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Status Games and Central Banks

February 12, 2010

Matthew Yglesias wonders why the pay of central bankers doesn’t regress toward a mean:

The Australia/New Zealand spread is especially dramatic. The convention, I guess, is that you can’t just recruit a central banker from abroad. But considering that Australia and Canada have outperformed the larger economies during this crisis and have low-wage central banks, it seems like someone might want to consider poaching one of those guys to run a bigger economy.

I think the one way to really explain this is within the context of signalling status. The Reserve Bank of New Zealand does operate under more of a contract-type structure, which stems from the 80′s, when New Zealand came close to privatizing their central bank. That may account for the difference between Australia and New Zealand…but why does Honk Cong’s chief make such a large amount of money compared to the rest? And why does Ben Bernanke make so little?

I submit that being the Fed chief is much more prestigious of a position to occupy than any other in the world. This lines Fed chiefs up for a high level of other career opportunities…including writing memoir’s of course. Everyone I know has read The Age of Turbulence, but I don’t even know if any of Hong Kong’s central bankers have ever written a memoir. As Ryan Vann points out in the comments, this is the permanent income hypothesis in action.

But more broadly, the “law” of one price severely breaks down outside of economic models, both at the macro level, and microlevel. For example, the most important test of this theory has been the creation of the European Union, and the Euro currency. As the theory goes, the large-scale dropping of trade barriers, the mobility of people, the reduction in currency transaction costs, and greater price transparency should have led to a convergence of prices across the EU. In reality, the opposite happened. Between 1998 and 2003, the standard deviation of prices within the eurozone rose from 12.3% to 13.8%…exactly the opposite of what the theory would predict [EuroStat].

If you would like to see this divergence from principle on the micro level, you can read about a study of London’s ketchup market done by James Monetier in his book, Behavioral Finance (pp 29-31). He found deviations of up to 43% from the theoretically predicted price. Where are the arbitrageurs taking advantage of this free lunch (and maybe even eating a tastier lunch)? Of course, in the real world, arbitrage opportunities take time to discover, come and go, and can be hampered by various barriers.

On Yglesias’ last point, small countries that don’t happen to operate the world’s reserve currencies are free to devalue whenever they see fit. In fact, according to Lars Svensson, it is a “foolproof way out of a ‘liquidity trap’”. The US, by contrast, would face many international problems in doing an outright devaluation, including being called out for our “beggar thy neighbor” policies (sound familiar?)…and this chorus would be much louder, being we operate the world’s reserve currency. So while small countries do have an easy way out…the US needs to focus on an easy way to avoid the situation altogether. Maybe that is a higher inflation target, maybe that is a nominal spending target, or maybe that is managing interest rates on reserves.

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