Working Papers

2009 08

Resolving Equity and Bond Market Divergence

Richard Cookson suggests two scenarios for the resolution of the current episode of equity and bond market divergence:

The benign argument for bond yields (and equities) revolves around supply.  Many pundits and investors have been in a lather about the vast quantities of debt that governments have to issue. But if an unexpected mountain of supply raises the risk premium that investors demand for holding longer dated paper, the opposite is also true: supply that becomes less Everest-like than feared would reduce it.

So the benign explanation for why bond yields have been falling even as equity markets have been rallying is that worries about the surge in government bond issuance are lessening as signs of recovery mount.

That in turn should lead to a fall in government issuance and thus long-term yields, especially since inflationary pressures (apart perhaps from the UK) are so muted and yield curves so steep by historical standards.

And if that’s right, lower government bond yields would increase the appeal of riskier assets, equities included.

Effectively, the ex ante equity-risk premium would be driven higher because the long-term risk-free rate, but not the growth rate, would be lower.

Sadly, there’s also an altogether more malign explanation. Much as was the case in Japan in the 1990s, it could be that low government bond yields are telling you that this recovery is unsustainable once the monetary and fiscal medicine wears off.

It could be saying that, thanks to the required private sector deleveraging, especially in the US and UK, the long-term potential growth rate of the developed world is much lower than it was. That would lead to a sharply lower ex ante equity risk premium and thus  potentially dreadful returns from equities.

Unfortunately, another lesson from Japan in the 1990s is that the world’s lowest bond yields can co-exist with the world’s worst fiscal policy outcomes.  This makes the first of Cookson’s scenarios less plausible.  We are more likely to end up with whatever is behind door number two.

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

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The Political Economy of House Price Doom-Mongering

The Rismark Monthly for August suggests the following explanation for house price doom-mongering:

It’s very easy to rip into housing since it is a non-institutionalised asset class. All of Australia’s 8.4 million homes are owned by highly dispersed and faceless families.  Australian and international equities, LPTs, unlisted commercial property, hedge funds, and private equity are, by way of comparison, mostly owned and controlled by powerful institutional stakeholders—fund managers, super funds, investment banks, corporates and/or super high net worths.  In turn, most of the analysts, strategists, economists, investors and journalists’ business models are built on these asset-classes succeeding. It therefore makes little commercial sense to bludgeon them with the relentless hysterics we hear about housing.  In contrast, bricks and mortar is easy game. There are few if any institutional constituents to annoy. Just anonymous individual families with little authority and influence.

Making unsubstantiated claims about a forthcoming housing Armageddon is a win-win situation. With one hand you distract attention away from the poor performance of your own Australian equities portfolio, while with the other you boost the likelihood of unsuspecting retail money flowing your way.

While this explains the sell-side bias against housing, it is harder to understand the buy-side interest in doom-mongering.  Presumably, the media know their own market and stories of housing boom and bust undoubtedly sell.

posted on 31 August 2009 by skirchner in Economics, Financial Markets, House Prices

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A Supply-Side View of Global Housing Markets

Matthew Hassan looks at the supply-side of global housing markets, finding that Australia has one of the world’s most under-supplied markets, which in turn explains the resilience of Australian house prices.  Hassan’s simple indicator does a good job explaining cross-national variation in house price growth.

posted on 27 August 2009 by skirchner in Economics, Financial Markets, House Prices

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More Survey Evidence for Ricardian Equivalence

Andrew Leigh uses survey evidence to estimate the amount by which the 2009 fiscal stimulus payments boosted spending in Australia.  The cross-sectional variation in the spending rate finds evidence in favour of Ricardian equivalence:

The third variable tabulates the spending rate against respondents’ degree of worry about government debt. This is a loose test of Ricardian equivalence – the theory that consumers will only spend a payment if it is accompanied by a reduction in government expenditure. Respondents who are more worried about government debt (and therefore perhaps more concerned that government payments now will lead to tax increases in the future) are significantly less likely to spend the rebate. For example, only 25 percent of respondents who are very worried about government debt spent the rebate, as compared with 46 percent of respondents who are not at all worried bout government debt. This difference remains significant even in a multivariate regression.

