Friends the ‘Austrian School’ Could Do Without

Should we be surprised when PIMCO’s Paul McCulley writes ‘A Kind Word for the Austrian School’?  We have previously drawn attention to the rather bizarre views of the senior officers at PIMCO, not least McCulley’s call for the re-regulation of financial markets, and Bill Gross’ doomsday cultism in relation to the US dollar.  But the PIMCO crew are not only ones invoking Austrian business cycle theory on behalf of bizarre macro views.  The ‘Austrian School’ has received favourable mention from central bankers at the BIS, not exactly the traditional home of Austrian School thinking.  The Economist magazine loves to say that ‘the Austrian school of economics offers perhaps the best framework to understand what is going on,’ and a few years ago ran a special feature on the world economy that was explicitly Austrian.  One could almost be forgiven for thinking that Austrian business cycle theory is undergoing something of a revival.

It is not coincidental that all of the sources cited above have also been prominent in arguing that ‘bubbles’ are the main driver of the business cycle and asset prices.  But what causes ‘bubbles’ in the first place?  Austrian business cycle theory seemingly provides the answer: ‘it was the central bank wot done it!’  This is actually a fundamental explanation, but if people choose to label the process a ‘bubble,’ then so be it.

The notion that the monetary authority is largely to blame for business cycle and asset price fluctuations is appealing in its mono-causality, but also dangerous, because it promotes the idea that a more activist monetary policy could effectively smooth the economy and asset prices.  Needless to say, this is not the preferred conclusion of those in the Austrian School, who focus instead on changes in monetary regime.  But they should not be surprised by the misuse of their theory, which lends itself to exaggerating the importance of monetary policy to economic outcomes. 

This is especially true in a world of interest rate and inflation targeting, where monetary policy is largely an endogenous response to economic activity and the exogenous component of monetary policy is very small - so small, in fact, that many academic researchers question whether the exogenous component of monetary policy is large enough to have important macroeconomic implications.  In the Anglo-American economies, it is now probably more accurate to say that the economy drives monetary policy, not the other way around, which is actually fairly close to the Austrian ideal of a market-determined monetary system.

posted on 24 June 2006 by skirchner in Economics

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Hillary and the Candlemakers

Senator Clinton breaths new life into an old classic:

One of the most famous documents in the history of free-trade literature is Bastiat’s famous “Candlemakers’ Petition.” In that parody, the French economist and parliamentarian imagined the makers of candles and street lamps petitioning the French Chamber of Deputies for protection from a most dastardly foreign competitor:

“We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation. This rival…is none other than the sun.”

For after all, Bastiat’s petitioners noted, how can the makers of candles and lanterns compete with a light source that is totally free? Thank goodness we wouldn’t fall for such nonsense today. Or would we?

Last month, Sen. Hillary Rodham Clinton and nine colleagues (ranging from Barbara Boxer to Tom Coburn) endorsed a petition from — you guessed it — the domestic candlemaking industry asking the secretary of commerce to impose a 108.3 percent tariff on Chinese candle producers.

posted on 24 June 2006 by skirchner in Economics

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Small Incentives Matter

Recent data have confirmed what many of us have known anecdotally for some time: the federal government’s increased incentives for new born babies has triggered a baby boom.  The number of births in 2005 was the highest since 1992.  The 2005 increase over 2004 is even higher adjusting for age-specific fertility rates.  Joshua Gans and Andrew Leigh have further quantified these effects in some well publicised research.

This comes as no surprise to economists, who have always stressed that even seemingly small incentives can have big impacts on behaviour where it counts: at the margin of choice.  The fact that small incentives impact life-changing decisions like when to have children says a lot about the likely behavioural responses to high marginal tax rates.  The case for lowering these rates has never been primarily about increasing after-tax incomes (welcome though that may be for the beneficiaries).  The importance of lowering high marginal tax rates lies in reducing distortions to behaviour, not least, the waste of resources devoted to tax minimisation.

posted on 20 June 2006 by skirchner in Economics

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Cranking Up the Wayback Machine on Stephen Roach

Stephen Roach accuses central banks of promoting ‘bubbles’ through excessively accommodative monetary policies.  So I thought I would dig up what Roach had to say at the time of the last Fed easing in 2003 (emphasis added):

the key objective for the authorities is to get the US economy back to a sustainable 4% growth pace - and hold it there for several years.  That’s the only way the deflationary gap between aggregate supply and demand can be closed once and for all.  A temporary growth spurt won’t do the trick, and yet that’s a classic symptom of a post-bubble economy.  I continue to fear that a post-bubble US economy plagued by a lack of policy traction will be unable to complete the critical transition from subpar to rapid growth.  And that underscores the ultimate risk: A persistence of subpar growth in the current climate could take the US economy further down the slippery slope toward outright deflation.

Once again, financial markets are telling me that I’m dead wrong.  The sharp run up in equities speaks of expectations of a sustained upturn in earnings that only a vigorous economy could deliver.  The recent sharp sell-off in Treasuries speaks of a bond market that now believes that the Fed has done enough to fight deflation and spark a snapback in the real economy.

