The Biggest Bubble in History?

House prices feature on the cover of The Economist.  With its usual hyperbole, the Economist claims that house prices are now ‘the biggest bubble in history.’  Its benchmark for this claim is the percentage change in the capitalisation of the housing stock relative to GDP.  Apart from the dubious stock versus flow comparison, the Economist would have us believe that this is all pure asset price inflation: 

the biggest increase in wealth in history was largely an illusion.

The many real factors that might be contributing to an increased capitalisation of the housing stock are all irrelevant apparently.  With all the authority of a hellfire preacher, The Economist claims to have seen it all coming and proclaims ‘the day of reckoning is closer at hand.’  It is all just so shriekingly obvious to The Economist.  It’s everyone else that must be stupid:

The rapid house-price inflation of recent years is clearly unsustainable, yet most economists in most countries (even in Britain and Australia, where prices are already falling) still cling to the hope that house prices will flatten rather than collapse.

I would suggest that what economists are clinging to is the intellectual modesty The Economist magazine surrendered a long time ago. 

The great Max Corden once said that worrying about something that is ‘unsustainable’ is like worrying about the growth rate of a teenager.  Australia’s experience both historically and with the current moderation in house prices certainly points to the ‘flatten’ rather than the ‘collapse’ scenario.  The fact that falling house prices have made the cover of The Economist, notorious as a contrarian indicator, is perhaps the most reassuring sign yet.

posted on 17 June 2005 by skirchner in Economics

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Current Account Sustainability

Tony Makin argues against the 5% of GDP rule of thumb on current account sustainability:

an internationally recognised rule of thumb has developed that says an external deficit is excessive if it reaches 5 per cent of GDP. Australia has not been below that for quite some time.  Yet this 5 per cent limit, popular with the IMF, has never been justified analytically and seems arbitrary…

In the meantime, the high current account deficit remains the best measure of the extent to which foreigners are expressing confidence in the Australian economy. It will persist as long as that confidence is warranted.

It is also worth recalling that the existing record current account deficit was preceded just a few years ago by a record narrowing of the deficit.  Current account balances cycle and this cycle is becoming more pronounced in Australia’s case.  It is no accident that the record narrowing in the deficit followed the AUD making record lows in 2001.  As Makin argues, floating exchange rates provide an adjustment mechanism to external imbalances.

posted on 16 June 2005 by skirchner in Economics

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Beazley Economics

If the Labor Party wants to restore its credibility on economic policy, it will have to do much better than this:

“Our country is at a crossroads; every day we sink further and further into unsustainable debt,” Beazley told the conference. “On average, foreign debt has gone up by more than $2.5 billion in every single month of the Howard-Costello Government.

“My deep worry for Australia is this: I believe John Howard and Peter Costello are taking us to the edge of the debt cliff. I fear Australia’s credit card is nearly maxed out.”

Net foreign debt increases under every government, for the very good reason that we need to borrow abroad to make good the shortfall between domestic saving and investment that drives the current account deficit.  If Beazley is seriously proposing to reduce foreign debt, then he is arguing for some combination of increased national saving or reduced investment.  We can maintain higher levels of both consumption and investment by borrowing abroad than would otherwise be possible.  Beazley is effectively proposing to cut our standard of living for the sake of a lower current account deficit, a self-defeating policy prescription.  It is the capital markets equivalent of an import substitution policy.  The gains from trade in goods markets are equally applicable to capital markets.  Australia’s debt servicing ratio is in very respectable bounds and the foreign currency risk is fully hedged, so Australia’s foreign liabilities are well below the level that would give rise to any concern.

