PIMCO to the Fed: Regulate Me!
PIMCO MD Paul McCulley makes the extraordinary claim that:
the conditions conducive to bubble formation are imminently predictable:
• A shift from a bank-centric to a capital markets-centric system of savings intermediation,
• In the context of price stability in goods and services, alongside
• A central bank unwilling to use regulatory tools to temper credit creation.
In fact, it is the absence of these conditions that is more conducive to systemic mispricing attributable to an inhibited price discovery process. The Asian crisis of 1997-98, for which the dominance of bank lending over capital market intermediation was a major contributing cause, more than adequately illustrates this.
At least McCulley is clear about the implications of his belief that asset price ‘bubbles’ are now endemic. He calls on the Fed to:
embrace a more activist regulatory approach to fine-tuning irrationally exuberant capital market-driven credit creation.
It is hardly surprising that those who believe asset price ‘bubbles’ are ‘endemic’ should also believe in re-regulating financial markets. If you think markets are so obviously incompetent to set prices and allocate capital efficiently, then it would seem to follow that the authorities can do better via discretionary intervention. It is the fatal conceit of the ‘bubble’ brigade. Fortunately, Ben Bernanke is much smarter than that.
posted on 12 December 2005 by skirchner in Economics
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Punditry and Cognitive Bias
A review of Philip Tetlock’s Expert Political Judgment : How Good is It? How Can We Know?
people who appear as experts on television, get quoted in newspaper articles, advise governments and businesses, and participate in punditry roundtables—are no better than the rest of us. When they’re wrong, they’re rarely held accountable, and they rarely admit it, either…They have the same repertoire of self-justifications that everyone has, and are no more inclined than anyone else to revise their beliefs about the way the world works, or ought to work, just because they made a mistake…
the better known and more frequently quoted they are, the less reliable their guesses about the future are likely to be. The accuracy of an expert’s predictions actually has an inverse relationship to his or her self-confidence, renown, and, beyond a certain point, depth of knowledge. People who follow current events by reading the papers and newsmagazines regularly can guess what is likely to happen about as accurately as the specialists whom the papers quote. Our system of expertise is completely inside out: it rewards bad judgments over good ones.
posted on 11 December 2005 by skirchner in Economics
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The Conundrum that Wasn’t
Alan Wood is coming around to the view that there is no bond yield ‘conundrum’:
there seems to be an emerging view that world bond markets may have been behaving rationally after all and that a 10-year US Treasury bond yield of around 4.5 per cent actually reflects the likely interest-rate path over the next decade.
An important test of this view is approaching. If, as markets expect, the Fed is close to the end of its rate rises and the Fed funds rate will peak at 4.5-4.75 per cent, and if this signals a peak in global interest rates, then a 10-year bond rate of 4.5 per cent won’t look too silly after all.
It is strange that Greenspan ever floated the idea of a ‘conundrum,’ since an obvious explanation for the phenomenon is the increased credibility central banks have amassed relative to previous cycles, particularly the 1994 bear market in bonds. Like his ‘irrational exuberance’ speech in 1996, the ‘conundrum’ was probably meant to be more of a rhetorical question than anything else, a case of Greenspan thinking aloud.
Current bond market pricing is also an obvious challenge to those who see the recent rise in the nominal gold price to near 25 year highs as heralding a new Great Inflation such as that seen in the 1970s. If you believe that this is what is driving the gold price, then you must also think the bond market is massively wrong. Is it really credible to argue that gold market participants know something bond market participants don’t?
posted on 10 December 2005 by skirchner in Economics
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VSU in Our Time
If the Minister is to be believed, then Australian university students are about to save up to $162 million dollars care of the abolition of compulsory student union fees. This also implies that universities will have to front as much as $162 million for student services, given that most universities have already exhausted the limited discretion they have to raise extra funds from Commonwealth funded students under the current funding regime. This should have the desirable consequence of forcing universities to assume control of student services and rationalise their operations, eliminating the inefficiencies, politicisation and rorts for which they have long been notorious. Universities will now have decide how much of this they are willing to tolerate, rather than just passing it on to students in the form of higher amenities and other fees unrelated to tuition.
As Andrew Norton has pointed out, this will exacerbate the problems that beset the current funding model for higher education, whereby the net operating position of universities deteriorates for every Commonwealth funded student they are unfortunate enough to enroll. This is an argument for deregulating the market for higher education along the lines Andrew has suggested in his book, The Unchained University. It is actually a very good argument for universities simply refusing to enroll Commonwealth funded students, de facto privatising higher education. While not an intended outcome of the legislation, to the extent that it hastens the demise of an unsustainable funding model, it is a welcome development.
posted on 10 December 2005 by skirchner in Politics
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30/30 Tax Reform
John Humphreys’ paper advocating a 30% flat tax and $30,000 tax free threshold, below which a negative income tax would apply, has been released by CIS as part of its Perspectives on Tax Reform series.
