The ‘October Surprise’ that Wasn’t
More of what Nouriel Roubini won’t tell you about the US economy, from my associates at Action Economics:
The U.S. Q3 GDP revision to 2.2% from 1.6% reflected all the component revisions that were expected, but an over-sized bump to inventories and trade, and a bonus upward revision to consumption of services. The revision eliminated the “1-handle,” and will go a long way toward marginalizing the market’s recession fears given the more optimistic spending trajectory as we enter Q4.
The service consumption boost will help close the income/spending gap through October, as will downward Q2 income revisions in this report. The mix leaves a more persistent and seemingly bullet-proof broad down-trend in the saving rate, despite the price-impacted “pop” we should see in the October personal income data tomorrow. The combination will reinforce our forecast of a robust outlook for Q4 consumer spending, and considerable upside risk to the consumption reports over the November-January period as the savings rate moves back toward trend.
We continue to expect a 2.6% GDP growth rate in Q4, and a 3% rate by Q1, as the growth undershoot of the middle quarters of 2006 scrolls by, and is replaced with trend-growth in the 3%-3.5% area. Indeed, we see upside risk to these estimates despite the market’s focus on signs that downside risks are emerging.
posted on 01 December 2006 by skirchner in Economics
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In Defence of Private Equity
John Chapman argues for the importance of private equity:
a dynamic market for corporate control is a key driver of economic growth. In fact, along with strong property rights and limited government, a stable monetary regime, low taxes on capital and income, free and open trade, and a culture conducive to entrepreneurship, vibrant M&A activity within dynamic capital markets is fundamental to maximizing growth in an economy. Further, superior M&A and private equity investing institutions in the U.S.—which are crucially supportive of entrepreneurial pursuits—are a major reason our economy is healthier than the capitalist economies of Europe or Asia, where these are less developed features of their financial markets…
M&A deals may or may not work out in any one case. But a dynamic market for corporate control, which the private equity sector has only served to make more broadly efficient and liquid, ensures that capital is quickly displaced from entrepreneurial errors and redeployed to higher-earning uses; thus, there has always been a strong correlation between M&A activity and macro-economic growth. Along with the other institutions of the market economy mentioned above, mergers and private equity serve to optimize the productivity of capital in an economy, which is its ultimate source of wealth.
posted on 30 November 2006 by skirchner in Economics, Financial Markets
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Interpreting Prediction Market Prices
William Wilson and Philip Wallach argue that prediction market prices are often misinterpreted:
the prices do not represent the binary “win or lose” probabilities of a Clinton return to 1600 Pennsylvania. The clearing price for Clinton commodity speculation was $2.20; with two years until the election, as many people as not believe that at any future time the universe of TS bettors will pay more than $2.20 for her stock. Sure, some of these Clinton speculators may believe that her chances of winning the ‘08 election are better than 22%, but many of them may have also believed that near-term news cycles would be more favorable to her than not, or that the Democratic swell on November 7 would raise all Democrats’ chances relative to Republican ones. And for every one of those traders, a paired trader has speculated the opposite to an inversely proportional degree (i.e., someone was also willing to pay $7.80 to make $10 for the proposition that Hillary would not become President in ‘08). The beauty of Tradesports—what differentiates it from a simple sportsbook—is that it allows such speculation; no one must hold a contract until expiration. The “odds-speak” shorthand conveys the right price, but shouldn’t suggest an inappropriately probabilistic explanation of January 20, 2009.
posted on 28 November 2006 by skirchner in Economics, Financial Markets
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Ian Macfarlane’s Boyer Lectures
Former RBA Governor Ian Macfarlane’s Boyer Lectures give a misleading account of monetary policy developments in the late 1980s and their role in the early 1990s recession. Macfarlane notes that:
The risk that worried most observers was the large deficit on the current account or the balance of payments, and the associated build-up of foreign debt. Most politicians, businesspeople, economists, journalists, and the community in general, regarded this as public economic enemy No.1.