Beazley’s populist rhetoric on foreign debt is of course no different from that the government used when it was in opposition, but it doesn’t do much for his credibility.

posted on 14 June 2005 by skirchner in Economics

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Ben Bernanke and the Fever Swamp Austrians

Bryan Caplan defends Ben Bernanke against the attack of the fever swamp Austrians.  Those who refer derisively to ‘printing press Ben’ would do well to actually read some of Bernanke’s academic work.  Bernanke has done much to revive pre-rational expectations, old school monetarism and once again give it respectability in academic and policy circles after decades of neglect (his 2004 Brookings paper with Reinhart and Sack being a good example).  Even John Taylor, the pre-eminent exponent of interest rate targeting, has spoken of the need to resort to quantitative approaches to monetary policy when low inflation puts a floor under the real rate. 

Leland Yeager once said ‘I sometimes get the impression that Austrians recite their favourite cycle theory as a kind of elaborate password for mutual recognition and encouragement.’  Yeager has shown that acceptance of the importance of monetary disequilibrium actually argues against much Austrian business cycle theory.

Bernanke is currently front runner on the Intrade contracts to replace Greenspan, although the market is very thin.  My guess is that his lack of extensive experience in government relative to some of the other candidates will count against him, but he would make a fine Fed Chairman.

posted on 12 June 2005 by skirchner in Economics

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RBA Transparency: Right Up There With Motherhood

A survey has found a high level of public support for the proposition that the RBA should be required to release the minutes of its deliberations:

The Hawker Britton survey of 500 people found 80 per cent thought it was time the Reserve was forced into releasing its minutes, with just 16 per cent supporting the current closed book.

“The Bank of England and the United States Federal Reserve both release minutes of their board meetings, but not the Reserve Bank of Australia,” he said in a statement.

Of course, transparency is a bit like motherhood and so the high level of support is not really surprising.  Moreover, if the respondents were told about the practices of other central banks, this frames the question in a way likely to elicit a positive response.  Still, it is encouraging to see this issue being actively canvassed.

posted on 09 June 2005 by skirchner in Economics

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Investment and the Current Account

There has been scepticism in comments about my claim that Australia has experienced a non-dwelling investment boom and that this is the main driver of the deterioration in the current account balance.  The following chart shows the dwelling and private business investment share of GDP, although leaves out some investment components such as public investment.  Total investment has been at record levels as a share of GDP, yet the dwelling investment share has remained relatively stable.

posted on 08 June 2005 by skirchner in Economics

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Economists for Legalising Weed

The sort of applied economics we like to see:

Replacing marijuana prohibition with a system of legal regulation would save approximately $7.7 billion in government expenditures on prohibition enforcement-$2.4 billion at the federal level and $5.3 billion at the state and local levels.

Revenue from taxation of marijuana sales would range from $2.4 billion per year if marijuana were taxed like ordinary consumer goods to $6.2 billion if it were taxed like alcohol or tobacco.

If you are an academic economist, you can add your name to a list of over 500 economists supporting legalization here.

(via Mahalanobis)

posted on 08 June 2005 by skirchner in Economics

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The AEI Disgraces Itself Yet Again

Why is it that the right-wing American Enterprise Institute is channelling John Quiggin and Ross Gittins?

LETTERS TO THE EDITOR
The Economist  
Publication Date: June 2, 2005

Sir—You waxed lyrical about Australia’s 15 years of continuous economic growth. However, you gloss over the fact that Australia’s external imbalances have never been larger, even at a time when international commodity prices are booming and China is expanding rapidly. You also failed to note that Australia’s housing bubble and consumer over-indebtedness make the United States look like a paragon of frugality. A more balanced view might have asked what happens to Australia when commodity prices ebb and when China’s investment bubble bursts?

Desmond Lachman is a resident fellow at AEI.

Since the Australian economy powered through the global collapse in commodity prices in 1998 after the Asian crisis with a real annual growth rate of 6%, I think we already know the answer to that question Des!

