Comments on the London riots

I have a mind that continually seeks answers, and have therefore had an interesting time looking for answers to the London riots. The question is - why are people rioting?

Clearly there was a legitimate protest last week about police violence and the shooting of a man. But why would that lead to people completely unrelated to the event participating in social media facilitated rioting and looting?

Last night’s 7.30 report had a good interview with a former UK police advisor who pinpointed a growing pool of disengaged citizens, perhaps from families with generational unemployment and council housing – a pool of people with nothing to lose who are attracted to the excitement of the riots and the opportunity to be part of something, since they have never themselves felt like part of society.  This seems a reasonable explanation to me, but doesn't really help explain what type of actions government might want to take in the future to help avoid the situation.

Tyler Cowen links to some academic studies on the economics of riots, noting the importance of opportunity cost, chance of punishment, ethnic and cultural diversity, but not of poverty.

Here are some reader comments from Bristol West’s Liberal Democrat MP Stephen Williams’ blog that I found had some interesting angles. (ht:Chris M)

• The main thing to come out of this for me is how out of touch with today’s youth, and particularly the ‘lost’ youth, the government is. It’s not only the greed that caused this. It has as much to do with fun. These people were visibly enjoying themselves, it’s like heaven for them. Violence, hate and destruction are an intrinsic part of their lives. They love it, and the inability of anyone in power to understand why is why the problem will never go away.
  
• It’s the way this round of civil unrest has a weird consumerist spirit that seems genuinely unusual. Reports of looters standing around deciding what shops to kick in based on what stuff they want; of kids trying on different pairs of trainers in a kicked-in JD Sports before picking which ones to take. Even while burning buildings, smashing cars and attacking police, the looters retain a well-disciplined sense of their need to make ‘wise’ consumer decisions, and remain obedient to market-based desires.
  
• As usual an MP with no regard for considering who might be at the root of this unrest ie the bankers, politicians and big businesses who dont pay their taxes and make us all look like fools while they live in their Surrey mansions. How about, just for once, coming up with some policies that help people to make a contribution to their comminities instead of slashing jobs and services to pay for the failing of the banks. These people are angry,frustrated and have had enough of being told what to do by people whose only interest is serving themselves.
  
• They are only out clashing with police and looting shops because they have nothing else to do, and nowhere else to go. The riots are caused by ruthless austerity measures that mean their voices are drowned out. It is hypocritical for you to blame them for starting these riots when it was really your coalition government. You say we “need to have a good hard look at the direction in which our society is heading.” Damn right we do. The way your government is going, this cry for help from the deprived may become a lot more common.
  
• “A riot is the language of the unheard.” —Martin Luther King, Jr.
  
• so 30 years of boardroom pay rises of 60-80% per annum, funded by “efficiency savings” i.e. sacking much of the work force, along with no wage rises for those at the bottom of the corporate structure “lucky” enough to still have their jobs – would have absolutely nothing to do with all this at all? i guess the sight of wealthy bankers ruining the economy and causing people to lose their jobs and homes being repossessed while they retire at 50 (sir fred goodwin) with £1million+ per year pensions is setting the right example? if the system is seen to be corrupt, greedy & there is no hope even given to those at the bottom, while they are constantly taunted by glamorous billboards advertising the latest “must haves” in a consumerist society, things they can never afford, who can be surprised when the first opportunity is taken, and any excuse will do, to just say sod it, and take what you can. god helps those who help themselves – just ask any burglar. and burglars are pretty much what the boardroom giants and bankers are. does sir philip green and other wealthy people even pay tax? i think not.

Chart of the day: Shares v houses

I have noted before at this blog that comparing share prices and house prices is a terrible way to examine the real differences in returns in these two markets. My key arguments are:

1. The share market is and equity market, and to compare like with like you would need to subtract the debt against housing to compare the volatility of equity.

2. The negatively geared investor usually sets the market price (they are the marginal buyer). That means they are losing money each year on the house, so a certain degree of price growth is necessary to break even.

3. The cost of home ownership is high, as are the transaction costs. In one trade of a home you would need to make an additional 10% return compared to a share trade.

So today I note again that an incomplete comparison has been undertaken by a prominent property analyst. The general finding is clear.  There is no doubt that property (in Sydney and Melbourne at least) has outperformed the share market over the past four years. But I thought is wise to add some modifications to compare like with like.

The original graph is below.

Again, the problem is that this graph fails to consider returns, and in particular, comparing the position of a negatively geared property investor. So I made my own comparison of the house price and ASX200, along with my own housing equity accumulation index taking into consideration the negative returns (and tax breaks at the highest marginal rate), compared to the ASX accumulation index. I also added the returns to cash at 5.5% average over the period (a bit of a guess at the average term deposit rate), and an accumulation index for residential property bought with cash (click for larger image).