Unfortunately, this was also a view then fully shared by the Reserve Bank, which had disastrous consequences for the conduct of monetary policy. In relation to the recession that followed the tight monetary policy of the late 1980s, Macfarlane says:
What adjustments to monetary policy could have prevented this situation from arising? There were many critics who believe that we should have had tougher monetary policy in place, and suggestions were made for stricter arrangements including such exotic ones as currency boards and commodity standards. Calls for monetary policy to take a harder line continued to be the refrain right through to the 1993 election, with the Fightback policy of the Coalition Opposition parties as its logical conclusion. But interest rates were already extremely high in real and nominal terms, and had been for most of the decade. Any monetary policy that could have prevented the surge in credit and asset prices in the second half of the 1980s, would have involved even higher interest rates. But how could the regular parts of the economy, those parts relying on cashflow from producing goods and services, and those competing with the rest of the world, have coped with higher interest rates…
The issue of how monetary policy could have been better conducted in the 1980s will probably never be resolved. I think we can conclude, however, that to the extent that there was a failure of monetary policy, it was not due to the traditional problem of the government and the central bank being unwilling to take tough measures, but was instead due to a failure to understand the implications of a sudden financial deregulation.
This misrepresents the nature of the debate over monetary policy in the late 1980s and early 1990s. The underlying issue was not about whether policy was too tight or too loose, but the framework within which monetary policy was conducted. The critics of the RBA at the time argued that Australia had high interest rates because monetary policy lacked credibility and could only establish credibility via institutional reform. This is why the federal Coalition’s 1993 Fightback manifesto advocated the adoption of NZ-style inflation targeting. Macfarlane’s reference to currency boards and commodity standards is an attempt to muddy the waters, by associating the advocates of reform with arrangements which no longer have much support. The only reason some of these more exotic arrangements were seriously discussed in the Australian context was that monetary policy had become such a mess that some reform advocates were doubtful that monetary policy credibility could be established in any other way. That view proved too pessimistic, but such pessimism could easily be forgiven in the early 1990s.
The RBA’s adoption of inflation targeting from the early 1990s was a vindication of the Bank’s critics, who had always stressed the need to focus on a single policy objective. It is thus wrong to say that ‘The issue of how monetary policy could have been better conducted in the 1980s will probably never be resolved.’
John Edwards, former economic adviser to Prime Minister Paul Keating, has also taken issue with Ian Macfarlane’s interpretation of history in his Lowy Institute paper, Quiet Boom:
This interpretation of the period seems to me quite wrong…. For some of the key players the tightening of monetary policy was not mainly about inflation. The Reserve Bank officially claimed in its 1988 annual report that the tightening began as a response to higher imports threatening ‘the improving trend in the balance of payments’, as well as a response to growth in earnings and prices threatening ‘the downward trend in inflation’. So far as Treasurer Paul Keating and his cabinet colleagues were concerned, the policy objective was not inflation so much as the current account deficit. This objective made the tightening episode vastly more difficult because after a period of stability the current account deficit began to widen again. In the mid eighties Prime Minister Bob Hawke and Treasurer Paul Keating had used the rising current account deficit to illustrate the necessity of faster economic reform. In doing so they made the size of the current account deficit a test of economic success. As Keating would later remark, the government was ‘hoist on its own petard’ by the sudden widening of the deficit in the late nineteen eighties. When it began to increase with rising business investment, they were convinced that it must be narrowed by slowing domestic demand. What began mildly enough with ‘the sound of a harp’ became a struggle to rein in the current account deficit before the next election… The political and economic impact of the subsequent recession was conditioned by the fact that it began after the Reserve Bank had began to cut interest rates.
posted on 27 November 2006 by skirchner in Economics
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EWI’s Stable Currency Benchmark: How Useful Is It?
Elliott Wave International has developed a Stable Currency Benchmark (BEWI Index DES
on Bloomberg) that is designed to serve as an alternative valuation metric for assets denominated in specific currencies and as a vehicle for protecting ‘global purchasing power.’ The SCB gives a 25% weight to each of the US, New Zealand and Singapore dollars and the Swiss franc.