Maybe Quiggin and Brad DeLong were right after all:

“Back in the late 1970s, the American Enterprise Institute ranked close to the Brookings Institution as a think tank you could trust not to deliberately lie to you. Now it has fallen very deeply into the pit indeed”.

posted on 07 June 2005 by skirchner in Economics

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More Housing Nonsense from Gittins

Ross Gittins’ column today is almost a perfect summary statement of all the nonsense written about housing in recent years.  In particular, Gittins claims:

What many people don’t realise, I suspect, is that the housing boom effectively crowded out external demand (“net exports”). You can see this from two perspectives. The first is that, on the one hand, the housing boom added to consumption and so reduced saving while, on the other, it added to investment (in the housing stock). So, by reducing national saving and increasing national investment, the housing boom caused a widening of the current account deficit.

The problem with this argument is that it is simply not supported by the data.  As we have pointed out on previous occasions, consumption and national saving as a share of GDP have been remarkably steady.  Investment has boomed, of which housing makes up only a part.

The widely held perception to the contrary stems in part from the fact that the ABS does not highlight the national saving data in the national accounts release, for the simple reason that these data are so boring.  They do report the household saving ratio, because it shows more colour and movement, but if you read the fine print, you will see that the ABS doesn’t believe its own numbers.  In particular, they warn that the data are potentially subject to significant revisions which ‘can cause changes in the apparent direction of the trend.’

In fact, one can argue that it is the increased purchasing power of domestic production from improvements in the terms of trade that is driving income growth that is in turn driving consumption and house prices.  In other words, consumption and house prices are jointly driven by strong growth in national income, not the other way around.  Strong growth in the terms of trade is also driving the growth subtraction from net exports, as we substitute cheap imports for domestic production.  This makes us better off in welfare terms, but you won’t see this looking at the domestic product account. In fact, the peak in annual growth in house prices coincides quite nicely with the growth peak in real gross domestic income.

Gittins goes on to argue:

The second way to think of it is that, thanks to the economic growth emanating from the housing boom, the unemployment rate fell steadily to a 28-year low of 5 per cent.

The Reserve Bank would not have wanted to see the economy growing any faster than it did. In its management of demand along the path it took, the Reserve kept the official interest rate higher than otherwise, which probably kept the exchange rate higher than otherwise, thereby crowding out net exports.

I trust Gittins is not seriously arguing that we should have a slower rate of economic growth and a higher unemployment rate, just so we can have lower interest rates, a weaker dollar and a better current account balance, but that is the clear implication of what he is saying.  That is exactly the formula which brought us the early 1990s recession.

posted on 06 June 2005 by skirchner in Economics

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The Euro:  Too Crappy, Even for the Italians

One of the great attractions of the euro was that it offered instant monetary credibility to countries with less than stellar inflation records like Italy.  For these countries, the euro was a free lunch.  They could import monetary policy credibility, without having to make difficult monetary and fiscal policy decisions over and above satisfying the convergence criteria.

Italian politicians are now seeking support for a referendum to pull Italy out of the euro:

Roberto Maroni, Mr Berlusconi’s social security minister and a joint acting leader of the Northern League, said his party would start collecting signatures for a referendum on the issue later this month. He also appealed for the process of ratifying the EU constitution to be halted.

Mr Maroni held up Britain as a model to be copied. “It is growing [and] developing while keeping its own currency,” he said.

(via Alex Singleton)

posted on 05 June 2005 by skirchner in Economics

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From Nostradamus to Krugman: 450 Years of Economic Doom-Mongering

Mark Mahorney has compiled an inventory of published economic doom-mongering, showing the remarkable persistence of the genre.  I’m sure there is a great behavioural finance paper to be written about our willingness to believe that the economic end is nigh, which is generally belied by the actual personal financial decision-making of most people.  I can think of at least one prominent market forecaster who must have a lot of canned food stocked in his basement if he takes his forecasts for the S&P 500 at all seriously!