As you can see, when you consider the higher annual positive returns on shares, the losses are not a severe as the price index would make out. For housing bought with cash, the accumulation index shows the same effect of increasing returns, but to a lesser degree due to the lower net rent compared with dividends in the ASX200.

What stands out is the tremendously better position the leveraged housing investor is in if they bought a home in 2007 with a 20% deposit (and capital growth similar to the index – this is not the case in Brisbane and Perth). This investor would have made over 80% on their equity in 4 years due to capital growth alone. This is especially impressive since the annual cost of ownership is 9% of their equity. (As a side note, the high transaction costs in property mean that to convert that return to cash will cost in the order of 3.5% on the purchase price, and 3% of the sale price, or 36% of the original equity, giving a 'sold up' return of 46% return on equity of over the period- still VERY impressive.)

However, there are important things to note. First, leveraging works both ways. The leveraged accumulation index fell for 3 months longer in 2008, and for a house price drop of just 4.9%, the index fell by 27.5%. Also, at the April 2009 trough, although the house price was still 4.1% higher than when they bought in June 2007, their equity was only 3.7% higher.

This is particularly important to note during the current falling trend in house prices, which has so far amounted to just 2%. The leveraged investor has already lost 9.6%, and every extra percent decline leads to a 5% decline in this index (and more still for a similarly leveraged investor who bought during 2010 or 2011).

Given these leverage considerations, the question of whether housing investment is a way to soften the downside from your investment portfolio is not so clear cut. For someone with plenty of cash looking for a home, perhaps a cash purchase of a well located home with potential to add value is an option. Of course, you need to expect some early losses in value, and low returns, but when the alternatives are looking quite bleak, there might be no harm. I would be waiting a couple of years to buy in Sydney and Melbourne, but perhaps sooner in Brisbane and Perth where prices have already fallen substantially.

Of course, in the mean time, anything could happen. Please don't take this as investment advice.

One final question for readers. If Australia is headed the way of the US, with negative real returns to bank deposits, and housing market that will seemingly not find a bottom, will we see a surge in the share market simply due to lack of other options to invest locally? Perhaps the bottom of the share market will be in later this year and some good value can be found.

*note to readers, the CBA cut its fixed rate mortgage rate this morning. Next interest move is down.

Peak life expectancy

Life expectancy has peaked in some US States according to recent research. This follows research published in 2005 that suggests current living children may not outlive their parents, and that peak life expectancy in the US may be reached between 2030 and 2040. Mostly, this is attributed to the massive spike in childhood obesity which typically results in lifelong obesity and associated health problems.

In coming decades, as obese children carry their elevated risks of death and disease into older age, average life spans could fall by two to five years.

The map below shows areas of the US where life expectancy fell between 1987 and 2007 (in red). At first glance it seems that rural areas are overrepresented in falling life expectancy. There is usually is typically a strong inverse correlation between obesity and income, which would appear consistent, but also one could guess that more automation of rural jobs, and greater propensity of sedentary recreation activities (the internet etc), may be a contributing factor.

Since then more evidence of decreasing life expectancy is dripping into the debate, especially in the US. One recent study suggests that based on data from 2008, the latest available, life expectancy in the U.S. fell 36.5 days from 2007 to 77.8 years.

But the overall picture still looks very good. The below graph compares the growth in life expectancy in a selection of countries.

In Australia, life expectancy continues to grow, but there appears to be no similar geographical disaggregation studies showing the divergence between urban and rural life expectancy. The data below shows that men have gained 3.1 year of life expectancy at birth in the past decade, while women have gained 2.1 years

For me, the surprising thing in these data tables is that our life expectancy at birth is rising mostly due to the prevention death earlier in life, not the extension of life after 85. If you make it that far, you have only gained six months of extra life expectancy over the decade – around a quarter of what you gained at birth (one fifth for men).

The other trend of note is that men are catching up to women in the life expectancy at birth. Again, this concurs with the observation that early preventable deaths are being reduced, as risk taking behaviour is disproportionally male.

A couple of questions spring to mind. First, will the rising trend in life expectance continue in the rest of the world? And second, the big question is whether there is a biological limit to life expectancy that developed countries are trending towards, to whether peoples lifestyles are compensating for improved medical care by being less vigilant about their health or taking more health risks?

When I watch extreme sports I often think that it could be a sign that we as a society have made life so risk free that people need to compensate by taking on risky activities. I would classify this type of risk as low probability but high impact, and it is the type of risk we seem to regulate tightly, with seatbelts, helmets, fire alarms and other safety precautions.

