Very interesting links

Following my previous post on the Debt Reduction Taskforce, I thought I would provide some links that explain my views on monetary theory more explicitly. Essentially, the money multiplier is a myth, and money is created first by debt, and reserves are accumulated after the fact if necessary - try Bill Mitchell’s blog for an explanation of Modern Monetary Theory (which is close to my personal views), and this site for more detailed discussion on the multiplier myth.

Ross Gittins reiterates my population growth arguments

Environmental concern and unemployment – a negative correlation. We are all too happy to worry ourselves about the environment when the going is good, but in a recession we suddenly shuffle the environment down our list of concerns.

Update on skills shortage and emigration of Australian trained professionals. This recent research suggests that “positive selectivity is stronger where the reward to skill in the destination is relatively large”. Translation: those who pay get the skills they desire.

Economists applying statistical techniques to strange social phenomena - worship and sacrifice:
The theory we test is that, when faced with uncertainty, individuals attempt to engage in a reciprocal contract with the source of uncertainty by sacrificing towards it. In our experiments, we create the situation whereby individuals face an uncertain economic payback due to “Theoi” and we allow participants to sacrifice towards this entity. Aggregate sacrifices amongst participants are over 30% of all takings, increase with the level of humanistic labelling of Theoi and decrease when participants share information or when the level of uncertainty is lower. The findings imply that under circumstances of high uncertainty people are willing to sacrifice large portions of their income even when this has no discernable effect on outcomes.

The Superstar Effect – when you receive massive gains from being marginally better than second best. The paper is here. I read once that the Beatles were probably underpaid for the wellbeing they imparted on the masses through their music. My view was that they earned a pretty penny. They were probably only a little better than the next band that would have formed and become an international sensation had the Beatles never existed. In the purest economic sense they were superstars.

Population problem? It’s called longevity

Population growth advocates often rely on the ‘age dependency ratio’ as their core economic argument.  This ratio is the population aged over 65 divided by the population aged 15-64.  To give this measure meaning there is an assumption that people will not work beyond age 65 and will therefore be need to be financially supported by those at a working age.  Workers will get less of the return on their productive output because it needs to be shared with more non-workers.  Essentially, the percentage of people in the formal economy will decline. 

I have a different opinion on the age dependency ratio. I see it as a shining beacon of success.  People are working for shorter periods of their life.  We as a group are finally taking some of our productivity gains of the past half-century in the form of leisure time. 

Whether or not you agree this a problem, the suggested solution of population growth is, in reality, counterproductive, and will only aggravate the situation.  An increase in the dependency ratio is principally caused by improving longevity. If each generation lives longer than the last we will face this problem even with a growing population. Simply adding more at the bottom of the population pyramid to keep it bigger than the top has the apt label ‘population Ponzi scheme’. Indeed, to counteract this trend would require a significant increase in the natural birth rate, or age biased migration policies, or even the extreme scenario of sending migrants back home when they hit 65.  None of these are desirable.

Debt reduction taskforce - bad timing

Tony Abbott recently announced his plan to establish a debt reduction taskforce to reduce government debt that he believes Labor foolishly incurred. I have no problem with governments paying down debt and aiming to have a zero debt balance over the business cycle, but does he really think that governments should pay down debt while the citizenry is trying to do the same? To me this sounds like a recipe for disaster.

Debt deflation is what happens when indebted households and businesses start to pay off debt after a period of debt accumulation. Money used to pay debts is not used for consumption and no longer circulates in the economy. This decreases demand, but also reduces the money supply. The net effect is to slow economic activity and reduce prices (deflation). To read quality analysis of debt deflation read Steve Keen’s superb articles here.

The government response to this should be to print money. Because a portion of the new money is used to pay debts, a far smaller portion circulates in the economy to cause inflation. If it is done well, it should slow deflation, keeping demand and prices stable, and allow debts to slowly be repaid without the value of debt rising in proportion to incomes.  Whether this will promote further malinvestment (investing in non-productivity improving assets) remains to be seen.

Establishing a taskforce is a clear sign that it is not Abbott’s intention to pay down government debts by printing money. His plan appears to be the reduce government spending to pay debts – the exact same thing households are currently doing.