The survey results find that just under 60% of respondents save the payments/paid off debt, while 40.5% claim to have spent it. Leigh suggests this points to a marginal propensity to consume out of the stimulus of 0.41 to 0.42.  However, he also notes an obvious limitation of the Australian survey data:

the US questions asked respondents whether the rebate would lead them to increase spending, while the Australian question asked respondents whether they would spend the money. In theory, Australian respondents who did not think that the money would increase their overall spending might nonetheless have told the interviewer that they would spend it, if they thought that the question related to cash flow rather than net expenditure.

Because stimulus payments are fungible with other income, the survey question does not directly address the issue of whether recipients increased their overall spending.  This problem also afflicts the Westpac-Melbourne Institute survey noted by Leigh.  The ANU survey results may therefore overstate what is already a low MPC.

Meanwhile, Peter Garrett discovers the marginal propensity to import.

posted on 26 August 2009 by skirchner in Economics, Fiscal Policy

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Mid-Week Linkfest

The strangest bid in the worst of the worst of the US equity market.

How not to fall down the data mine.

Uncertainty and the negative equity risk premium.

How ‘peak oil’ nonsense leads to bad public policy.

Rule of law in the US ‘at the level of China’.

Tony Makin on Keynesian economics.

posted on 25 August 2009 by skirchner in Economics, Financial Markets, Oil

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Anchoring Fiscal Expectations

Eric Leeper argues that expectations for fiscal policy are as important as those for monetary policy.  Leeper points to ‘an egregious example of non-transparent fiscal policy’:

the recent $787 billion American fiscal stimulus plan. Leading up to the introduction and passage of the American Recovery and Reinvestment Act, the entire economic rationale for thestimulus package consisted of the job creation prediction in a document by Romer and Bernstein (2009).  The document claims it “suggests a methodology for ensuring the package contains enough stimulus. . . [to] create sufficient jobs to meet the Presidentelect’s goals [p. 2].” An appendix reports multipliers for a permanent increase in government spending and decrease in taxes of 1 percent of GDP. Four years after the initial stimulus, government purchases raise GDP by 1.55 percent, while tax cuts raise GDP by 0.98 percent. Sources for these numbers are reported as the Federal Reserve’s FRB/US model and “a leading private forecast firm.”

To assess how this rationale for stimulus measures up in terms of transparency, I raise some questions that are not addressed in the Romer-Bernstein document, but are important for anchoring fiscal expectations:

• What are the economic models underlying the multiplier numbers and are those numbers reproducible?
• Why consider permanent changes in fiscal variables when the Act makes transitory changes?
• What are the consequences of the stimulus for government debt?
• What are the repercussions of significantly higher government debt?
• Will the debt run-up be sustained or retired?
• How will policies adjust in the future to either sustain or retire the debt?
• What “methodology” does this document suggest for gauging the necessary size of fiscal stimulus?

Some might accuse me of finding a straw man to ridicule. But this is an important example because of its potential impact on the world economy.

The same questions could be asked in the Australian context.

Robert Carling and I make a similar case for rules-based fiscal policy here.

posted on 25 August 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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CIS Policy Point Lecture: Stern Hu and Stern China

CIS Policy Point Lecture: Stern Hu and Stern China - Why Beijing did it and what it means for Australia-China Relations.

Since the arrest of Rio Tinto executive Stern Hu in mid July, Beijing has stood firm by reiterating several times that evidence against Mr. Hu for commercial espionage causing massive losses to the Chinese state is serious and irrefutable. What has Stern Hu actually done, why has China chosen to charge Mr. Hu and others for espionage, rather than commercial theft, and what will the consequences of this action be for diplomatic and political relations between Australia and China? Join research fellow at CIS and visiting fellow at the Hudson Institute in Washington, Dr John Lee and Paul Kelly, Editor-at-Large of The Australian, as they discuss this issue.

Venue: The Library, The Centre for Independent Studies, Level 4, 38 Oxley Street, St Leonards.
Parking is available across the road at the Hume Street Car Park.

Date: Tuesday, 25 August 2009
Time: 6:00pm – 7:15pm followed by drinks.

Cost: Members – free, Non Members $10 payable in advance by credit card.