There is now no shortage of reform proposals for the Australian taxation system. Jeff Pope has put forward a revenue neutral reform proposal in the latest Economic Papers, which also deserves attention. Although revenue neutrality is in many ways the enemy of meaningful tax reform, Pope’s proposal is nonetheless valuable in showing that the benefits of reform have very little to do with the take home benefits accruing to different income groups and everything to do with lowering the distortions, compliance and collection costs associated with the existing tax system.
What is lacking is the political will to proceed with reform. Both John Howard and Peter Costello remain wedded to a view of tax reform as a residual to be funded out of the surplus, after paying for the middle class welfare churn, a view that renders meaningful reform almost impossible.
In the WSJ, Martin Feldstein makes the case for getting rid of taxes on interest, dividends and capital gains:
A tax on interest, dividends and capital gains creates a major distortion in the timing of consumption, and also exacerbates the adverse effects of the income tax on all aspects of work effort and personal productivity. Such distortions create unnecessary economic waste that lowers our standard of living. The combination of a lower tax rate on the income from savings and a revenue-neutral rise in the tax on earnings can produce a higher net reward for additional work and productivity, as well as a reduction in the distortion between consuming now and in the future. That would reduce the economic damage caused by the tax system while collecting the same total revenue with the same distribution of the tax burden.
posted on 08 December 2005 by skirchner in Economics
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Fundamentals of House Price Inflation
There is a remarkable coincidence between Q3 capital city house price growth and growth in state final demand, as recorded in the Q3 national accounts. House prices in Sydney have recorded the largest decline of the capital cities at -4.7% y/y. NSW also saw the weakest growth in state final demand of 2.3% y/y.
The two cities with the strongest annual house price growth were Darwin, NT at 21.9% y/y and Perth, WA at 17.7% y/y. These just happen to be the capitals of the mainland states that recorded the strongest growth in state final demand at 13.6% y/y and 6.7% y/y respectively.
This is an interesting test of causality. It has been common for analysts to attribute moderating economic growth nationally to a wealth effect from more subdued growth in house prices. Yet we know that economic growth in WA and NT is benefiting strongly from the global boom in commodity prices, a development that is entirely exogenous to the domestic economy. This would strongly suggest that it is broader economic developments that are driving house prices, not the other way around. On a state-by-state basis, house prices would seem to have a firm connection with fundamentals.
posted on 07 December 2005 by skirchner in Economics
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Japan Was Never a ‘Bubble’
Japan’s asset price inflation and deflation of the 1980s and 1990s is often held up as the paradigmatic example of the dangers of asset price ‘bubbles.’ This view has been challenged by real business cycle theorists like Prescott and Hayashi, who note that Japan’s experience is readily explicable in terms of neo-classical growth theory and the standard decomposition of economic growth into labour and capital inputs and productivity.
In a remarkable paper, Fed Board economist Robert Martin explains real house prices and interest rates in terms of the demographics associated with the baby boom generation and applies it to a number of countries, including the US and Japan. The model very accurately predicts the decline in Japanese real house prices since the early 1990s:
Since 1990, real house prices have fallen around 34 percent. The sharp increase in real estate prices in the 1980s followed by a fifteen-plus year fall in prices has led many to refer to 1980s Japan as the original bubble economy. This simple model, using Japanese demographic data, successfully predicts the 1974 and the 1990 house price peaks. Strikingly, the model also predicts a 30 percent decline in real house prices over the fifteen years following the 1990 peak.
Apart from giving us something else to blame on the boomers, the model generates some interesting long-term predictions for real house prices and interest rates in a number of countries, including the US.
posted on 07 December 2005 by skirchner in Economics
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Cato Unbound
The Cato Institute has launched a new blog, Cato Unbound:
Each month, Cato Unbound publishes a lead essay by one of the world’s leading thinkers. Then, every other day or so, a new reaction essay by one of three commentators will appear, to be followed by a more free form discussion inspired by the initial exchange of ideas. In the spaces between, we’ll publish the best of your letters and blog posts, creating a hub for a broader conversation about our heady topics.
The first issue is off to a flying start, with Jim Buchanan proposing three amendments to the US Constitution. Incidentally, you can read yours truly on Buchanan here.
posted on 06 December 2005 by skirchner in Economics
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Central Bank Governors Gone Wild: Don Brash Was Never Like This
The RBNZ is widely expected to raise the official cash rate 25 bps to a record 7.25% at its December 8 Monetary Policy Statement. With the NZD TWI at a post-float record high, this leaves nominal monetary conditions the tightest since the RBNZ was made independent in 1990.