This will only exacerbate the decline in demand and accelerate our march towards deflation.

Competition Series Part II: Theories, assumptions

Let us look at the theory to see why the productivity gains from Australia’s pursuit of competition reform have been so hard to come by. Oliver Williamson’s 1968 model of the competition-coordination tradeoff is a good starting point.

The assumptions in Williamson’s model are that the monopoly industry has a lower marginal cost than competitive firms, that the monopolist sets their profit maximising price according to traditional economic theory, and that in a competitive market firms set their prices at marginal cost.

The graph below shows the resulting welfare implications of this model.

In this situation, while the competitive firms face higher costs (MC2), they set a price lower than the profit maximising monopolist (at P2 instead of P1). The welfare implication is that the area A is transferred from producer to consumer surplus, area B is the loss of producer surplus due to coordination costs, and area C is the gain to consumer surplus. There is a net loss of social surpluses (including all producer surplus) from competition in this model, however there are significant gains to the consumer surplus (areas A and C).

For a net gain to consumers in this model, two conditions need to be met:

1. The profit maximising price of the monopolist is higher that the marginal cost to the competitive producer (MC2 < P1), and
2. The competitive producers set prices at marginal cost (P2=MC2)

Unfortunately, neither of these conditions can be known in advance. In fact, if we drop just the second assumption, which has been proven many times to be far from realistic, the chances of a competitive market generating greater surpluses than a profit seeking monopolist greatly diminishes. In the above diagram this would mean that P2 is somewhere above MC2 (and of course we still don’t know if MC2 is below P1).

Scared of deflation?

I have always been puzzled at the assymmetry of 'flation fear'.  A little inflation is good, but a little deflation is a scary thing.

Paul Krugman outlines the general argument as follows:
So the argument that deflation is a bad thing is also an argument saying that some economic problems get worse as inflation falls, and that too low an inflation rate may actually be economically damaging.

For the life of me I can't see how an inflation rate of zero can be damaging in the long run.  Also, if we look at Krugman's argument in reverse, more inflation is better.  Why isn't the optimal inflation rate zero instead of some positive number? Why 3% instead of 10%? Do human have an inbuilt behavioural trait that only we are able to plan and invest knowing that currency in the future will worth less rather than more?

Steve Landsburg on the other hand makes the argument that deflation fears are not justified by economic theory or evidence - I don’t see the problem in theory and I don’t see the problem in practice.

And he concludes that even if deflation is bad, it is easily solved.
Even if deflation is a bad thing, we know how to solve it. Print enough new money and people will eventually start spending it. It’s alleged that no matter how much you print, it can all just fall into the liquidity trap, and it’s alleged that this is what happened in Japan over the past decade. But I am sure the Japanese just didn’t try hard enough. Liquidity trap or not, I guarantee you there’s a central banker in Zimbabwe who knows how to fight deflation. If we really get into trouble, all we have to do is hire him.

As I have noted before, the world survived just fine for a long period of time with inflation at zero on average. Positive inflation in the long run did not occur until post WWII. Some might even argue that this is simply the longest ever business cycle stimulated by enough debt to keep inflation positive, and that the next fifty years, subject to international politics, might see prolonged deflation.

Avoiding deflation in the short run may have made the global economy far less stable in the long, long run.

Maybe it is just that with high debt levels adjusting to deflation from a persistent inflationary environment will unsettle much investment, and mean a transition period were many jobs are lost.  Any thoughts?

Competition Series Part I: Experimentation

The annual ACCC Regulatory Conference was held last week at the Gold Coast. At a time when various governments are intervening to separate Telstra’s business, sell public railways, subsidise a fibre broadband network, and introduce competition in water markets, any evidence on the effectiveness of competition reforms in such network industries would be helpful. Yet my take home message was that nobody is sure if competition reform has provided, or even can provide, the social benefits it was designed to achieve.