The role of alternative valuation metric recognises the simple fact that changes in the price of given assets can look very different when denominated in other currencies. For example, the gold price can look very different when quoted in euros or the Australian dollar. The much vaunted relationship between the USD and the gold price is partly just a straightforward valuation effect that arises from the fact that gold, along with most other commodities, is typically quoted in USD.
This leads to the second concern about ‘global purchasing power.’ The SCB is designed to offer protection against a loss of ‘global purchasing power’ due to exposure to a single currency. Since most investors do most of their purchasing in their home market, the need for such protection is far from obvious. Investing in foreign currencies or foreign currency-denominated assets, rather than providing a hedge against loss of ‘global purchasing power,’ gives the investor an additional exposure to movements in foreign exchange rates, as well the underlying assets themselves.
This is why many investors hedge their holdings of foreign currency denominated assets against exchange rate movements. They are more concerned about securing the domestic purchasing power of their foreign asset holdings than their ‘global purchasing power,’ and so are often more than happy to give up possible gains from exchange rate movements in exchange for protection against exchange rate losses. Hedging foreign asset holdings back into an investor’s home currency offers better protection of purchasing power than taking on an unhedged exposure to even a well diversified basket of foreign currencies
The composition of the SCB is also a curious one. While the NZ dollar has the desirable characteristic of being backed by a generally sound monetary and fiscal policy, it is subject to large cyclical fluctuations. These fluctuations play an important role in insulating NZ against external shocks. While the NZD offers a high yield that appeals to foreign investors, an exposure to the NZD is essentially an exposure to a highly cyclical, small open economy.
The Singapore dollar is actively managed by the Monetary Authority of Singapore against a basket of foreign currencies, which serves as the main vehicle by which Singapore conducts its monetary policy. Singapore has a policy of ‘non-internationalisation’ of the Singapore dollar, discouraging its use for purposes other than those related to economic activity in Singapore. In practice, this policy relies on only very modest restrictions, since most non-residents have little interest in holding Singapore dollars. While its use as a monetary policy instrument gives the Singapore dollar some stability, holding Singapore dollars still involves taking on an exposure to the business cycle of a small city-state, whose economy is in turn highly exposed to the global business cycle.
The SCB would thus appear to be of limited value. It is far from clear why most investors should care about the performance of their assets measured against the SCB, as opposed to their home currency. At the same time, investments in the SCB involve foreign currency exposures that, however well diversified, may well do more harm to one’s domestic purchasing power than they do to enhance ‘global purchasing power.’
posted on 24 November 2006 by skirchner in Economics, Financial Markets
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The Cato Institute’s Annual Monetary Conference
The proceedings of the Cato Institute’s annual monetary policy conference are available here. Best as I can tell, The Economist is no longer sponsoring this event. Perhaps not coincidentally, there was one notable improvement in this year’s conference: no Nouriel Roubini.
I get a critical mention in a paper by Larry White:
Inflation targeting is not a market-based policy. Contrary to economist-blogger Stephen Kirchner (2006), Ben Bernanke is not a prophet of “the view that markets and not monetary policy should determine growth rates in broad money, credit aggregates and asset prices.” In a fiat money regime, the central bank controls the monetary base, and broad money is geared to the base via the money multiplier, so monetary policy-makers and not markets determine growth rates in broad money. Under inflation targeting, the Fed would adjust the base and thereby broad money to support the targeted price level path. In that sense the quantity of money becomes endogenous. It’s not really helpful to call that “markets” determining money growth.
Needless to say, I think this view is wrong, for reasons outlined in my critique of another economist with impeccable libertarian credentials, Tim Congdon. Like Congdon, White believes we face a ‘central-bank-generated-asset-bubble problem.’ The only evidence White offers for this is some quotes from leading market ‘bubble’ drone, Stephen Roach, and some ritual quotes from Hayek.