My interpretation is that as a society we have removed many high impact low probability risks, but compensated them to a small degree. This compensation must be small, as the data show that the prevention of death early in life the key reason for increased life expectancy at birth.

The other type of risk, high probability but low, or distant, impact is what we usually don’t address well. Smoking laws in Australia are probably the stand out success in this area. But when we do address them, they are the easiest risks to substitute for others. For example, a former smoker might find that chomping down a bit of chocolate is a good substitute for their addictive habit.

Further, we might be avoiding high impact risks by substituting for low impact risks. Parents need to be especially aware of this. For example, cycling appears to be dangerous because of the need to wear helmets, so parent might be less inclined to encourage cycling. The same goes with sports where there is a perception of high risk, such as rugby or Aussie rules football. Even the most basic of actions such as walking to school is often seen through the high risk lens (due to the low probability of abduction) and a generation used to being dropped at the gate may be less likely to walk later in life.

I have no definitive answer to either question. My gut feeling is that medical breakthroughs will stay one step ahead of any compensatory behaviour, and that life expectancy will creep up ever so slowly. I also feel that life expectancies between countries will continue to converge. But I will be on the lookout for more evidence of a peak in life expectancy elsewhere, and should we see this case arising more frequently, I believe that the theory of compensatory behaviour will need serious investigation.

Quick links and curious thoughts

Housing bubble – my favourite quote ““No one can produce an explanation as to how fundamental factors can lead to a run-up in home sale prices, but not rents” (originally from here)

ACCC says milk war is actually what competition is all about

Dumbed down debate -  
In 1860, in New York Abraham Lincoln began his campaign for the presidency with a very complex speech about slavery at the Cooper Union, 7500 words long, complex and nuanced. All four New York newspapers published the full text, which was sent by telegraph across the nation, widely read and discussed. In 1860 the technology was primitive but the ideas were profound and sophisticated. In 2011 technology is sophisticated but the ideas uttered by presidential aspirants are embarrassing in their banality, ignorance and naivety.

Dog whistle politics -   
JASON REIFLER: Well we're certainly susceptible to misinformation in that once we believe something that is wrong then it's really difficult to correct people.

ELEANOR HALL: So we know that our ignorance about certain issues makes it easy for us to be misled but your research shows that we don't necessarily change our minds even when we have the facts. 

I wonder about the geographical boundaries used for the capital city price indices. For example, the Brisbane City Council area would not include many homes that are in ‘greater Brisbane’, but not in the local government area. These areas include Moreton Bay Regional Council, Redlands and Ipswich (where a large portion of the new housing supply is located).  Different data providers using different areas would explain some of the inconsistencies in price movements detected. I would happy to hear some detail about this from the data providers.

(ht: okakesan)

An explanation of equality concerns about progressive tax systems (ht: Chris Boulis)
Suppose that every day, ten men go out for beer and the bill for all ten comes to $100...
If they paid their bill the way we pay our taxes, it would go something like this...

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7..
The eighth would pay $12..
The ninth would pay $18.
The tenth man (the richest) would pay $59.
So, that's what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve ball. "Since you are all such good customers," he said, "I'm going to reduce the cost of your daily beer by $20". Drinks for the ten men would now cost just $80.

The group still wanted to pay their bill the way we pay our taxes. So the first four men were unaffected. They would still drink for free. But what about the other six men ? How could they divide the $20 windfall so that everyone would get his fair share?

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer.

So, the bar owner suggested that it would be fair to reduce each man's bill by a higher percentage the poorer he was, to follow the principle of the tax system they had been using, and he proceeded to work out the amounts he suggested that each should now pay.

And so the fifth man, like the first four, now paid nothing (100% saving).
The sixth now paid $2 instead of $3 (33% saving).
The seventh now paid $5 instead of $7 (28% saving).
The eighth now paid $9 instead of $12 (25% saving).
The ninth now paid $14 instead of $18 (22% saving).
The tenth now paid $49 instead of $59 (16% saving).

Each of the six was better off than before. And the first four continued to drink for free. But, once outside the bar, the men began to compare their savings.

"I only got a dollar out of the $20 saving," declared the sixth man. He pointed to the tenth man,"but he got $10!"

"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar too. It's unfair that he got ten times more benefit than me!"

"That's true!" shouted the seventh man. "Why should he get $10 back, when I got only $2? The wealthy get all the breaks!"

"Wait a minute," yelled the first four men in unison, "we didn't get anything at all. This new tax system exploits the poor!"

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn't show up for drinks, so the nine sat down and had their beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and government ministers, is how our tax system works. The people who already pay the highest taxes will naturally get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas, where the atmosphere is somewhat friendlier.