Ironically, in the second session of the conference the following findings were put forward:

...in most circumstances, profit maximising vertical integration decisions are efficient, not just from the firms’ but also from the consumers’ point of view. The vast majority of studies support this claim,.. even in industries which are highly concentrated…

However, the thrust of competition reform is directed at unbundling vertically integrated monopolies to reduce potential abuse of market power.  Railways, electricity, and telecommunications are classic examples, yet a quarter century of evidence shows that vertical integration is in fact the efficient outcome for both producers and consumers. I would note however, that even where market structures appear to be competitive, price competition and innovation may still fail to eventuate.  On the other hand, monopolies may innovate simply due to a the threat of competition. Arguing that competitive outcomes will be achieved based on market structure alone is flawed.

That got me thinking. Is competition reform more about ideology than social gains through efficiency? Are we just swapping government incompetence at regulating and incentivising its monopoly with incompetence at developing sufficient regulation for a competitive market operate while still relying on government owned monopolist components of the value chain?

This post is the first in an August series on competition which will follow my emerging understanding of this controversial topic. I hope to investigate key theoretical assumptions, investigate the history of competition reform, compare theoretical outcomes with real evidence, and identify regulatory shortcomings. In doing so my personal opinions will become known, yet I hope that some debate will challenge these opinions. Any comments and criticisms are welcome.

Quick housing update and forecasts

The residential property bears breathed a sigh of relief with the release of the monthly RPData hedonic price index for June - down 0.7% (with Brisbane prices down 1.3%). The bulls however are happy enough with the 20% capital growth performance since June 2009.

In light of this, Steve Keen has laid out his forecast of things to come in residential property:

Firstly, with an increased stock of unsold houses on the market, buyers are likely to take yet more time to make a decision—which will add further to the backlog. If prices are falling, why hurry? The urgency will leave the buy side.

Secondly, so-called investors—whom I prefer to call speculators, since 90% of them have bought existing properties rather than built new ones—will start to consider whether they should swap from the buy side to the sell side. After all, no-one in their right mind buys an investment property in Australia for the rental returns: it’s capital gains or nothing DownUnder. Do you capitalize on gains to date, or hang on hoping that the upward trend will re-assert itself once more?

I expect these two processes to lead to an accelerating rate of decline in house prices now, as they did in the USA when “Flip That House” ceased being a winning trade.

Chris Joye has made a typically broad prediction:

Rismark had been forecasting a substantial deceleration in housing conditions back to single-digit annualised growth rates since October 2009. Over the long-run, house prices track purchasing power quite closely. Disposable household incomes were only projected to rise by about 5 per cent in 2010. We’ve had 4.7 per cent growth in dwelling values in the year-to-date. We do not, therefore, expect to see the market rise much further over the remaining year subject to labour market conditions and the course of monetary policy.

Interestingly, Joye notes the decline in housing credit outstanding, but does not seem to believe this will strongly influence prices in the near term.

Finally, over at Delusional Economics we have this gem:
There is no "soft landing" for a debt driven economy that suddenly decides to shun debt

Economic myths - another dose

Population growth

I have written at length on why population growth does not improve welfare. Mark Crosby over at Core Economics reiterates these fundamental arguments.

The pro-population growth arguments are theoretically flawed, and empirically dismissed. Below is a chart of the relationship between population growth and GDP per capita for around 200 countries and localities, showing a distinctly inverse relationship. If I was in the business of improving welfare, low population growth would be a key avenue.

Another emerging myth is that population growth will decrease interest rates. Renowned property spruiker Chris Joye has created plenty of media fanfare recently with his spurious connection between population growth and interest rates. This table shows the interest rates in 23 countries, and if I’m not mistaken, shows that countries with the lowest population growth (and highest GDP per capita) also have the lowest interest rates.

Food

Food myths are widespread. The environmental movement wants us to believe that vegetarianism is better for the environment and that ‘organic’ (what does that mean?) food is more nutritious and can solve hunger around the world. The agricultural lobby would have us believe that food self-sufficiency is of utmost importance, although their argument is shallow at best.

The latest myth to be busted is that chickens are pumped with artificial hormones and steroids to make them grow faster and larger. However, it appears that hormones are not part of the poultry picture at all.

While I firmly believe that raising animals for food should be conducted in a humane manner, those who push for change would garner more support if they were fully informed of current practices - their message could then be taken seriously by industry and government. Furthermore, the organic food movement could concentrate on promoting farming practices that reduce externalities, as a result of chemical use for instance, and improving land quality. The incentives for such change often align with the long term goals of the agricultural industry and may attract wider public support.

