from here if they get their act together.

        1. Yes but if central banks cutting rates really works properly, then we should net be seeing lower and lower rate “peaks”. Now the RBA is cutting. OK. Then there will be a point where they’ll start increasing again. Yes? But I bet rates won’t get even close to the previous peak. And then a new cutting cycle will start… until…. what??? Negative IR?

          Sometimes rate cutting only seems to be like postponing “pain”. What investments are worth to be made now at 2.5% that were not at 3.5% really? Investor moving from term deposits into property hunting for yields? Is that a “good investment”? Yes, easier money might promote investments but bad investments too (which are what will prevent rates from getting to the previous rate peak).

          Are IR peaking lower and lower because bad investments are accumulating and getting larger and larger?

          1. A deep question … I am not schumpeter, but i do think that perhaps this is the way of things. Not sure why, but as capital deepens we tend to see lower rates.

          2. Agree it is a deep question and there is no simple answer. Probably something to do with declining productivity and hence trend real growth. What I would say is that nominal rates got to zero first in the country with the lowest NGDP growth (Japan). So higher NGDP should be associated with higher rates, other things being equal.

          3. Almost by definition, lower rates are supposed to make it more attractive to borrow, relative to saving, isn’t it? If rates are successful, ever more people get enticed into debt at ever lower interest rates. If we assume that there will always be a reasonable proportion of people who will struggle to service their debts even at current interest rates, rates then need to be cut further to give those folks a bit of headroom to encourage spending, not to mention entice yet more folk into debt. And so the cycle goes. Until you get to zero, like we have in pretty much everywhere else outside Aust. All of this means that a few teeny increases will cause massive pain and the extent of the pain is directly proportional to the number of people enticed to borrow at lower rates. Given all of that, I can’t imagine how rates will even get back up to 4% on the next tightening cycle, if and when it ever arrives. I agree with ssec that some sort of ‘reset’ is required at some point to get things working properly again.

          4. There’s a sort of debt dominance of households operating here – somewhat like how a monetary policy impact fiscal policy via interest rates. In this case, higher rates tamp spending and that lowers demand and hence inflation.

            Hard to see a 6% fed funds rate when it took a 3.5% mortgage rate to clear the US housing market.

            Also, hard to see the RBA taking mortgage rates to 7% when 5% has been required to get housing moving again.

          5. IMO, central banks tend to be too “dovish”, and sometimes they even try to use monetary policy for more than it should be used for, as a short term substitution for the real issues. In a people’s democracy, monetary policy is one of the few things that can be decided upon, without much debate and discussion, but because of that very reason, central banks tend to feel much public pressure when they raise or do not cut rates as the public would like. For instance now in Australia inflation is at 2.4% and rates already at 2.5%, with unemployment at 5.7%: one could argue rates are already too low. The goal of monetary policy should be to “smooth” the economic cycle not to completely avoid it. So now we have the govt increasing deficits and spending, to “save” the economy, the RBA cutting rates: sometimes it really feels to me like a panic reaction that is using all the ammunition now and leaving nothing for the future (generations). The RBA for instance could have cut faster instead of this multiple little 0.25 steps and maybe we did not need to get this low already. I also do not see why they would need to cut if govt is not balancing the budget. The dollar seems the only reason forcing them to. In truth I think if the dollar was lower they would be already done with cutting rates. I think we need a lower dollar rather than lower rates!

          6. Perhaps, but we do not get to set the AUD, so they are left with moving the cash rate. Most other economies have lower rates – i think the force of the flows that generates is an important part of this story.

          7. Yeah, what I meant to say is that if the overall system was stable and fundamentally strong, we would not see rates peaking lower and lower. And part of this instability is also caused by central banks, in my opinion, who, at the first signs of trouble, lower interest rates aggressively and, by doing so, simply introduce more instability. It’s a bit like the parents of a kid growing up who come to the rescue at the first signs of trouble: however it’s a much better approach to let the kids learn from their mistakes and work it out now which will only make them stronger in the future.

  2. Your mate CJ had a pretty poor column in the Fin yesterday, seemingly reflecting a complete lack of understanding of monetary policy. So what, I suppose, he’s not Robinson Crusoe. Why do people feel the need to opine beyond their areas of expertise? (Blog commenters excluded of course!)

    1. Yeah, i spoke to him about it. Seems he and WM remain joined in their views. Both warned of an inflation breakout, and have switched to warning about financial stability now global inflation is so low.

      I am less worried – seems that the biggest risks come from the bubble-poppers. Has been the case for ages in most markets. I am not so sure a 3% funds rate in 2005 could have stopped the gfc, but it would have made it smaller.

    2. Defending “understanding of monetary policy” must be quite a hard task after the GFC mess. Still not clear what went wrong there, I guess, but it hasn’t worked at all, has it? The very concept of lowering the cost of money as to make it easier for people to borrow more, when the real issue is that there is too much debt around, it really does not make much sense. By lowering rates now, they are enticing people into more debt, because inflation is too low???? The link between the two is getting more and more muddy.

