Crowding-Out Gets Crowded-Out

I have an op-ed in today’s Age, noting that it is the crowding-out effect and not the short-run multipliers that will determine the long-run economic effects of the government’s discretionary fiscal policy actions:

In the 366 pages of Budget Paper No. 1, where the Government outlines its fiscal strategy, crowding out isn’t mentioned once.

It wasn’t always this way. The budget papers released in the second half of the 1990s were full of references to the contribution federal budget surpluses were making to national saving and investment. One of the advantages of budget surpluses, Treasury informed us, was that the government would no longer make a net call on capital markets. Instead of crowding out private capital and investment spending, budget surpluses would crowd them back in.

All this was said when the economy was still well short of full employment.

Treasury Secretary Ken Henry’s “secret” speech to Treasury officers in March 2007 drew heavily on the idea of crowding out to explain why government intervention in an economy at full employment was counter-productive, resulting in a misallocation of resources and reduced output. Only by augmenting the supply side of the economy, he noted, could Australia increase national income.

When the public sector saves less, all else being equal, national saving is also reduced, reducing future growth in national income. This crowding-out effect can occur even if there is no change in interest rates and the economy is below its full employment level of output.

posted on 22 May 2009 by skirchner in Economics, Financial Markets, Fiscal Policy

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Is the RBA Still Agnostic on Bubble Popping?

In contrast to the cautious agnosticism of his boss on the question of bubble-popping, RBA Assistant Governor Guy Debelle is remarkably clear on the issue:

the current episode vindicates the position that monetary policy, narrowly defined as the setting of the policy interest rate, should be confined to targeting inflation. Set interest rates primarily to achieve the inflation goal as that, in itself, contributes to sizeable social gains. A departure from that runs the risk of losing the nominal anchor that the inflation target provides.

But other tools, most notably the much-touted (although not clearly defined) macro-prudential instruments, should be used to address asset price and credit imbalances. I do not think that a slightly tighter setting of interest rates would have prevented the development of the imbalances that have led to the current financial crisis. When human psychology is such that optimism about asset price rises is at the fore, then an excessively stringent setting of interest rates would be required to suppress the optimism. The Australian and Scandinavian experience in the late 1980s shows the sort of interest rate settings required to achieve such an outcome. In that example, a credit boom and bubble-like asset price dynamics took hold and only a very high setting of real interest rates ultimately curtailed that, but at the cost of a historically high level of unemployment.

I do not think it would be socially acceptable or desirable to endure the level of unemployment that would come with the high interest rates necessary to pop the bubble. It is asking too much of the single monetary policy instrument, namely, the targeted short-term interest rate to target both financial excesses and inflation.

Nor do I believe there is much to be achieved by ‘leaning against the wind’. The wind that is blowing in most episodes of credit booms is generally at least gale force. Setting interest rates a bit higher in such circumstances is likely to be close to futile when such credit dynamics take hold. Again, what would be the point of undershooting the CPI inflation target and enduring a higher than desirable level of unemployment with little to be gained. How would such actions be explained to the public?

posted on 21 May 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Government Bonds to Underperform?

Jeremy Siegel, on the poor prospects for returns on government bonds:

40 years ago [US] treasury bonds were yielding over 6.3 percent, about twice their yield today. It is mathematically impossible for government bonds to come close to matching those 12 percent returns in future decades. Stocks, on the contrary, can easily repeat their returns over the past four decades, since those returns were near their historical average…

For the 55-year period from December 1925, when the well-known Ibbotson stock and bond series begins, through January 1982, total real government bond returns were negative. This means that, by rolling over in long-term government bonds, reinvesting all the coupons, and thereby taking no income, investors’ bond portfolios were sinking in value.

Most strikingly, for the 40-year period from 1941 through 1981, government bond investors lost a whopping 62 percent of their value after inflation. A loss in purchasing power over this long a period has never happened in stocks. There has never even been a 20-year period when real returns in stocks have been negative. In fact, the worst 30-year real return for stocks is plus 2.6 percent per year, just slightly below the average real return investors earn with government bonds.

Looking at today’s markets, the forward-looking prospects for government bonds are very poor. Yields on 30-year inflation-protected bonds are 2.3 percent, and yields are only 4 percent on 30-year Treasuries. In contrast, after stocks have fallen 50 percent from their previous high, as they did in March of this year, their subsequent 30-year real returns have always been in excess of 10 percent per year.