What this stylised Austrian theory of the business cycle and asset price determination lacks in empirical support, it more than makes up for in popular appeal, chiefly because of its simple mono-causality and because it gives people what they want most: an institution to blame when things go wrong. It completely ignores the real dimension to asset price booms and busts, what Jason Potts calls ‘liberty bubbles,’ which are a necessary expression of the market discovery process.
posted on 20 November 2006 by skirchner in
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The Quiet Boom
John Edwards has produced an overview of recent developments in the Australian economy for the Lowy Institute, ‘Quiet Boom.’ Edwards does a very good job of showing the origins and consequences of Australia’s 15 year economic expansion. I disagree with many of his conclusions, in particular, his claim that ‘the gains from more market reforms maybe worthwhile but will be marginal.’ This does not sit comfortably with his demonstration of the enormous gains that previous reform efforts have delivered or his observations about the challenges that slowing productivity growth presents to policymakers. Edwards notes that ‘at the beginning of the upswing market disciplines, deregulation and “economic rationalism” were widely questioned. Fifteen years on, there is no call to go back.’ Yet Edwards doesn’t exactly present much of a call to go forward either, instead falling back on tired mantras about ‘the importance of education, training, innovation and research and development,’ areas in which the returns to non-market based policy initiatives have been very low.
There is also a nice dig at The Economist magazine, which he notes:
sternly predicted that the collapse of Australia’s long house price boom would foretell a global downturn. The magazine had moved on to new alarms by the time it quietly ended.
Of course, The Economist was hardly alone in this.
posted on 20 November 2006 by skirchner in Economics
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Milton Friedman, 1912-2006
Friedman was a giant of 20th century economics, as well as the post-war revival of classical liberalism. Ben Bernanke paid this tribute to Friedman at the 2003 Dallas Fed Symposium on The Legacy of Milton and Rose Friedman’s Free to Choose:
Friedman’s monetary framework has been so influential that, in its broad outlines at least, it has nearly become identical with modern monetary theory and practice. I am reminded of the student first exposed to Shakespeare who complained to the professor: “I don’t see what’s so great about him. He was hardly original at all. All he did was string together a bunch of well-known quotations.” The same issue arises when one assesses Friedman’s contributions. His thinking has so permeated modern macroeconomics that the worst pitfall in reading him today is to fail to appreciate the originality and even revolutionary character of his ideas, in relation to the dominant views at the time that he formulated them.
Of course, Friedman’s influence extended well beyond monetary theory and policy. He was an enormous influence on my own thinking about economics and public policy. He is one of the few 20th century intellectuals who changed the world for the better.
posted on 17 November 2006 by skirchner in Economics
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No One is Calling Perth a ‘Bubble’
Or at least no one I could find using Google News. This follows yesterday’s release of the ABS house price index, which had Perth established house prices up 10% over the September quarter and 46% over the year. Perth seems to have escaped being tagged with the ‘b’-word, because there is a fairly straightforward fundamental story that accounts for the rise in Perth property prices: the flow of income and population associated with the commodity price boom. Even the vexed issue of causality is less problematic than usual, since the commodity price boom is exogenous to the Australian economy and so we can be more confident in the case of Perth that it is economic developments driving house prices rather than the other way around.
While Treasury Secretary Ken Henry would argue that there is long-run, terms of trade-driven, shift in Australia’s centre of economic gravity to the west and north, Perth is unlikely to sustain double-digit annual growth rates in house prices of this magnitude indefinitely. When house price growth slows, no doubt some will start talking about a ‘burst bubble,’ but the experience of other state capitals suggests that Perth will hold on to most of its recent gains.