David R. Kamerschen, Ph.D.
Professor of Economics.

For those who understand, no explanation is needed.
For those who do not understand, no explanation is possible.

Chart of the day - long run house price comparison

Many thanks to Chris Joye for putting in the leg work to produce the below graph and associated analysis.  I recommend reading Joye's analysis before drawing any conclusions.

Current account deficits and house prices

As I alluded to in recent posts, Australian banks reliance on foreign funding has lead to the alarming situation whereby we (as a nation of households) have borrowed from the rest of the world to buy existing houses from each other at inflated prices. As I said, “it makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses”.

I made that claim without evidence – it was an intuitive interpretation of the data in the balance of payments and in particular, the interest payments heading abroad in the primary income account. But, in the interests of an informed debate, I have digested some of the literature on this matter and found that the intuitive principle is well supported.

In February this year, Andrea Ferrero, of the Federal Reserve Bank of New York, published this paper arguing that “a progressive relaxation of borrowing constraints can generate a strong negative correlation between house prices and the current account. Households increase their leverage borrowing from the rest of the world so that the current account turns negative”.

The following plot is from the paper (p2).

The model demonstrates the mechanism by which relaxed lending standards decreases domestic saving, increases foreign bowings and decreases the current account. The model also shows that prices vastly overshoot the new equilibrium point. The quote below is from p14 (my emphasis).

The key shock that generates a house price boom and a contemporaneous current account deficit in the model below is a reduction in the parameter that measures the loan-to-value requirement. At a broad level, lower collateral requirements capture easier access to credit for housing finance.
...
The main experiment consists of shocking the collateral constraint parameter. In particular, financial innovation corresponds to a higher loan-to-value ratio.
...
At a very basic level, the model captures the negative correlation between house prices and current account balance. In response to the shock [relaxation of collateral criteria], house prices persistently increase while the current account worsens, at least for a couple of periods, before slightly overshooting its long run average of zero. A more realistic sequence of shocks approximating a progressive relaxation of collateral constraints (the process of financial liberalization) is likely to generate a run-up of house prices and a deterioration of the external balance more in line with what observed in the data.

This appears to support the idea that simply constraining lending criteria would have been an effective measure to contain house prices, and reduce the current account deficit. Steve Keen would not be surprised.

Indeed, the evidence of this relationship appears quite strong, and it is easy enough to find other articles supporting this argument empirically.

My main criticism is the timing of the house price growth measure. China for example appears to have flat real price growth in the above graph for the period 2001-2006. That would seem consistent with the arguments surrounding the relationship between the current account and house prices. However, since that time credit standards in China were reduced, prices shot up (around 2007), then access to credit was subsequently tightened, and prices flattened (around 2008). To me, a good experiment to demonstrate this relationship, although hampered by global conditions at the time. The below graph from The Economist house price comparison tool shows China’s house price growth in this period was far below that of the US, UK and Australia. More recent data shows strong house price growth since 2009.

One stand out example of where the relationship  between house prices and the current account fails is Japan in the 1980s.  A housing bubble coupled with a current account surplus and a large growth in ownership of foreign assets is not what these models predict. 

Out of interest, here is a list of countries according to their current account balance. Eyeballing this list it is pretty easy to find the prominent housing bubble markets near the bottom.

To be clear, the access to credit is the key (and this may provide the explaination of the Japanese experience in the 1980s). Lower LVRs force domestic saving and limit the need for foreign borrowing, meaning asset prices can reflect the economic reality of that country alone. (One might argue that Japanese saving was high enough that the current account was simply lower tha it woul dhave otherwise been, but not negative.)

I will present one final conclusion from here, with my emphasis.

We find robust and strong positive association between current account deficits and the appreciation of the real estate prices/(GDP deflator).

Our results are consistent with the notion that for all countries, current account deficits are associated with sizeable appreciation of the real estate. This effect holds controlling for the real interest rate, GDP growth, inflation, and other conditioning variables. We also find evidence consistent with the growing globalization of national real estate markets. These findings are consistent with various scenarios explaining patterns of capital flows across countries, including differential productivity trends and varying saving patterns. In the absence of pre-existing distortions, financial inflows are unambiguously welfare improving. Yet, in a second-best environment, public finance considerations imply that inflows of capital may magnify distorted activities, increasing thereby the ultimate costs of these distortions. Arguable, the experience of emerging markets in the aftermath of financial liberalization during the 1990s illustrated these concerns. Needless to say, this second-best assertion is not as argument against financial integration, but a cautionary tale – greater financial globalization implies the need to be more asserting in dealing with moral hazard and other pre-existing domestic conditions. (p20)

What sovereign wealth? Continued...