The 40-year outperformance of government bonds over large stocks has ended.

posted on 15 May 2009 by skirchner in Economics, Financial Markets, Fiscal Policy

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Akerlof and Shiller’s Economic Authoritarianism

My review of George Akerlof and Robert Shiller’s Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism (Princeton: Princeton University Press, 2009), below the fold.

continue reading

posted on 30 April 2009 by skirchner in Economics, Financial Markets

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Robert Prechter Discovers Rational Expectations

Robert Prechter’s latest Global Market Perspective argues that:

movements in the cash target rate set by Australia’s central bank, the Reserve Bank of Australia (RBA), appear to follow those in 3-month Australian Treasury Bills. After decisive moves up in T-bills from 2006 to early 2008, for example, the RBA faithfully raised its target. T-bills have since led the RBA during the financial crisis of the past year. In fact, the record indicates that the RBA almost always follows T-bills over time.

The proper conclusion to draw… is that their interest-rate decisions are not proactive, but reactive, and that they continually follow in the footsteps of the market for lack of any other useful guide…. The myth of central bank potency is so pervasive that conventional analysts can’t even imagine a better explanation for price trends: that the market is the dog wagging its central bank tail, not the other way around.

The fact that market-determined interest rates lead official interest rates does indeed have a better explanation: the market successfully anticipates central bank policy actions.  This does not render central bank policy actions ineffective, as Prechter would have us believe.  Indeed, it makes monetary policy more potent, because central banks can influence monetary conditions through open mouth rather than open market operations.  But it does point to the fact that both market and official interest rates are largely endogenous to economic activity.  Both the market and central bank look at the same data in much the same way, drawing similar conclusions.  The main difference is that the markets make these judgments every day, while the central bank acts on them more slowly.

posted on 26 April 2009 by skirchner in Economics, Financial Markets

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Explaining Capital Xenophobia: Cranky Old Conservatives?

The latest Newspoll asks whether foreign companies should be allowed to acquire shareholdings in Australian mining companies.  A separate question asks whether Chinalco should be allowed to increase its stake in Rio.  52% of respondents are opposed to the former and 59% to the latter.  Opposition is stronger among Coalition voters than Labor voters, which may reflect National rather than Liberal Party voters.  Opposition also increases with age.  While it would be tempting to conclude that capital xenophobia is mainly attributable to cranky old conservatives, there is still more opposition than support even in the 18-34 age group.

Taken literally, the question on foreign shareholdings in mining companies implies that Australians are opposed not just to foreign direct investment, but to foreign portfolio investment as well (a 10% equity stake is enough to qualify as FDI according to the ABS; the threshold for FIRB scrutiny is generally 15%).  In any event, this and other opinion poll data (see Andrew Norton’s round-up) render Australia’s FDI controls readily explicable in political terms. 

Opposition Treasury spokesman Joe Hockey has even sought to raise concerns about foreign (ie, Chinese) portfolio investment in Australian debt markets, arguing that this might give the Chinese leverage over Canberra.  Like US debt markets, Australian markets are deep and liquid enough that the Chinese are unlikely ever to be effective price-makers.  Chinese threats to sell-off Australian dollar denominated debt would just provide a buying opportunity for other investors, to the detriment of their own portfolio.  But excluding all foreigners from participating in Australian debt markets would of course lead to a massive increase in domestic interest rates, something voters wouldn’t be too thankful for.

The irony is that at the same time the government is setting up Rudd bank to offset the implications of potential foreign capital flight for the commercial property sector, and politicians complain about the failure of banks to pass on reductions in official interest rates, neither the government or opposition are putting out the welcome mat to foreign capital.

posted on 08 April 2009 by skirchner in Economics, Financial Markets, Foreign Investment

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Should We Use Monetary Policy to Regulate Human Nature?

Writing in the letters page of today’s AFR (no link), Des Moore says:

Whether or not a targeting of asset prices warrants more attention, any review of policy surely needs to address the difficult issue of changes over time in human nature…

There is a long history of swings in attitudes from optimism to pessimism, often “inspired” by governments, that result in changes in risk behaviour: our most recent swing of optimism was reflected in the boom in investment in commodity production. 