Looking at each of the state capitals, only Sydney has recorded negative annual growth in house prices in recent years, with a trough of -5.9% in the March quarter of 2005. As former RBA Governor Ian Macfarlane has argued, what is most likely happening here is an equilibrating process, where the ratio of Sydney house prices to other state capitals returns to historical levels. High relative prices in Sydney have actually helped this process along, by adding to the attractiveness of inter-state and regional migration driven by differences in regional economic performance. This is a far cry from the stylised ‘bubble’ story promoted by Robert Shiller, in which prices collapse due to some inexplicable reversal in investor psychology, a theory of asset price determination that is entirely devoid of analytical content. Instead, what we see is a standard response to economic incentives.
posted on 16 November 2006 by skirchner in Economics
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Easterly vs Sachs
Bill Easterly, author of The White Man’s Burden, responds to Jeffrey Sachs’ anti-Hayek outburst in Scientific American:
Mr. Sachs (in his book “The End of Poverty”) is peddling his own administrative central plan—449 steps in all—to end world poverty. In his plan, the U.N. secretary-general (to whom he is an adviser) would supervise and coordinate thousands of international civil servants and technocratic experts to solve the problems of every poor village and city slum everywhere. Mr. Sachs is not in favor of central planning as an economic system, but he offers it as a solution, anyway, to the multifold problems of the world’s poorest people. If you want the best analysis of why the approach of Mr. Sachs and his confreres in Hollywood and the U.N. will fail to end world poverty this time (as similar efforts failed over the past six decades), you can find it in Hayek.
Third, Mr. Sachs’s attempt to make the case for his best possible society, the Scandinavian welfare state, is a little shaky. If this is what passes for the scientific method in Scientific American, American science is in even worse shape than we thought. Economics is usually about the incentives that cause people to solve their own or other peoples’ problems, but to Mr. Sachs, problem-solving seems always to be about raising more public money for whatever cause he is concerned with at the moment.
posted on 15 November 2006 by skirchner in Economics
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The Deputy-less Reserve Bank
It seems Treasurer Costello has been so busy solving the world’s problems at the G20, he has neglected his portfolio responsibilities:
TREASURER Peter Costello is in no hurry to appoint a deputy to the Reserve Bank’s governor, Glenn Stevens. With the delay now stretching into its ninth week, Mr Costello told the Herald he “may” fill the position by Christmas…
Yet the Reserve Bank Act empowers only a deputy governor to run the bank in the governor’s absence - raising questions about who could make crucial decisions if a financial shock hit while Mr Stevens was on a plane or otherwise uncontactable.
When asked whether he has a shortlist of candidates, Mr Costello said: “When I’ve got some news for you I’ll let you know.”
Asked whether the position would be filled by Christmas, he said: “It may be, yep.”
The position has been vacant since September, but the vacancy has been expected since July 2003, when the former governor, Ian Macfarlane, was appointed for a shortened second term.
A recruitment firm engaged by Mr Costello was making initial contacts with potential candidates in September.
Observers speculated that Mr Costello does not see the appointment as a priority.
Mr Costello is also yet to fill a board vacancy that has been open since December.
The bank’s separate payments system board has had a seat unfilled since its creation in 1998 - and two vacancies since July.
The Australian recently highlighted last minute re-appointment of Warwick McKibbin to the RBA Board in July.
The government’s Mid-Year Economic and Fiscal Outlook will be released in coming weeks, but as usual, the government will not commit to a release date and time. The MYEFO is usually flung out at the Treasurer’s convenience, sometimes with as little as a few hours notice, yet the Treasury likes to lecture the rest of the world on transparency.
posted on 15 November 2006 by skirchner in Economics, Financial Markets
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The G20’s Dubious Achievements
Given the chance to impress us with the G20’s achievements, Treasurer Peter Costello can name but two: The G-20’s breakthrough commitment to new higher standards of transparency to prevent harmful tax practices in 2004 is an example of this, as is the significant IMF quota and governance reforms achieved this year under Australia’s stewardship.