Nominal monetary conditions are now tighter than during the mid-1990s and the MCI targeting episode from 1996-1999, prior to the introduction of the official cash rate. Under that operating regime, short-term interest rates were market-determined, although overall monetary conditions were subject to jaw-boning by the RBNZ. While the RBNZ was notionally agnostic on the mix of conditions, the decline in the NZD TWI during the Asian crisis caused short-term interest rates to increase, a factor in NZ’s 1998 recession. However, as the following chart shows, the RBNZ did in fact accommodate a significant easing in overall monetary conditions during this episode:
The contrast with the current situation is that the RBNZ is raising the official cash rate at the same that the NZD TWI has risen to record highs. While the RBNZ has sought to jaw-bone the NZD lower, such jaw-boning is pointless and self-contradictory while it keeps raising the official cash rate.
The RBNZ is not just concerned that inflation has breached the top-side of its medium-term target range, with little prospect of returning to the target range before 2007. RBNZ Governor Bollard is also trying to use monetary policy to contain its current account deficit and redress the underlying domestic saving-investment imbalance that is driving it. The RBNZ is now more or less explicitly targeting house prices.
The problem for the RBNZ is that raising the official cash rate to achieve these objectives is simply counter-productive. A higher official cash rate encourages further capital inflow, putting further upward pressure on the exchange rate and making the current account deficit worse. This was the lesson learned by the RBA in the late 1980s, when it sought to target the current account deficit, with disastrous consequences. Most NZ mortgage lending is at fixed rates, so raising the official cash rate gives it little traction over household borrowing. Indeed, the yield curve inversion being driven by the RBNZ’s tightening efforts is actually facilitating new fixed rate borrowing below variable rates.
While the RBNZ might be justified in raising the cash rate to contain medium-term inflation pressures, there is no justification for targeting domestic saving-investment imbalances and the current account deficit. Governor Bollard has claimed that these imbalances are unsustainable, but he has not made a compelling case for a systemic failure in capital markets that would account for why these private borrowing and lending decisions are mistaken. Nor has he made an argument for these imbalances being causal for inflation pressures, as opposed to being merely symptomatic of the underlying strength of the domestic economy. Australia’s experience during the late 1980s-early 1990s suggests that this is a recipe for recession and the current NZ yield curve inversion certainly points to this as a likely outcome.
posted on 03 December 2005 by skirchner in Economics
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The Pessimistic Punditocracy
Brian Wesbury notes the pervasive pessimism of the economic commentariat, which extends well beyond the doomsday cultism of Setser and Roubini:
During a quarter century of analyzing and forecasting the economy, I have never seen anything like this. No matter what happens, no matter what data are released, no matter which way markets move, a pall of pessimism hangs over the economy.
It is amazing. Everything is negative. When bond yields rise, it is considered bad for the housing market and the consumer. But if bond yields fall and the yield curve narrows toward inversion, that is bad too, because an inverted yield curve could signal a recession.
If housing data weaken, as they did on Monday when existing home sales fell, well that is a sign of a bursting housing bubble. If housing data strengthen, as they did on Tuesday when new home sales rose, that is negative because the Fed may raise rates further. If foreigners buy our bonds, we are not saving for ourselves. If foreigners do not buy our bonds, interest rates could rise. If wages go up, inflation is coming. If wages go down, the economy is in trouble.
This onslaught of negative thinking is clearly having an impact. During the 2004 presidential campaign, when attacks on the economy were in full force, 36% of Americans thought we were in recession. One year later, even though unemployment has fallen from 5.5% to 5%, and real GDP has expanded by 3.7%, the number who think a recession is underway has climbed to 43%.
A similar phenomenon is evident in Australia, where some of the best macroeconomic outcomes in decades in relation to unemployment and investment are at best taken for granted, or at worst, completely ignored. I suspect much of this pessimism is ultimately motivated by hostility towards the current occupants of the White House and The Lodge.
posted on 02 December 2005 by skirchner in Economics
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The Secular Case Against Gold
With the gold price at 23 year highs, Mahalanobis reminds us of the secular case against gold. The Dow/gold ratio isn’t pretty either. Funnily enough, gold bugs love this chart, believing it shows overvaluation in stocks!
posted on 02 December 2005 by skirchner in Economics
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Betting Against Themselves: Buffett, Gates and the Dollar
The AEI’s John Makin has put together a surprisingly good piece on the US dollar, which begins with an amusing comparison with George W Bush:
Why is the dollar like a Republican president? Answer: Because the dollar faces incessant predictions of imminent collapse, but in the end it wins out over weaker alternatives.