To the cynic, the RBA’s role is to assure citizens that they have everything under control. In this light, we can see the recent speech delivered by Guy Debelle, the Assistant Governor, where he defends a persistent current account deficit. While he shows that much of the deficit has historically been the results of Australian banks seeking funding abroad (an inflow in the capital account), only to send interest payments back annually (an outflow in the current account), he artfully avoids the distasteful conclusion that we have gone into debt with the rest of the world to sell houses to each other at inflated prices.

Indeed his speech is a critique of the reasonable conclusion that “the Australian banking sector is ‘funding the current account’." The balance of payments accounting identity, where the sum of the capital account and the current account should equal zero, appears to demonstrate this is true. If banks did not seek offshore funding, they wouldn't pay interest on these funds, and the current account would more closely reflect the balance of trade (which is much less negative).

The graph below shows that capital account flows since 1990. To translate, this account reflects the sum of our sale of assets to foreign ownership and our international debts incurred (inflows of funds), which is balance by outlfows of funds in the current account.

With the RBA’s view of the economic landscape in the back of our mind, I thought it worthwhile to repost the Wildebeest blog explaining why a sovereign wealth fund in this environment is simply funded by debts in the rest of the economy.
______________________________________________________________________

Should Australia have a sovereign wealth fund (SWF)? Whenever I hear this discussed my first thought is what do you mean by sovereign wealth? The Australian government can set aside a pool of funds at any time and call it whatever it wants. For example the “Future Fund” is listed in wikipedia as being an Australian sovereign wealth fund. The discussion in recent times seems to be linked to the once in a generation mining boom. Mining by definition extracts a non-renewable resource, so at a time when windfall profits are being made in mining, due to the demand from China, people understandably feel that some portion of that money should be set aside for the future. But does Australia actually have “sovereign wealth” from which a SWF can be funded?

There is a national accounting identity:

CA = (T – G) + (S – I)

This says that taxes, T, minus government spending, G, plus private savings, S, minus private investment, I, must equal the current account CA. If (T - G) is positive then the government is running a surplus, if it is negative a deficit. (S - I) can be thought of as the net private sector savings. If it is positive then wealth is being accumulated. This accounting identity is what it is independent of ideology or political beliefs: the identity is the same whether you are progressive or conservative, or regardless what brand of economic belief system you subscribe to.

If the government sets up a SWF it could be funded from existing money:

CA = SWF + (T – SWF – G) + (S – I)

or it could be funded by raising taxes

CA = SWF + (T – G) + (S – SWF – I)

Australia has been running current account deficits for ever and a day.

So the left hand side of the equation is negative, has been negative for a long time, and is likely to be negative for a long time. By definition the right hand side must equal the left hand side so must be negative. Now imagine that the government was to “quarantine” money in an investment fund which, we'll call a SWF. Prior to the formation of a SWF we know that (T – G) + (S – I) is a negative number. In order to create the SWF the net government and private sector balances have decreased by an amount equal to SWF:

(T – G) + (S – I) – SWF

If follows that while Australia runs a current account deficit, if money were to be placed in an investment fund by the government the rest of the government and private sector would be further indebted by an amount equal to the SWF. In such circumstances a sovereign wealth fund would be an inappropriate name since the fund would in fact be funded by driving the rest of the economy further into debt.

Contrast this with Norway which runs current account surpluses from which it follows that (T – G) + (S – I) is a positive number. As long as their SWF does not exceed the current account surplus, then money can be set aside while still leaving the net government and private sectors in surplus. Norway is accumulating sovereign wealth and is able to set aside this wealth in a SWF without making its economy indebted. Australia on the other hand, by running current account deficits is not accumulating sovereign wealth. While one sector of the economy, mining, may be doing very well, as a nation you have to ask “what sovereign wealth?” If an investment fund was created it would be from money which drives the remainder of the economy further into debt. Perhaps “sovereign debt fund”, SDF, would be a better description of such a fund. Creation of a SDF would have a negative effect on GDP growth.

This analysis of the national accounts also ties in to discussions about balanced budgets. We can see that if T – G = 0, i.e. the government balances its budget, then the private sector must carry the debt burden arising from the current account deficits. This presumably hasn't occurred to politicians from either persuasion who thump the table about the need for the budget to be balanced, or even worse for the budget to go into surplus. A balanced budget in these circumstances of endless current account deficits is likely to hamper GDP growth.

However should it be decided, for whatever reason, political or ideological, that Australia needs to run a sovereign investment fund, or needs to balance its budget, then the national discussion would be better off focussing on the structural reasons for continued current account deficits, since mandating a balanced government budget merely shifts the debt burden to the private sector rather than addressing the source or cause of the debt.

