The visible hand in economics

Rod Oram has had another crack at explaining why he thinks higher output will lead to lower inflation. His argument is, that higher output can help us reduce housing, labour, and business capacity constraints which are dogging the economy.

The first point seems to be his main one, that there are too few houses and so building more houses will reduce house prices . He has a point here, but not a strict point about inflation. House prices rising doesn’t mean inflation, it means that there has been an increase in the price of houses relative to other goods. However, house prices increases can drive inflation by making people feel wealthy, and thereby increasing their rate of general consumption. As a result, all that matters is the rate of growth (return) in house prices, which is driven by short-run demand factors (as supply takes time to adjust).

Now, growth won’t help increase house construction enough to drive house prices down, the constraints holding up house prices are structural. Councils refusing infill, the difficulty of getting consents to build property, these are the reasons that house construction activity has been sub-par. As a result, its not a matter of keeping interest rates low, it is more a matter of regulatory constraints.

His second point is that we need to increase labour skill training and capital to increase output. Yes that would increase output, however it is not current growth that drives investment, it is the expectation of future growth. As a result, the current goal of monetary policy of stabilising prices is the best way of driving efficient long-run investment (by reducing uncertainty).

The third point is that businesses need to innovate. Again this is a business decision, government policy is not trying to stifle innovation and so this doesn’t do anything to defend the idea that keeping interest rates down will reduce inflation.

Ultimately, I think in this second article he switched tack slightly, and discussed situations where we could grow, rather than attacking monetary policy as he did in the first article, which we wrote about. However, I don’t believe that he has shown that all things constant higher growth leads to lower unemployment, all he has done is changed some of the parameters (making people more productive etc).

In this article, Rod Oram discusses the two options he sees for battling inflation:

1. Raise interest rates to slow growth, thereby reducing the pressure on our limited resources.
2. Increase the resource base

Both of these ‘strategies’ would reduce inflationary pressure. One would reduce aggregate demand; the other would increase aggregate supply.

The first strategy is what NZ is doing (and most countries try to do when inflation comes out of the bag). The second ‘strategy’ would be preferable, as it would increase the number of goods we can buy as a nation. However, Rod didn’t tell us how we are supposed to increase our resource base. According to him we can ‘grow it’, so as the economy is growing the resource base will magically grow as well.

I don’t agree with this idea, but I’m going to try and rationalize what he is saying, and then say why I think it won’t work. Many people have been saying that if we had lower interest rates, investment would be greater, which is an increase in our resource base. As a result, this may be his solution, lower interest rates increase investment, which increases aggregate supply. The problem is, if we kept interest rates at a lower level, we are implicitly allowing a greater level of money supply growth into the economy, which will in turn cause upward pressure on inflation. Which effect dominates depends on the productivity of new capital investment, as if new capital is very productive then the increase in resources requires an increase in the money supply for prices to remain constant.

New Zealand currently has relatively low capital productivity (capital productivity has only risen 1.2% in the last 10 years), and at the margin, this level of productivity will be even lower. This implies that any increase in the supply of resources from a lower interest rate will be very small, and as a result inflationary pressures will be strong.

Furthermore, when a firm makes a long-run investment decision what matters is the long run (risk adjusted) cost and benefit of that investment. In this case the short-term interest rate is not of importance, it is the long-run rate of interest that matters (as interest rate changes can be insured against). Uncertainty for the firms investment decision comes from issues of price, if the level of inflation is high there will be significant volatility between the price of goods (as prices would change at different discrete time periods) making the return on the investment more volatile than in a low inflation environment. As firms are risk averse, higher inflation will lead to lower long run investment – implying that trying to grow our way out of inflation will not work.