‘Harmful tax practices’ is OECD-speak for tax competition. See David Burton’s discussion of the OECD’s efforts to cartelise the international tax system, about which Peter Costello is so enthusiastic. The Treasurer might have been better served paying more attention to the tax practices of former RBA Board member Bob Gerard. The current Australian government is normally more dismissive of multilateralism, but the Treasurer is clearly the victim of bureaucratic capture when it comes to the G20.
posted on 14 November 2006 by skirchner in Economics
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Another RBA Non-Statement on Monetary Policy
The RBA’s November Statement on Monetary Policy continued the recent pattern of leaving the inflation forecast unchanged, largely because of an intervening policy move that had effectively pre-empted what might otherwise have been a change in the inflation forecast. With the RBA’s inflation forecast already at the top of the target range, any upward revision to the inflation forecast demands prompt policy action. While the RBA’s inflation forecast is made on a ‘no policy change’ basis, for the purposes of the quarterly Statements, it has effectively become endogenous. The Statements are timed for release after the Board meeting following each quarterly CPI release. They thus become vehicles for ex post rationalisation of existing policy moves, while studiously avoiding explicit discussion of the policy outlook. It is very difficult for a change in the inflation forecast to make it into the quarterly Statements, without being pre-empted by actual policy action. It is unlikely that the RBA would forecast underlying inflation outside the target range in the context of a quarterly Statement, since this would beg the question as to why policy action had not already been taken to pre-empt it. The Bank would essentially be admitting that it was in the process of making a policy error.
posted on 13 November 2006 by skirchner in Economics
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The Vastly Overrated G20
The G20 meets in Melbourne next week and the Treasury has been busy telling us how important its work is (a line faithfully regurgitated by Ross Gittins today). While the G20 is undoubtedly good for the self-importance of Treasury and the Treasurer, the list of apologies attests to its real significance:
The Bush Administration’s glamour appointee, Henry “Hank” Paulson, who was poached this year from Goldman Sachs to head the US Treasury, has been grounded to focus on domestic economic challenges in the wake of the Republican Congressional elections debacle.
The British Chancellor of the Exchequer, Gordon Brown, will also stay home to prepare for next week’s Queen’s Speech…
And the well-regarded Governor of the Bank of England, Mervyn King, has a personal commitment.
Walking the dog perhaps.
UPDATE: Treasurer Costello explains the significance of the G20 to Barrie Cassidy:
BARRIE CASSIDY: All right. Let’s move on to the G20 now and its involvement next weekend under your chairmanship. 90 per cent of the world’s economies under one roof, but could you identify one key result you would like to see emerge from the conference?
PETER COSTELLO: First of all, let’s say, Barrie, this is the biggest financial conference Australia has ever hosted and ever will. This organisation, where Australia not only has a seat at the table, of the 20 most important economies of the world, but is chairing it, that brings together the developed world and the developing world, is important in itself. That’s significant in itself.
So now you know. Costello then goes on to talk about what sounds like international price fixing of world commodity markets:
If we can get an agreement on adequate supply, adequate security, proper international pricing, then I think we can actually ensure that what could otherwise become jostling and instability over resources over the next couple of decades will be taken out of the system. Prices would be better and that will benefit consumers.
The sort of ‘agreement’ we could well do without.
posted on 11 November 2006 by skirchner in Economics
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‘Who Do You Trust to Keep the Unemployment Rate Low?’
‘Who do you trust to keep the unemployment rate low?’ might have made a better campaign tag line for the Coalition at the last federal election. In the same week that the unemployment rate fell to a new 30 year low of 4.6%, the government found itself on the defensive over the RBA’s latest official interest rate increase. The further decline in the unemployment rate was even interpreted as ‘bad news for interest rates.’ This is the same perverse logic that argues we should forgo tax cuts for the sake of lower interest rates.
As the following chart shows, there is a close relationship between turning points in the unemployment rate and the official cash rate. This suggests that the RBA looks for confirmation from the unemployment rate before changing the direction of official interest rates. The sort of economic growth that drives the unemployment rate to 30 year lows is not going to give you low interest rates. Indeed, it is remarkable that the RBA held interest rates below their previous cycle peak for as long as it did through the current tightening cycle.
Neither the government nor the Reserve Bank has much to do with the direction of interest rates. Australia is a price-taker in global capital markets and the direction of interest rates in Australia is largely determined offshore. Claiming credit for low interest rates leaves the government hostage to forces beyond its control and on the defensive even when the economic news is good.
posted on 10 November 2006 by skirchner in Economics
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