On the other hand the purpose of this article is not to make a case for or against current account deficits, but to note that if they exist it follows that an equivalent deficit must exist among the private and government sectors.

In summary while Australia is experiencing a mining boom it doesn't have sovereign wealth in the same sense as other countries that run successful sovereign wealth funds. So to the question of whether or not Australia should have a sovereign wealth fund I say “what sovereign wealth?”

What sovereign wealth?

Glenn Stevens recently noted that Australian households grew their consumption faster than their incomes from the mid 1990s till 2006 and that this wasn’t particularly sustainable. He produced the below chart.

As a nation we have consumed more than we have produced in 52 out of the last 53 years, and as the chart below shows, the growth in imports has far outweighed the growth in exports over the past decade. Is that sustainable? (note the chart is a chain volume measure and the $ values are not representative of the current price value of exports and imports)

*As a side note, the country is made up of its households and businesses so we would expect the country aggregate situation to be similar to households in aggregate.

As a backdrop to this situation, the Australian economy is in debt to the rest of the world, with a debt balance that continues to grow due to our persistent current account deficits (graphs below).

This background is an important consideration for policy makers listening to calls for Australia to establish a sovereign wealth fund (SWF) with revenue generated from a resource rent tax (let’s put aside the political debate for a moment).

Blogger Wildebeest has explained that in these macroeconomic conditions, a sovereign wealth fund is necessarily comprised of public and private debt. To use an analogy of the household, Australia would be investing in foreign markets by mortgaging the house – borrowing from foreigners to invest in foreign economies. We don’t actually have any sovereign wealth to speak of, unlike other countries where such funds operate (such as Norway and Saudi Arabia – see chart below comparing the current accounts of a selection of countries).

Even if as a nation we produced more than we consumed to actually generate sovereign wealth, there is a strong argument that we should use the income to continue to invest in our own economy, not in the economies of others. There is also an argument that a fund that simply chases short term returns abroad is not being used in the best long term interests of the country.

When some people talk about a sovereign wealth fund, as I have in the past, it usually goes hand-in-hand with some kind of tax regime to equalise the two speed economy – resources vs services and manufacturing. But these issues should be separated. By all means, if the people decide that fiscal policy should be used to ‘balance out’ the economy, then I see no reason not to. But whether the revenues from some kind of ‘equalising taxation’ should be invested abroad to protect the exchange rate is another question entirely.

I will expand these arguments surrounding optimal investment of surpluses in another post. Today, I want to explore in more detail why Australia, blessed with a massive capacity for agricultural production and plentiful mineral and energy resources, has consumed more that it has produced since WWII.

No doubt we are all aware that the terms of trade measure, the ratio of prices of exported goods to imported goods, is at an all time high. But terms of trade calculations tell us nothing about the volume of the countries' exports, and the net financial position.

A better measure of the international performance of a country is the current account, which considers volume, price and ‘non-traded’ financial transactions include ownership of foreign assets. A deficit in the current account occurs when a country's total imports of goods, services and transfers is greater than the country's total export of goods, services and transfers. This situation makes a country a net debtor to the rest of the world.

Australia has run a current account deficit every year since ABS records start in 1959, except the 1972/73 financial year. Indeed, Australia economic growth in light of the persistent deficits has lead to the Pitchford Thesis, which contends that after the floating of the exchange rate the current account deficit was the residual outcome of rational optimizing decisions of private agents ...[therefore] the policy of targeting the reduction of the current account deficit... was misconceived.

Whether this is a logical position is a debate for another time.

So let us take a look at the data to see exactly why Australia’s current account is persistently in the red.

First, the chart below shows the monthly balance of trade in goods and services in current dollars. Notice that it is rare for us to even export a higher value of goods and services than we import, happening just 4 out of the last 32 years. As the second chart above showed, with the recent trends of import volumes growing faster than export volumes it will get even more difficult to maintain a trade surplus if the terms of trade return to historical norms.

Next, we explore the capital and financial accounts, which measure changes in ownership of financial and non-financial assets, capital transfers, and transactions between residents and non residents. In particular, the account known as primary income, and the part of this account called investment income, is the key to understanding the current account. The ABS gives the following definitions -

The primary income account shows primary income flows between resident and non-resident institutional units. The international accounts distinguish the following types of primary income: compensation of employees; dividends; reinvested earnings; interest; investment income attributable to policy holders in insurance, standardized guarantees, and pension funds; rent; and taxes and subsidies on products and production 

Investment income is income generated by financial assets. This includes dividends paid on direct and portfolio equity investments and interest paid on debt securities and other debt instruments.