If monetary policy does not pay sufficient regard to such swings, it is very likely that we will end up with a “bust” - and high unemployment. That is what happened in the 1980s and what is happening now…

The idea that human nature is variable at business cycle frequencies is highly questionable, as is the assumption that the monetary authorities are somehow immune to these ‘swings of attitude’.  Des falls into the classic trap identified by public choice theorists of assuming that human nature changes when we relocate people from the private to the public sector. 

In arguing that the recent boom in commodity investment was a ‘reflection’ of ‘our most recent swing in optimism’, Des Moore identifies himself with behavioralists like Robert Shiller, who maintain that sentiment drives economic activity, rather than the other way around.  But as I argue in Bubble Poppers, the more asset prices are thought to be disconnected from the real economy, the weaker the case for using monetary policy to regulate asset prices via the real economy.

posted on 06 April 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Bubble Wrap

Reactions to my Bubble Poppers monograph, here and here.

posted on 31 March 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Bubble Poppers: Monetary Policy and the Myth of ‘Bubbles’ in Asset Prices

CIS has released my Policy Monograph, Bubble Poppers: Monetary Policy and the Myth of ‘Bubbles’ in Asset Prices.  The text was finalised before Greenspan published a defence of his record in the WSJ, but takes a similar position to the former Fed Chair.

The monograph is partly devoted to debunking the concept of a ‘bubble’ in asset prices.  It argues that if the idea of ‘bubbles’ in asset prices cannot be given analytical or empirical substance, then monetary policy should not attempt to actively manage asset price cycles.

There is a shorter version in the latest issue of Policy and an even shorter version in today’s Age.

posted on 19 March 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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Arbitraging Congress

The Congressional Effect Fund takes advantage of an interesting violation of the efficient markets hypothesis – the S&P 500 outperforms when Congress is not in session:

The Congressional Effect Fund seeks to capture the historically higher returns on Congressional out of session days by primarily having exposure to price moves of the broad market as measured by the S&P 500 index on vacation days. The Fund does not try to capture the dividends of stocks in the index. Instead, it invests in interest bearing instruments including, without limitation, treasury bills, other government obligations and bonds, collateralized repurchase contracts, money market instruments and money market funds.

The Congressional effect holds on average over 43 years of data.  The fund has outperformed since its inception in 2008.  However, as the fund manager readily concedes, a sitting Congress isn’t all bad, all of the time:

in 1997, Congress enacted significant tax cuts, including a cut in capital gains taxes generally. In that year, the annualized average price increase on the days when Congress was in session was 59.5% (an average daily gain of 0.18% or 18 basis points) as compared to an annualized average price loss of -4.6% (an average daily loss of -0.02% or 2 basis points) when Congress was out of session.

It is exceptions like this that perhaps explains the persistence of this apparent anomaly in market pricing.

posted on 17 March 2009 by skirchner in Economics, Financial Markets

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Greenspan versus Taylor

Former Federal Reserve Chairman Alan Greenspan defends the Fed’s record against criticism from John Taylor:

However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his “Taylor Rule,” “it would have prevented this housing boom and bust. “This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover, while I believe the “Taylor Rule” is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble. All things considered, I personally prefer Milton Friedman’s performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”

Proving that great minds think alike, I will shortly be releasing a CIS policy monograph making much the same argument in the context of a broader discussion of the relationship between monetary policy and asset prices. I discussed the issue with John Taylor at the New York MPS meeting, but could not bring him around to my point of view.

posted on 12 March 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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‘They will just dig them up and cart them away’

The FT’s David Pilling on the proposed increase in Chinalco’s stake in Rio:

But to say there is state involvement is not the same as imagining a monolithic apparatus planning world domination. In any case, the west, whose banks, carmakers and god-knows-what else are underwritten by the state, is not in an ideal position to lecture others. If China wants to use its trade surplus to secure mineral resources, one response might be: so what? But Chinese companies, even state-owned ones, are as likely to be engaged in cut-throat competition as in cosy cartels or state-sponsored carve-ups.

That undermines the idea that Chinalco, an aluminium maker with no need of iron ore, would seek to persuade Rio to sell cheaply to China Inc. Even if Chinalco were in a position to influence price negotiations – and with just two board members that seems doubtful – it is more likely to try to maximise prices for its own sake than to minimise them for China’s good.