      I am no expert in monetary policy, just trying to understand it during the last few years: well, it does not sound like a very clear process to me, where policy maker know what they are actually doing. Central banks look pretty much powerless and the tools at their disposal are very limited.

      Let’s see, now the plan is: since the mining boom is ending, we need higher house prices, so we can stimulate more construction. We do not really know if we NEED more houses, but we need to stimulate the economy somehow. Since prices are very high already and people do not want to get into a mortgage at 7%, let’s lower the mortgage rate to 5%. Surely they’ll surely find it an irresistible offer. You see what is not working with that thinking? We do not know if more housing is a good / valuable / needed investment for Australia at current prices, but we have somehow decided it’s the only thing that can save the economy? What if we then find out that we have overbuilt like they found out in the US in 2006? We are lowering the barrier of entry, why? You lower rates and you make bad investment decisions easier to make. But if there was a real business case for more housing investment it would also work at 7%.

      I do not see much difference between this way of managing the economy and the Chinese centrally planned economy. At least the Chinese planners do not hide behind the “free market” paradigm.

      END OF RANT , now time for dinner!

      BTW: my long ASX200 over short AUD is now at up 43% in two years. Yes, we might complain about how things can be improved, but at the same time we play along. cheers and long live the RA blog!

  3. Central banks have plenty of power – the issue is whether they are willing to use it. See where the Yen got to in April compared to where it was a year ago. Compare the US to Europe, that’s the difference between tight Mon pol and neutral Mon pol. The difference to China is that the RBA doesn’t decide what people invest in. I’ve suggested houses because we haven’t built many for a while and we need a big boost to domestic demand because the RBA has been too tight for over 2 years and housing investment is a big sector. But it could be manufacturing investment or consumption – that’s for the market to determine. All easy Mon pol does is meant to do is overcome nominal wage and price rigidity, which can prevent markets from clearing.

    1. Re Japan, let’s see what happens next. So far, all they got is huge volatility…..

      “The RBA has been too tight for over 2 years”, you might be right there… but they also been much too loose before that, including in 2009 and from 2000 to 2007 when they let credit growth run too wild and out of control. But not only in Australia, in basically every advanced economy, rates were obviously too low and debt went unchecked for too long (which we are paying the price for now).

      “I’ve suggested houses because we haven’t built many for a while” what about US pre-GFC and many countries in Europe too? They had a construction boom too and we know how it suddenly has now badly ended.

      “But it could be manufacturing investment or consumption – that’s for the market to determine” these things take time, serious investment (differently from housing speculation) does not come and go from morning to evening and it’s definitely not a 2% difference in rates that makes a business case. There’s other factors that are much more important.

      “All easy Mon pol does is meant to do is overcome nominal wage and price rigidity, which can prevent markets from clearing.” monetary policy becomes often a replacement for what it’s not working. It’s monetary policy that is too easy which *temporarily* bails out and supports bad investments and prevent markets from clearing properly; hence we get lower and lower rate peaks, and bad investments are accumulating, investments that were done under the wrong assumptions.

      1. Just compare Japanese GDP growth for Q4/12-Q1/13 against Germany and France. The difference is easier monetary policy.

        Not sure what you mean by saying ‘serious investment’ – whatever that is – takes time and depends on ‘other [non-interest rate] factors’. Perhaps you can elaborate? Investment, serious or otherwise, does not happen when there is over-capacity relative to demand, as there usually is when growth is slow and expected to remain slow. That’ much of the developed world right now.

        Housing only goes up in Australia because we have a growing population, high and rising construction cost and land use restrictions. Remember, housing is one of life’s basics. It provides an essential service, a lot more essential and valuable than producing widgets that other countries can produce more cheaply. CJ has actually made this point very well a number of times.

        What problems does monetary policy substitute for/overcome if not wage/price rigidity? Your approach to market-clearing is redolent of Andrew Mellon’s dictum of ‘liquidating’ everything, to “purge the rottenness out of the system”. Yet most people agree that the Depression only really ended thanks to WW2. I don’t see how making a load of tanks and ships and losing thousands of young men in war helped the US economy to recover other than by stimulating demand in a hugely wasteful fashion.

        1. “Just compare Japanese GDP growth for Q4/12-Q1/13 against Germany and France. The difference is easier monetary policy” I am not sure I agree with this, fiscal policy (austerity in Europe) is the real difference IMO. Plus there are other social differences that are much more important than monetary policy.

          By “serious investment” I mean businesses, small and large, factories, innovation, the “real” economy. Not selling a few existing houses to each other at a higher price to create the temporary illusion of wealth, just because I can borrow more at lower rates.