The investment income category shows that $21billion of investment revenue is heading out of the country each quarter (ABS Cat 5302.021 column D). Important observations include the $4billion of income from shares and $7.6billion in interest generated (down from a peak of $8.4billion in 2007) leaving our shores last quarter. On the other side of the ledger, $3.5billion in income from shares and just $277million of interest entered Australia from abroad.

The graph below shows the balance of these two items alone (which comprise about 50% investment income). By my reasoning this means that foreigners are buying up more assets - property (the media has taken note of this in agriculture) and shares - and lending more to local households and businesses over time.

On primary income alone, Australia was $50billion in the red this past year. It takes a lot of trade in agricultural and mining products to offset this transfer of financial assets, and our best effort was a peak of $23.3billion of net exports of goods and services over the past 12 months with an all time high terms of trade (noting that even the balance of trade is usually negative).

So not only do we usually import more than we export, we sell more domestic assets than we buy foreign assets, and the incomes from the transfer of assets to foreign ownership far outweigh the value of the actual trade of goods and services.

A quick example.  The government owned business Telstra was privatised, and 25% of the company is now foreign owned.  That purchase by foreigners was a transfer of assets to foreign ownership as part of the capital accounts, and the dividends earned on the foreign owned portion now leave the country as part of the deficit in the primary income balance of the current account.  The same applies to foreign purchases of agricultural properties, mining shares, and lending to Australian businesses.

For the past 50 years is seems that Australia has been selling off its bountiful natural assets, and going into debt to the rest of the world. It makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses, doing nothing to improve our productivity as a nation.

In a later post I will consider the Pitchford Thesis and policy remedies in more detail, including the role of the Foreign Investment Review Board.

RBA pragmatism and global stagflation

Since the higher than expected CPI print last Wednesday, the economic blogosphere has flooded our screens with opinions on the likely RBA decision at its board meeting tomorrow. Some have argued that the CPI was filled with ‘once-off’ movements in price (eg, the deposit and loan facilities and some fruits) and should therefore be taken with a grain of salt. Others have argued that the CPI is clear evidence that the RBA should move on interest rates to get ahead of the inflation curve.

I have a different opinion.

Raising the cash rate while Australia could be in a technical recession is a situation the RBA needs to avoid more than anything else. Think about the criticisms – “How could our central bank be so out of touch?” “Give Glenn the boot!” The very institution itself would be at risk. Forget demonstrating independence. Self preservation is the name of the game (note also that the inflation target is not a mandate of the RBA, but its own interpretation of how to fulfil is statutory role).

Therefore, the only logical decision for the RBA board tomorrow is to leave the cash rate unchanged, even if it has strong concerns about inflation. It is the same action central banks are taking in the UK and other developed countries in similar situations.

But there is more to this story. The present bout of high inflation and low growth is global, and there is little our domestic policy can do to intervene. Further, I suspect that this has much to do with physical constraints to global oil supply (at least in the short term).

As I said two years ago during the financial crisis –

...some interesting trends should occur in the next year or two. First, we should see the price of oil rise again from its current price of around $60 a barrel. Second, we should see an increase in the inflation rate on a relatively global scale. (Note that in the UK, inflation is currently at 4.4%. With the base interest rate at 4.5%, the real interest rate is now effectively zero). Third, we will see a sustained decline in global output. Taken together, a recipe for stagflation. (I also predict continued volatility on financial markets as demand and supply expectations feed back on each other).

The following three graphs show the oil production, oil price and the correlation between oil price and inflation in Australian, Asia, and other developed markets (DM). (Thanks Ricardian Ambivalence for the third graph).

The simple explanation for oil price led inflation is that a century of capital equipment, particularly in transport, is reliant on oil, has very little ability to substitute to other energy sources.  Therefore, the cost of goods is at the mercy of the oil price due to our invested capital.

Typically, there is an expectation oil production will respond to higher prices. But if there are short term physical and technological limitations, this cannot occur. In 2007 the oil price was double the price in 2005, yet total global oil production was identical. If there was not a physical limit to oil production, oil producers should have responded to this price by greatly increasing supply.

Ricardian Ambivalence has weighed in with an opinion that global inflation is not about oil. Oil price leading inflation globally in the above graph is explained away because “Oil leads CPI, in part, because variations in demand lead variations in CPI”. There may be some element of demand and oil price as co-contributors to price volatility, but my suspicion is that physical production limits to oil are the key.

Indeed, the reason these limits are having such a dramatic effect is because they were not foreseen, and investment decisions were made on the expectation of higher volumes of oil available at similar prices.