The widespread adoption of general equilibrium theorising by the economics profession has actually encouraged the belief that any observed cycle must somehow be indicative of an irrational, and potentially ruinous, boom and bust.  The great contribution of Austrian economics is to show that disequilibrium is in fact the norm, not the exception.  It is a tragedy that much popular Austrian economics is these days so heavily implicated in doom-mongering, inspired by a gross misreading of its own tradition.

posted on 04 June 2005 by skirchner in Economics

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Robert Shiller on Australia’s House Price ‘Bubble’

Robert Shiller has an op-ed in the WSJ that attempts to use Sydney as an example of a house price ‘bubble’ gone bust:

Real home prices in Sydney, Australia, rose 12.8% in 2003 and then dropped 2.5% in 2004, a pretty sharp bursting of their bubble.

The Q1 data released today actually show an even larger fall in real terms of 5.8% y/y (-3.4% y/y in nominal terms).  But if a 2.5% fall in real terms following double-digit growth rates is enough to satisfy the definition of a ‘burst bubble,’ then this is in fact a fairly routine occurrence for Sydney.  This is just another way of saying that real house prices cycle and any given boom needs to be interpreted with reference to the cycle as a whole, not taken out of context.  Much of the run-up in Sydney house prices in recent years is arguably compensation for previous cyclical weakness, in which house price growth was well below trend.  Since Shiller’s Irrational Exuberance was little more than an argument in favour of mean reversion in stock prices, none of this should be surprising to him. 

Shiller is nonetheless right to suggest that Sydney provides an example of how house price inflation might end: benignly.  None of the doomsday scenarios based on an end to house price inflation have been realised (many of these forecasts were just publicity seeking exercises by economic consultancies).  Sure, the economy has slowed on some measures, but there is an important issue of causality here.  As I have argued previously, Sydney real house prices have at best a contemporaneous and often a lagging relationship with economic activity. 

As always, ‘bubble’ talk is just a distraction from fundamentals.  If Shiller had done a search for stories about fundamentals rather than bubbles, he would have come up with no end of stories like this:

Sydney will need to squeeze in 7000 extra apartment blocks to house the million-plus new people expected by 2030…

UPDATE: Alan Wood is also unimpressed by the claim that a 2.5% decline in real terms constitutes a burst bubble (no link):

Really?  Australia’s house prices more than doubled in real terms, and a fall back of 2.5% isn’t that nasty, although it may be having some effect on household spending.

There have in fact been no less than 10 quarters since Q2 1987 in which Sydney house prices fell by more than 2.5% y/y in real terms, although this probably says as much about consumer price inflation as it does about house prices.

posted on 03 June 2005 by skirchner in Economics

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Housing and the National Accounts

The Q1 headline GDP outcome of 0.7% q/q sparked none of the hysteria attaching to the Q4 result (now revised up to 0.3% q/q).  Yet domestic final demand contributed nothing to headline growth in Q1.  Consumption and investment were a wash, leaving a large run-up in inventories to fully account for the growth in gross national expenditure, before the subtraction from net exports.

Another little remarked upon feature of the national accounts was that ownership transfer costs, a reasonable proxy for turnover in the established housing market, did not subtract from growth for the first time since Q4 03 (rounding to a tenth of one percentage point).  One of the reasons I have been so dismissive of the gloom and doom scenarios in relation to house prices is that weakness in the housing market is seen on volumes as much as prices.  Ownership transfer costs in chain volume terms have fallen by 17.1% over the year to March, but the decline has moderated every quarter since March last year.  While weakness in house prices still has further to run (see this Friday’s release of the ABS series), the worst of the decline in transaction volumes would appear to be behind us based on past cyclical experience with this series.  The stylised Australian house price cycle of recent decades would point to a bottoming of house prices relative to trend by the end of 2006.

posted on 02 June 2005 by skirchner in Economics

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Gloom, Doom and Boom Competition: We Have a Winner!