Evidence that China’s forays abroad have been led by companies, and not orchestrated by an all-knowing state, is plentiful. Chinese companies often compete for the same asset. Both Shanghai Automotive and Nanjing Auto bid for Rover when the UK carmaker went chassis-up. Fears that Beijing is making a huge asset grab while the world reels from financial crisis also ignore the fact that foreign adventures are out of vogue in China. State institutions that invested in sinking foreign banks have faced public outrage for squandering national resources.

Pilling quotes NLP Senator Barnaby Joyce as saying:

“If they own the resources, they will just dig them up and cart them away.”

Yes, Barnaby - that’s how mining works. 

posted on 26 February 2009 by skirchner in Economics, Financial Markets, Foreign Investment

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The Giant GSE Risk Turkey: The Future of Freddie and Fannie

Alex Pollock on what to do with the Congressionally-mandated GSEs, Freddie and Fannie:

It’s a perfect time to think about the fundamental restructuring of the world famous, now broke, Government-Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac.

Last summer, as we could all observe, the giant GSE risk turkey, weighing in at $5 trillion, came to roost in the dome of the U.S. Capitol.  Like Edgar Allan Poe’s celebrated raven, it won’t go away.  It roosts there, so the elected representatives of the people can’t forget the mistakes they made in fattening it up.

But while Poe’s raven croaked “Nevermore,” does the GSE risk turkey gobble “Evermore”?  Is this risk a permanent burden on the public finances?  Should it be?  My answer is No.

posted on 24 February 2009 by skirchner in Economics, Financial Markets

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PIMCO: Bail-Out Profiteers

PIMCO’s Bill Gross, bail-out profiteer:

in 2008 Gross shifted from Treasuries and corporate bonds into mortgage debt backed by Fannie and Freddie because he believed that the government would ultimately keep those government-sponsored enterprises (GSEs) afloat. By May, Gross had moved 60% of Total Return into GSE-backed bonds, up from 20% the year before. “In a way, we’ve partnered with the government,” says El-Erian. “We looked for assets that we felt the government would eventually have to own or support.”

Pimco also made a bet on GMAC, the struggling finance arm of General Motors, reasoning that Washington would not let the lender fail for fear of crippling the U.S. auto industry. “We tried to move ahead of the government,” says Gross, “to purchase assets before we believe they will have to.”

Once the financial crisis hit, Gross was not shy about calling for a bailout - and he is an especially effective advocate for his causes. Where many big money managers try to keep a low profile, Gross has always maintained a forceful public persona, making regular television appearances to promote his views.

posted on 21 February 2009 by skirchner in Economics, Financial Markets

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Anglo-American Outperformance

The Anglo-American economies are outperforming in the current global economic downturn, as Chris Dillow observes:

The “Anglo Saxon” model - lightly-regulated financial markets and high debt - makes their economies unusually vulnerable to boom and bust…

This has become conventional wisdom. Today’s figures, though, seem to contradict it. They show that euro zone fell 1.5% in Q4 (6% annualized!), as much as it did in the UK and more than in the US. With next week’s figures likely to show a huge fall in Japanese GDP, this means that the major “non-Anglo” economies are doing at least as bad as the US and UK.

As Chris notes, this is partly due to the exposure of the non-Anglo-American economies to highly cyclical manufacturing industries.  However, the importance of manufacturing to these economies is itself a function of the mistaken strategic industry and trade policies pursued by these countries.

The cyclical outperformance of the Anglo-American economies reflects their structural outperformance, which affords them higher trend growth rates around which their economies cycle.  Japan’s trend growth rate of around 1.5%-2% is so low that it takes only a modest downturn to throw its economy into recession, which is why Japan experiences so many of them.

Fiscal stimulus packages and other interventionist policy responses in the Anglo-American economies will undoubtedly hurt their structural performance.  However, these polices are no worse than those being pursued elsewhere, so the Anglo-American economies and asset markets still have scope to outperform in the context of the current downturn.

It should not be surprising then that those who followed the asset allocation advice of some of the leading permabears are now seeing their portfolios underperform.

posted on 14 February 2009 by skirchner in Economics, Financial Markets

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