Weighing up the fundamental determinants of exchange rates, Makin argues that ‘it is surprising that the dollar has not risen further.’ He also highlights the absurdity underlying the doomsday cultism of Buffett and Gates:
America’s two richest men, Bill Gates and Warren Buffett, are losing hundreds of millions of dollars having bet against the dollar on the premise that rising U.S. current-account and budget deficits would have to weaken it. Maybe these two remarkable men should have pondered a little more the question of whether they could have become multibillionaires in Europe or Japan, where the environment for growth and innovation is far less friendly and the underlying vigor of the economy is less conducive to a strong currency. Beyond that, I guess they did not notice that the budget deficits and government debt are considerably larger in Europe and Japan than they are in America. Betting against the dollar meant that Gates and Buffett were betting against themselves. I can’t see why they would want to do that.
posted on 30 November 2005 by skirchner in Economics
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The Gerard Affair and RBA Governance
Most columnists are, rather predictably, analysing the Gerard Affair purely in party political terms. The AFR’s ‘special investigation’ published yesterday never thought to question the significance of the Gerard matter for RBA governance, instead couching it solely in terms of the Treasurer’s political judgement. Alan Wood is the stand-out exception in appreciating the affair’s real significance in exposing the antiquated model of monetary policy governance that has been allowed to persist in Australia, which has its roots in the class warfare of the 1920s and 30s:
under the Reserve Bank Act there are no grounds for dismissing Gerard. Whether he has breached the Reserve Bank’s code of conduct for board members, published last year, is another matter.
The code was established because, as its preamble explains, the Reserve Bank Act says little about the conduct of board members. The preamble also says that board members recognise their responsibility for maintaining “an unparalleled reputation for integrity and propriety in all respects” in agreeing to the code.
Under the heading General Principles, the code states that board members will avoid any action, or inaction, that compromises the bank’s standing in the community and its reputation for integrity, fairness, honesty and independence.
There is no question of Gerard behaving improperly in carrying out his duties as a board member or compromising the RBA’s independence. But if the tax office documents cited by Monday’s Australian Financial Review, alleging that tax investigators were misled, are confirmed as accurate, Gerard would appear to be in breach of the code.
The fact that his actions predated the code and his appointment to the board does not necessarily mitigate the harm that revelations of his conduct could cause later. It would be interesting to hear the uncensored opinions of his fellow board members on whether his behaviour has injured the board’s standing.
However, as with most codes of conduct, there is no penalty for a breach. It is up to Gerard to decide whether he should resign to avoid any risk of damage to the board’s reputation.
Whatever his decision, it has raised again the vexed question of whether the existing RBA board arrangements are adequate.
Curiously, the Gerard Affair also seems to have prompted a change of view on the part of UQ’s Stephen Bell, the author of the most comprehensive study of the RBA to date (which I review here). Bell is quoted in the SMH as saying:
It makes the case stronger to stick more professionals … who don’t have shady deals in the business sector and who can contribute more to meetings.
This is surprising given the rather uncritical endorsement Bell gave to the current governance arrangements for the Bank in his book, although no less welcome for that.
posted on 30 November 2005 by skirchner in
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‘Bubble’ Collectibles
The contrarian in me thinks that when ‘bubbles’ have become collectible kitsch, we are well beyond the point of having to take alleged asset price ‘bubbles’ seriously!
posted on 29 November 2005 by skirchner in Economics
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RBA Governance
Robert Gerard’s main qualification for serving on the RBA Board were his contributions to the Liberal Party in South Australia. It now also seems that being involved in a dispute with the Australian Taxation Office, which falls within the Treasury portfolio, is no disqualification to being appointed to the Board:
Adelaide businessman Robert Gerard was appointed to the RBA board in March 2003.
The appointment came as Mr Gerard, who owns the family business Gerard Industries, was fighting the Australian Tax Office (ATO) over a Caribbean tax haven deal described as tax evasion.
A $150-million settlement in 2003 ended a 14-year investigation, that came after Mr Gerard’s appointment was taken to Cabinet by Treasurer Peter Costello.
Mr Gerard says he told Mr Costello about his ATO dispute before his appointment, and the Treasurer later contacted him and said he had no problem with him being on the board.
This has the federal opposition calling for an inquiry, but it is hardly the first time the business interests of an RBA Board member have been the cause of controversy. Anyone remember Solomon Lew and Yannon? Solomon Lew was one of the few outside appointments to the RBA Board not to serve a second term after the Yannon affair blew-up half way through his five year term.
As suggested in previous posts, the problem with the RBA Board is not so much the inevitably political nature of the appointments, but the many hats and potential conflicts of interest that some appointees bring to the Board table. The RBA’s efforts before the Administrative Appeals Tribunal to suppress the release of the minutes of Board meetings effectively acknowledges these conflicts. The setting of monetary policy should be kept separate from the other governance functions of the Bank and placed in the hands of a full-time committee of monetary policy experts, with substantial representation from outside the Bank.
posted on 29 November 2005 by skirchner in Economics
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