Booking: Places are limited and reservations essential. To book please email CIS Events Assistant, Alanna Elliott, at aelliott AT cis.org.au or call (02) 9438 4377.

posted on 24 August 2009 by skirchner in Economics, Foreign Affairs & Defence

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Job Vacancy: Public Affairs Manager, Centre for Independent Studies

The Centre for Independent Studies, Australasia’s leading free market public policy think-tank, is looking to hire a new public affairs manager.  Details here.

posted on 20 August 2009 by skirchner in Media

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Stimulus Skeptics

I’m quoted in a story in The Australian today on the effectiveness of fiscal stimulus.  As I noted in this post, if we are to accept the proposition that fiscal stimulus has been effective in supporting demand, then this implies that monetary policy has had less work to do and that interest rates have been higher than they otherwise would have been.  To be clear, that is not my view, but it is where the logic of the pro-stimulus camp must lead.  In that case, all fiscal stimulus has done is trade-off monetary for fiscal easing.

Kevin Hassett has noted the same inconsistencies in the discussion of fiscal policy in the US:

Democrats opposed the Bush tax cuts from the beginning not because lower marginal tax rates are bad, but rather, because they believed they would lift deficits and interest rates.

The interest-rate effect is so large, goes this line of reasoning propounded by disciples of the “Rubin school,” that the net effect of tax cuts would be harmful.

But now we hear that we can adopt the Obama health-care plan, increase an already massive deficit, and it will be no problem. But if raising taxes can reduce deficits and spur the economy, then cutting spending should do that too. So why are we increasing spending yet again? Democrats have no answer…

The fact is, deficits are a problem precisely because politicians can get away with running them with near impunity. If interest rates did soar in the face of deficits, it would provide a constraint on the growth of big government.

Sadly, there will be no such constraint.

posted on 19 August 2009 by skirchner in Economics, Financial Markets, Fiscal Policy

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Australia: Developed Country Institutions, Emerging Market Growth Rates

Treasury Secretary Ken Henry suggests that Australia remains an attractive proposition to foreign investors:

it seems quite likely — to me at least — that the Australian economy might attract an even greater share of global capital flows, and quite possibly even larger capital flows in aggregate.

This fifth observation might surprise you. My thinking is simply that, in a world that pays more attention to fundamentals than herd-driven investor psychology, the Australian economy will be seen as possessing the best of the qualities — of governance and flexibility — of the developed world while also offering an abundance of real investment opportunities usually found only in the developing world. That is to say, the Australian economy may be seen as offering the best of both worlds.

It follows from what I have just said that I do not think it likely that, relative to earlier growth periods, the future expansion of the Australian economy will be constrained by a reduced capacity to attract foreign capital.

Henry failed to mention that the main constraints on Australia attracting foreign capital are imposed internally, not externally: relatively high rates of tax on capital and a Whitlam-era, Chinese-style regulatory regime for foreign direct investment.  We will find out at the end of the year what Henry proposes to do about the former.  The government’s modest tinkering with the latter suggests that Australia will continue to underperform its potential in attracting FDI.

posted on 18 August 2009 by skirchner in Economics, Foreign Investment

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Demand is Not Supply

Asked about the effectiveness of discretionary fiscal stimulus measures, RBA Governor Stevens told the House Economics Committee on Friday that:

we believe that the fiscal measures have supported demand and, therefore, at least to some extent, output.

The distinction was probably lost on members of the Committee, but is nonetheless an important one.  Demand can be met out of imports and inventories, without boosting domestic production.  This is why indicators like retail sales are entirely inappropriate as a measure of the effectiveness of fiscal policy.

Some remarkably good questioning from Liberal MHR Scott Morrison also flushed out some more of the Governor’s position on using monetary policy to target asset prices:

One view, the Alan Greenspan view, is you cannot know it is a bubble until it has burst, so you should not do anything much, and then you should clean up the mess once it has burst… I personally would not want to commit to saying, ‘We’re definitely never going to pay attention to asset prices and totally ignore them.’  That has been shown to be a mistake, basically. But nor do I think it is our brief to aggressively chase down asset things that pop up here and there that we might personally find hard to accept or agree with, at the expense of other things that we have as our objectives. So I think that, into the future, it is going to be a matter of judicious, careful use of our instrument in trying to meet all these worthy goals—keeping in mind as well that there is a whole separate debate about other tools that might be applied to booms and busts and asset prices. That is a whole separate section of this debate—what tools could be used by the supervisory authority to rein in the lending.

In fact, no one has ever suggested that asset prices should be completely ignored.  Greenspan explicitly rejected this proposition in his 1996 ‘irrational exuberance’ speech.  The issue is whether asset prices should have a weighting in the central bank’s reaction function that is independent of the inflation forecast.