          I do not have a problem with house prices going up (why not? it’s free money for me too) .. but I have a problem with people borrowing too much and carry forward demand from the future. We all know we then all have to pay for it, when we find out that people have too much debt and it can’t be repaid. And this includes the govt too, the RBA is making more debt cheaper for them too.

          It’s not monetary policy that caused WW2. Printing more money would not have changed anything. I still think central banks suffer too much of short termism in general. Cutting rates is used too easily as the solution for every economic problem. Raising rates is always the last resort. You can’t tell me you think central banks have done a good job in the last 10 years?!? Where were they when credit was growing at > 10% p.a.?

          1. The US and UK have done lots more ‘austerity’ than Germany and France, but are performing much better.

            Businesses producing what? No one knows; the market can decide this and my point is that housing may be the most productive thing we can devote resources to right now. That’s certainly what the market is indicating, with even our anemic overall growth manifesting most strongly in greater demand for housing. You make it sound that people buy houses purely to speculate. Look at vacancy rates – they are not high – people are living in these houses and paying mortgages or rent because of the value of the accommodation services they are receiving.

            Not sure how to decipher your final para. My point was not that monetary policy caused WW2; it’s that your suggestion of not loosening monetary policy and allowing markets to self-clear did not work in the 1930s. The only thing that worked was coming off the gold standard (ie looser monetary policy) and later, massive unproductive government spending courtesy of WW2. We don’t want a repeat of that!

          2. OK, let’s agree at least on one thing :) Comparing 1930 to today is a bit of a wasted time. The world today is completely different. It’s actually so different that whatever worked or did not work then has no usefulness in establishing what would work or not work today.

            Regarding GDP growth in economies around the world, I think the equation is quite complex and monetary policy actually a minimal part of it. Unfortunately there’s no magic economic formula for growth, otherwise we would definitely all use it.

            Re housing: be careful, because housing investment it’s pushed so much that it’s hard to work out if it’s really a sound investment. Housing is at the core of our major banks profits. You can go into a bank and borrow 80% of an investment property easily, especially if you have existing equity, try to do the same to start a business or invest in shares. Add to that negative gearing and you’ll see why ‘investors’ are piling into housing right now while the RBA is busy cutting rates (first home buyers are nowhere to be seen). Pushing more and more debt while unemployment is tipped to go higher…. I am fine with this as long as we then do not have to bail them out if things do not work as planned.

          3. I’m afraid I completely disagree with your first para!

            Banks don’t care what’s a sound investment in some wider sense; they care what’s safe. and home lending is safer than business lending, in terms of arrears. Again, CJ has provided some good data on this. Negative gearing is a distortion, but one that applies to shares as well. And in part it could be regarded as compensating for the distortion that is CGT (don’t get me started).

          4. “I’m afraid I completely disagree with your first para!”
            I knew it ! :)

            On housing you seem to have forgotten what has happened in the US, Ireland, Netherlands, etc! “Safe as houses”. The probability that it will happen here is low, but it can’t be ruled out and the RBA should monitor that very closely (which central banks have not done at all – pre-GFC).

            Why is the RBA pushing for people to get into more debt, while at the same time they are forecasting unemployment to go higher? Will someone get hurt in the name of the “common good”? When will the old trick of more debt to support growth not work anymore? Again, why are rates peaking lower and lower? Many questions without answers …..

          5. Been to switzerland before?

            Life there is pretty good despite super low rates.

            It has been a long time since their last war – perhaps the low real rates reflect decreasing returns to capital?

            I just do not think low rates or larger debt are signs of sickness.

            If the capital stock is larger, why shouldn’t we have higher debt and lower rates?

          6. I find this stuff odd – if the CB controls demand via rates, and a part of that is cashflow control (raise repayments and you take money out of people’s pockets), then why is it a problem if the mortgage ‘set’ means that as the CB raises rates they will cause more harm at lower rates when they start tightening?

            It is hard to see the need for much higher rates when even modestly higher ones would cause a lot of damage.

          7. I mean debt appear high as it was inflated due to a tax arb. Once the A and L positions are collapsed the netherlands isn’t drowning in debt or anything dramatic like that.

          8. I don’t think there’s anything too surprising about the fact that property prices have fallen during a recession. The recession seems to have caused the price drop rather than the reverse. Netherlands can’t loosen monetary policy as they’re in the Euro. Hopefully we can avoid the same fate.

          9. Interesting that the same story links to another saying UK house prices have leaped to an all-time record.

          10. Ricardo you say “It is hard to see the need for much higher rates when even modestly higher ones would cause a lot of damage.” OK, so rates will stay low. But then what happens when the next recession hits and rates are already very low? CB will be unable to provide the same stimulus. That’s why I think they want to be able to go back to more normal levels (but they can’t)

            Rajat, “The recession seems to have caused the price drop rather than the reverse.” the issue is that they tend to feed on each other. A small recession can have a large impact on a highly-debt economy. The lower the rates, the more debt outhere, the less resilient we will be to the next recession and the hardest the recession will hit.

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