This week’s record current account deficit once again provided rich pickings for our quarterly Gloom, Doom and Boom competition for overwrought reporting.  AAP deserves the Speedy Banana Award for referring to a ‘banana republic’ in a story just minutes after the release: 

As a proportion of GDP, the current account deficit is around a record 7.2 per cent, prompting analysts to warn Australia is in danger of becoming a “Banana Republic”.

Of course, no analyst was actually quoted as saying anything of the sort, suggesting that AAP was engaging in the usual colour-by-numbers financial market journalism.

John Garnaut gets some credit for running a (somewhat selective) version of the consenting adults view of current account deficits, but then disappoints when he says:

The current account deficit, or CAD - which reflects the shortfall between exports and imports as well as financial transactions with the rest of the world - showed Australians paid foreigners $15.6 billion more than they received from them in the three months to March.

In fact the CAD shows the opposite – that foreigners lent us $15.6bn to make-up the shortfall between domestic investment and saving.

John Quiggin (in comments) seemed almost ready to concede the consenting adults view, noting:

Past experience would suggest either a recession or a sustained period of low growth, particularly in consumption. But we’re in uncharted territory here, and the optimists say global financial markets will look after us.

As RBA Governor Macfarlane noted in his most recent testimony to the House Economics Committee, many people were declaring the US current account deficit unsustainable at 5%.  The new cyclical highs in the US and Australian current account deficits suggest that there has also been a structural deterioration in the current account balances of both countries.  Quiggin questions whether we are heading for a current account deficit of 10% of GDP.  In a world of floating exchange rates and mobile capital, there is no reason why such large deficits should not be possible.  Indeed, deficits of that size would be a massive vote of confidence in the Australian economy.

The lucky winner of our competition, however, goes to…

continue reading

posted on 01 June 2005 by skirchner in Economics

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Non!  Right Decision, Wrong Reasons

France has made the right decision for the wrong reasons on the EU Constitution.  As David Carr puts it:

To all French crypto-communists, syndicalists, marxists, trotskyites, leninists, stalinists, national socialists, socialist nationalists, primitivists, Trade Union dinosaurs, student activists, greenie nutters, neo-fascists, old fashioned fascists, quasi-crypto-troglodyte-Pol-Pottist-year zero-flat-earthers, looney tunes and enviro-goons….Merci Beaucoup!!!!

I could kiss every single one of you.

You first Dave!  Unfortunately, we can take little comfort from the result because, as incredible as it may seem, many French people saw a ‘no’ vote as a rejection of market liberalism. 

It is disturbing the extent to which the EU project is still taken as given among elite opinion, despite being rejected on most occasions when EU institutions are actually put to a popular vote and growing evidence that foundational EU institutions like the euro are hopelessly flawed.  A good example of this thinking is Anatole Kaletsky’s analysis attributing the failure of the referendum to the European Central Bank’s monetary policy:

Europe’s economic failure can be blamed largely on the mismanagement of the euro project and the incompetence of the European Central Bank (ECB)…[and] do-nothing monetarist dogmatism of the ECB…The next recourse should be to call for the resignation of the ECB management, since they should be held accountable for the public rejection of the European project.

It apparently does not occur to Kaletsky that problem is the euro project itself, no matter how well managed, and that maybe the ECB is doing the best we could reasonably expect within the constraints of a single currency.  Critics of the euro having been warning of these very outcomes for years.  An easier monetary policy would do nothing to address Europe’s structural problems.

The danger is that the more EU institutions fail, the more politicians will resort to ad hoc fixes, rather than re-thinking the EU project itself.  The euro has already seen the Stability and Growth Pact effectively junked, removing an important institutional protection of monetary stability in Europe.  Kaletsky calls for European finance ministers to direct the ECB to engage in foreign exchange market intervention and even goes so far as to suggest that the legislative basis for ECB independence should be renegotiated.  It is in fact Kaletsky who is blinded by dogmatism in refusing to see that the euro project is fundamentally flawed.  In Europe, nothing succeeds like failure.

posted on 30 May 2005 by skirchner in Economics

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