Yet, if I’m even close to being right on the economy, the markets could well be blindsided by the next in a long string of relapses.

That’s the problem with Roach: you are either in a ‘bubble’ or a ‘post-bubble.’  The ‘bubble’ paradigm is an all-purpose analytical framework that explains everything and nothing.

posted on 18 June 2006 by skirchner in Economics, Financial Markets

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What Ross Gittins Won’t Tell You (or Just Plain Doesn’t Know) About Cutting Taxes

From Alan Reynolds:

More than a dozen highly regarded studies have shown that the amount of income reported by those facing the highest marginal tax rates is extremely sensitive to changes in those tax rates. This is measured by the “elasticity” (responsiveness) of taxable income…

What all this means is that cutting the top tax rate in half has resulted in much more income being reported and taxed in every country that tried it—the United States, United Kingdom, New Zealand and India, for example. Some mistakenly imagined that proved the rich suddenly became richer when U.S. tax rates fell from 1986 to 1988. What it actually proved was that the rich reported more taxable income when tax rates on an extra dollar became more reasonable. These facts are not seriously in dispute regardless what portion of this widely observed “Laffer Curve” phenomenon was due to a change in actual income (a supply-side effect) or to a change in the proportion reported to tax collectors.

In other words, supply-side economists were right all along. Their critics were wrong. Several Nobel Laureates in economics have now said as much. Get over it.

posted on 15 June 2006 by skirchner in Economics

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Permabears Seek Validation in the Cycle

Markets are sending very strong signals of late.  The yield curve inversion in the US and elsewhere, falling stock and commodity prices are all pointing to a weaker global growth outlook.  The curve flattening in particular reflects a ‘stagflation trade’ which anticipates central banks overdoing monetary policy tightening to contain inflation pressures. 

The permabears have been busy recasting their long-running structural bear call into a cyclical one, hoping the cycle will finally validate them.  It is increasingly likely that the cycle will finally oblige them on at least some counts.  If nothing else, they have the law of averages on their side.  Yet markets have not yet delivered much joy to the purveyors of macroeconomic anti-Americanism.  Just ask anyone who followed their advice and bought non-USD denominated asset markets, particularly Asian equities, as a hedge against USD weakness.  So far, the USD has been a beneficiary of recent market developments and Asian equities have been crunched.  Some hedge!

posted on 14 June 2006 by skirchner in Economics, Financial Markets

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The Wisdom of Crowds and Insider Trading

Henry Manne argues that the success of prediction markets supports the legalisation of insider trading:

The implications of what we already know of this “wisdom of crowds” approach to price formation, as against the traditional marginal pricing/arbitrage approach, are apt to be startling. We should rethink any current policies based on a view of pricing in which we exclude the best-informed traders and discard the wisdom of the many. For instance, we now have a new and more powerful argument than we had in the past for legalizing most insider or informed trading.

The new approach would suggest that it is undesirable to have laws discouraging stock trading by anyone who has any knowledge relevant to the valuation of a security.

posted on 13 June 2006 by skirchner in Economics, Financial Markets

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Why the Kiwis Have Not Become Tigers

The New Zealand Business Roundtable has released Frederic Sautet’s report, Why Have Kiwis Not Become Tigers?  Sautet concludes:

New Zealand has not become a growth dynamo like Ireland because the reforms implemented did not go beyond OECD standard practice. To become tigers, Kiwis must adopt more radical reforms. Unfortunately, the Labour-led government in its 2005 Budget (and in its new incarnation after the September 2005 election) shows little inclination to improve the institutional environment in which entrepreneurial activity takes place. Rather, it prefers to continue increasing the size of government and, through regulation, to tinker at the margin with the rules of the economic game.  In the absence of changes, New Zealand’s economic outlook seems likely to be mediocre rather than exciting.

posted on 13 June 2006 by skirchner in Economics

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Ebay and Online Gaming Regulation

Radley Balko on Ebay’s lobbying efforts in relation to on-line gaming regulation:

Thiel and Levchin’s vision for PayPal is long dead. But it lives on in similar, offshore companies like Neteller and FirePay. These companies are safe and reliable (FirePay is traded on the London Stock Exchange), but aren’t subject to U.S. law, and so can be used for all sorts of goods and services the U.S. government has determined Americans aren’t grown-up enough to purchase. The most notable of these is Internet gambling.

Which means that Goodlatte’s bill’s main effect will be to shield PayPal, a domestic company, from foreign competitors (foreign competitors that, ironically, are doing exactly what PayPal’s founders envisioned).

What’s more, the letter eBay government relations director Brian Bieron sent to Goodlatte announcing the company’s support of his bill actually goes above and beyond what any gambling foes in Congress have called for. Bieron in fact calls for the actual prosecution of Internet gamblers themselves, a policy which could only be enforced by allowing law enforcement officials to essentially begin monitoring everyone’s online activity, including tracing visited websites back to IP addresses.