As a final statement, I want to address the ‘lunacy’ of peak oil. Many economic thinkers rule out the possibility of such an occurrence, as high prices lead to more inaccessible reserves becoming viable, as well as substitute energy sources becoming economical. Yet the recent evidence is that global oil production is back where it was in the late 1990s even though the oil price is more than 5x higher. This doesn’t seem consistent with the economic rationalism, which ignores the major prolonged adjustments necessary for these investments and subsitutions to occur.

Some may still be arguing in their mind that the reason for lower oil production currently is because of a global demand slump. But again, this fails to explain why we are willing to pay 5x the price for oil, and producers are not willing to sell any more oil at that price.

In the end, Australia is at the mercy of global forces as much as anyone, and it would be foolish for the RBA to believe that our domestic interest rate will have any significant effect on inflation without crushing our economy.

The housing market's 'once-off adjustment' meme

There is a meme floating around which has its origins in Chris Joye's numerous articles on the Australian housing market. While I often challenge Joye's economic arguments on this blog, I hope that readers realise this is simply part of a rigorous intellectual debate, and not a personal attack. Indeed, I admire his quest to provide better housing data, and agree with quite a few of his economic and political beliefs.

The meme is that the surge in debt levels and the price of Australian homes since the late 1990s was a once off adjustment to a period of low interest rates and inflation. Therefore, if these conditions hold, current prices are sustainable.

RBA Governor Glenn Stevens mentioned this 'once-off' adjustment in his recent speech 

The period from the early 1990s to the mid 2000s was characterised by a drawn-out, but one-time, adjustment to a set of powerful forces. Households started the period with relatively little leverage, in large part a legacy of the effect of very high nominal interest rates in the long period of high inflation. But then, inflation and interest rates came down to generational lows. Financial liberalisation and innovation increased the availability of credit. And reasonably stable economic conditions – part of the so-called ‘great moderation’ internationally – made a certain higher degree of leverage seem safe. The result was a lengthy period of rising household leverage, rising housing prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. (here) 

Chris Joye recently reiterated the argument here

This was a once-off "level-effect" (ie, sustainable adjustment reflecting the huge reduction in the cost of debt), not a permanent growth effect, and now these ratios are flat-lining. This is why the household debt-to-disposable income ratio, as shown below, has gone sideways since 2005, years before the GFC first materialised. That is, credit has been tracking incomes, as you would expect.

The household debt to disposable income graph is below, as is a graph demonstrating the structural adjustment of interest rates.

What makes this meme powerful is its truth. Australian interest rates did see a structural adjustment in the mid 1990s. There is also no denying that lower interest rates should lead to asset values rising relative to other prices in the economy. It also makes sense that the level of debt able to be sustainably managed, as a portion of incomes, is greater.

In the housing context, the 'once-off adjustment' argument can be demonstrated as follows.

Prior to the structural adjustment in interest rates, a buyer looking to buy a home that rents for $15,000pa, who is willing to pay a 20% over the cost of renting to buy the home, would capitalise $18,000 at the going rate of 12.8%. That's a price of $140,625. After a structural adjustment, the cost would be capitalised at 7.3%, giving a price of $246,575. A 75% real price increase should be as sustainable as the previous price (almost).

The same calculation can be made against household income, where for a fixed percentage of incomes, a 75% greater price, and level of debt, can be sustained.

Unfortunately, this logical argument only accounts for a part of the debt build up and house price growth since the mid 1990s. The RBA graphs of household finances and real house prices (below) show clearly why this is the case.

The graph of interest paid as a proportion of disposable income shows that the actual cost of debt relative to incomes has doubled (4% to 8%) since the mid 1990s. This is clear evidence that much of the debt binge, and the subsequent house price inflation, is not attributable to the 'once-off adjustment'. This adjustment would only account for the amount of debt, and home prices, that could be supported with interest costs of 4-5% of household incomes - not 8%.

The RBA also shows that real home prices have more than doubled (100% growth) since the mid 1990s to 2007, rather than seeing 75% real gains. Indeed the 2009 boom saw real home prices inch up again (with some subsequent falls in real terms).

The ABS home price figures (though not ideal for this purpose) suggest that real home prices gained approximately 150% since 1996. That's twice what is expected from interest rate conditions alone.

To get back to that 'sustainable' point, either home prices need to fall by around 30%, or interest rates need to fall by 30% (mortgage rates to 4-5%), or some combination of the two (noting also the geographical disparity any correction is likely to have). With today's CPI print surprising many on the high side, the market prediction (and mine) of rate cuts by year's end seems far less likely.  The negatively geared housing investor should take note.  

In all, the meme is powerful because it is true, but dangerous because alone it is an incomplete explanation of debt and home price trends of the past two decades. What appears clear from the data is that we have overshot the expected price and debt adjustment due to the changing interest rate environment. With this in mind, the downside risks for property values appear to far outweigh any upside potential.