Stevens can at least be thankful he does not have to appear before the US Congress:

Far from deference, Mr. Bernanke’s recent testimonies have been treated with all the delicacy usually reserved for a mob boss.

posted on 17 August 2009 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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The Market Can Only Know What is Knowable

Eugene Fama explains why recent asset price volatility is entirely consistent with the efficient markets hypothesis.

posted on 12 August 2009 by skirchner in Economics, Financial Markets

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The End of America

If people are most bearish near the bottom of the cycle, it is probably a good sign that Slate has been running an interactive feature on The End of America: How It Will Happen.  It is even more encouraging that of the top five apocalyptic scenarios most favoured by Slate readers, two are economic crankery deserving little serious consideration: ‘peak oil’ and ‘China Unloads U.S. Treasurys’ [sic].

There are more prosaic reasons for considering the ‘end of America’, at least as we once knew it, as suggested in David Goldman’s Top Ten Reasons Why the Recession Will Last Forever:

1. Barack Obama.  Bill Clinton, the last Democratic president, thought in effect, “Let’s get economic growth so I can tax it and pay for all my toys and games.” That was the “New Democrat” approach. Obama knows that if the economy crumbles and he’s the only one left with a checkbook, then everyone has to come to him. Where is the independent base of entrepreneurial business to which the Republicans might turn to raise money against Obama? The banks, the hedge funds, the manufacturers, the municipalities, in fact everyone who is left standing in the economy is beholden to Obama. This is Chicago city politics writ large. Leave aside all of the individual things that Obama is doing that harm economic growth: Obama is the first American president (with the possible exception of FDR) to actually benefit from economic weakness.

posted on 11 August 2009 by skirchner in Economics, Financial Markets

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The Efficient Markets Hypothesis as Meta Predictor

Bill Easterly answers Her Majesty’s questions on the role of economists in the financial crisis:

We correctly predicted that we would not be able to predict it.

Robert Lucas spells out the obvious implications:

The main lesson we should take away from the EMH for policymaking purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.

posted on 10 August 2009 by skirchner in Economics, Financial Markets

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The Wizards of Oz: Behind the Curtain

The always interesting Scott Sumner (who is right on most things) falls into the grass-is-always-greener trap that seems to afflict many Americans when it comes to monetary policy:

Earlier I said Australia is very similar to the US.  The main difference is that the wizards who run monetary policy in Australia don’t listen to Puritans who insist we must suffer high unemployment for our sins. 

Scott is impressed with Australia’s high rates of nominal GDP growth, which he attributes to superior monetary policy.  But as Scott himself notes, Australia has had a high average growth rate for nearly 20 years.  Real growth has also averaged at or near the top of the OECD.  In other words, this outperformance is structural rather than cyclical and has little to do with short-run demand management.  The fact that Australia has continued to outperform in the context of a global economic downturn lends further weight to the view that this outperformance has been structural rather than cyclical.

Scott fails to consider the downside of this high rate of nominal GDP growth: a high rate of inflation.  While Australia’s headline inflation rate has moderated recently, the statistical core series that capture the persistent component of inflation are still running well above the upper bound of the RBA’s 2-3% target range, even after a nearly two percentage point increase in the unemployment rate.  Australia consequently also has some of the highest nominal interest rates of any developed country.  As Friedman noted, high nominal rates are often indicative of monetary policy that is too loose due to a high inflation premium. 

The RBA’s inflation target range has a mid-point above the 2% widely considered to be consistent with price stability in the rest of the world.  Australia has thus institutionalised a relatively high rate inflation.  If the central bank’s primary responsibility is long-run inflation and price stability rather than nominal income growth, then Australia’s monetary policy performance does not compare favourably to the US.  What is considered to be an acceptable inflation rate in Australia would be considered a policy failure in the US.

posted on 09 August 2009 by skirchner in Economics, Financial Markets, Monetary Policy

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FDI Liberalisation Falls Short

Following hot on the heels of the New Zealand government’s announcement of reforms to its regulation of foreign direct investment, the Australian Treasurer has also announced changes to the thresholds for screening FDI applications.  My take on the changes can be found in an op-ed in The Canberra Times today (text below the fold).  I’m also quoted on the subject in a story on page three of the AFR today.

continue reading

posted on 05 August 2009 by skirchner in Economics, Foreign Investment

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