Industry insiders estimate that as much as 4 percent of the U.S. population participates in online gambling. That’s about 12 million people. It’s likely that a good percentage of those 12 million active, online users also patronize eBay. I wonder what they’d think if they knew that eBay has called for them to be arrested and prosecuted?

posted on 11 June 2006 by skirchner in Economics

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Digesting Dow 36,000

Dan Gross eats James Glassman’s words - literally.

posted on 11 June 2006 by skirchner in Economics

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What Kind of Bird is That?

Bird-watching with James Hamilton:

What does Bernanke really believe? Well, for starters, that:

Some people find that level of complexity unsettling. But personally, I prefer to have the U.S. Federal Reserve run by a human rather than a bird.

posted on 11 June 2006 by skirchner in Economics

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Bernanke and Inflation

No one ever accused Allan Meltzer of being soft on inflation:

Allan Meltzer: I think the best measure of Mr. Bernanke’s credibility is the bond market, and there is no sign there that traders expect big inflation or even much inflation.

There are enough anti-inflationists at the Fed that even if Mr. Bernanke were mild on inflation—and I don’t think he is—there would not be a majority supporting that position. So I don’t think inflation-fighting credibility is Mr. Bernanke’s problem.

posted on 09 June 2006 by skirchner in Economics

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A Not So Tragic Current Account Deficit

Opposition Treasury Spokesman Wayne Swan piles on the hyperbole following the release of the Q1 current account deficit:

“I think it is a matter of national tragedy that, given we have a global commodities boom and the best trading conditions in a generation, that we are importing into this country more then [sic] we are exporting,” he said.

If this is a national tragedy, it is a long running one, since Australia’s balance on goods and services has averaged -1.1% of GDP since 1960, little different from the -1.8% of GDP seen in Q1 2006.

Now that the current account deficit is actually narrowing, the sub-editors have switched their attention to record foreign debt levels for their headline grabs.  Record foreign debt levels should be no more newsworthy than the record levels of exports of goods and services that go with them: both series are subject to a secular expansion.  Press releases announcing record exports each financial year are a favourite trick of National Party trade ministers, who can practically write the press release a year in advance.  All you have to do is fill in the export numbers.

What matters is the ratio of net foreign debt to exports, which as the chart below shows has been steadily narrowing since the early 1990s.  Another reason I don’t lose any sleep worrying about current account deficits.

posted on 07 June 2006 by skirchner in Economics

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FDI Protectionism: Australia Gets Some of its Own Back

One of the great success stories of the Australian economy that we have sought to highlight on this blog has been the rise of Australia as a net exporter of direct investment capital, a reflection of the globalisation of Australian business.  As this story notes, Australia is the eighth largest investor in the US, with leading Australian companies like Macquarie Bank, BHP Billiton, Santos, Woodside, Westfield, Rinker and Visy owning more than $US130 billion in assets and employing more than 80,000 people in the US.

Given Australia’s sorry record of FDI protectionism on spurious national interest grounds, often at the behest of local producer interests, there is a certain justice in Australian firms now being on the receiving end of similar protectionist sentiment in the US.  As the story cited above notes:

AUSTRALIA might have a free trade agreement with the US but it hasn’t stopped this country being caught in an outbreak of xenophobia towards foreign investors, particularly Macquarie Bank…

The multi-billion-dollar leases for toll roads in the US that Macquarie is acquiring with its Spanish partner Cintra appears to be falling into the definition of “critical infrastructure” that some congressional members want foreigners banned from buying.

The notion that Australian ownership of US infrastructure poses a threat to the US is absurd, but no more so than similar arguments routinely run in the Australian context.  The Australian government proposed to limit foreign ownership in the Snowy Hydro privatisation before the whole thing collapsed amid an outbreak of nationalism and parochialism that would shame even Pauline Hanson.  Australia runs one of the most restrictive FDI regimes in the OECD and the US-Australian FTA left in place sweeping ministerial discretion over foreign investment in Australia. 

FDI protectionism is a silly game to play, especially on the part of firms with global business interests and economies dependent on foreign investment to finance their current account deficits.

posted on 05 June 2006 by skirchner in Economics

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Snowy Hydro: Myth versus Reality

Myth:

‘This is an unique piece of infrastructure with a cultural ethos,’ said Bernie Fraser, governor of the Reserve Bank of Australia between 1989 and 1996, and whose father Kevin worked on the Snowy. ‘The plan to sell related around short-term fiscal gains, and that is mad ideology for this icon,’ he said in an interview.

Reality:

The Snowy Hydro electric scheme is no more iconic than the Loy Yang power station, the national phone network or even the TABs. In withdrawing it from sale the Government has capitulated to the paranoid and cynical campaigns of vested interests.

As discussed in this column two weeks ago, Snowy Hydro is, in fact, an investment bank - selling derivatives and insurance products to the electricity industry. It is not even really a power company and certainly not an iconic one. The “vast majority” of its revenue, according to the company, comes from investment banking activities, in competition with investment banks.

posted on 03 June 2006 by skirchner in Economics

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