Safety

Under the rebound effect banner I have discussed how some innovations to improve safety can backfire if peoples’ behavioural response is to take on more risk. For example, the vigorous uptake in sunscreen use has led to a culture of sun exposure, offsetting the intended consequence of reduced skin cancer rates. The name for this behavioural response in the context of risk taking is the Peltzman Effect.

You can find this type of response in broad range of situations. Most recently, in trials of automatic lane correction technologies in cars, one participant noted:

...that she would love to have this feature in her own car. Then, after a night of drinking in the city, she would not have to sleep at a friend’s house before returning to her rural home

Minimum wage

The business lobby loves the textbook response to minimum wage laws, but even world renowned economists are sceptical.  No doubt this debate will continue.

Stay informed for Election 2010 - Labor Factions: Basic Questions Answered

By Andrew McMicking

Why does the ALP have factions? What are the benefits?

Factions have been set up to serve a useful purpose in the ALP. In brief they:

• Allow support to be readily marshalled behind candidates and ideas.
• Provide for a sharing of power between different philosophical or ideological interests in the party.
• Serve as a mechanism to settle disputes.

Any organisation or group of people – be it the workplace, a golf club, church group or school classroom – will always see groups of like minded people associate more readily together. The ALP has recognised this and, through factions, has formalised such groupings. Members and unions in the ALP can now formally apply and join a faction. Each faction usually has a membership list, executive, AGM, bank account, fundraising activity and negotiation committee for dealing with other factions. This formalised nature allows the principle of solidarity to be applied i.e. a decision is made within a faction and all members are bound to abide by that decision.

What is Right and what is Left?

You often here the terms ‘left wing’ and ‘right wing’ applied to factions by both the media and in public discussion. In political/philosophical terms, ‘right wing’ means you tend to take a more conservative and pragmatic view of policy issues, whereas ‘left wing’ means you tend to take a more reformist or progressive view. Support for a budget surplus, tax cuts as opposed to more government spending, a close defence relationship with the US, free market economics, less red tape for business and uranium mining is regarded as ‘right wing’. Support for greater government spending on health, education, disability services and infrastructure, an Australian Republic, recognition of the rights of indigenous people and other minority groups, and opposition to the war in Iraq is regarded as ‘left wing’.

What do we currently have in Qld? Federally?

The ALP, in each State, have factions which can be classified as either Left or Right.

In Qld we have The Left as a left wing faction. However we have two right wing factions: Labor Unity known as the ‘Old Guard’ (refer page 3) and Labor Forum known as the ‘AWU’ faction (as the AWU, Qld’s biggest union, dominates this group). These two factions are now in close alliance together and many view them as one right faction. They technically remain separate entities, though, and many in Labor Unity would not see themselves as a right wing faction, but more in the centre between The Left and Labor Forum.

Is residential property Super?

The retirement plans of working families may soon succumb to Australia's residential property mania. If Chris Joye had his way, Australian super funds would invest in the emerging residential equity market to diversify their portfolios against highly correlated domestic and global equities markets. The argument for this move is summarised below.

Investors, such as super funds, get extremely low-cost, highly enhanced and very long-dated exposures to what has, during the past three decades (including the recent calamity) been the largest and best performing of all investment classes: residential real estate. Historically, investors have only been able to access highly concentrated, risky development-style holdings comprising small parcels of properties that incur heinous transaction costs of about 12.5 per cent. By investing in a portfolio of thousands of shared equity interests, super funds could avoid all of these costs and secure the low risk diversification that they have never had before. Independent actuarial analysis suggests that about 15 to 30 per cent of all super fund capital should, in theory, be allocated to housing, in part because its returns are so unrelated to the performance of other investments. Compare the 50 per cent plus losses in shares and listed property trusts in the past year with the fact that the RP Data-Rismark Australian House Price Index has tapered by only -0.8 per cent. (emphasise added)

Is this idea worth embracing? Or to put it another way, how many people would actively choose to invest superannuation in the residential property market?

Super funds investing in residential property equity face a couple major of problems in my view:

1. decreasing the diversity of investor portfolios, and
2. moral hazard associated with residential equity finance.