True Confessions of Peter Costello
Treasurer Costello is quoted in the weekend Australian Financial Review (no link) saying:
I think there is also evidence now that the round of tax cuts in May could well have been used to boost savings [sic]. The interesting thing is that although they were very substantial tax cuts, consumption didn’t grow by that much. It looks like people have taken the opportunity of the tax cuts to put some money away. Although I can’t give you figures yet, I do believe that a lot of money is being put into superannuation in preparation for the changes next year.
There is indeed very little evidence that recent tax cuts have boosted consumption. Costello probably doesn’t realise it, but these remarks effectively concede the point often made on this blog, that the government’s budget surpluses come partly at the expense of private sector saving. They make a nonsense of claims that tax cuts might result in higher interest rates, since the substitution between public and private saving leaves national saving unchanged. Household sector dissaving (on a national accounts basis) is largely a function of households paying more tax (and mortgage debt interest) as a share of GDP to keep their consumption share steady, while gross national saving has also remained approximately steady.
posted on 08 January 2007 by skirchner in Economics, Financial Markets
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Nouriel Roubini Can Now Put His Money Where His Mouth Is
Doomsday cultists like Nouriel Roubini can now put their money where their mouth is with Intrade’s 2007 US recession contract:
Contract on US Economy going into Recession
Thursday, Jan 4, 2007
The Exchange has listed a contract on the United States economy going into recession during 2007. This contract can be found under Financial—Economic Numbers—US Economy in Recession.
This contract will expire at 100 if the United States economy goes into recession during 2007. The contract will expire at 0 if it does not.
For expiry purposes a recession is defined as two successive quarters of negative real economic growth. Expiry will be based on figures released by the United States Department of Commerce and reported in three independent and reliable media sources.
The contract will be expired once the 2007 fourth-quarter figures are released (may not be until 2008). If however the 2007 third-quarter figures show positive growth the contract will be expired at 0.
As is often the case with prediction markets, the contract specification raises more questions than it answers. There is no reference to whether the contract expires with the advance, preliminary or final GDP releases. The potential expiry with the Q3 release still leaves open the possibility of a recession in 2007 as a result of revisions to historical data. You could be right about a recession in 2007 and still lose money with this contract specification. And why do we need the media to confirm data released by the BEA? Perhaps Intrade are trying to avoid the problems that arose with their North Korean missile launch contract.
posted on 05 January 2007 by skirchner in Economics, Financial Markets
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Does No New Spending Qualify as Expenditure Restraint?
We have previously noted that the federal government’s concern for the supposed impact of tax cuts on interest rates does not extend to new spending measures. Reports in the lead-up to the Expenditure Review Committee process now suggest that the government is ‘putting the squeeze on spending.’ But note that this does not refer to existing spending programs, only to ministers’ wish-lists for new spending:
BILLIONS of dollars in potential budget measures - including a costly schools and science package - have been dumped as the Howard Government puts the squeeze on spending…
Mr Howard, the Treasurer, Deputy Prime Minister Mark Vaile and Finance Minister Nick Minchin have already scrubbed out dozens of new initiatives brought forward by ministers before Christmas…
Decisions to curtail spending spread across health, welfare, indigenous policies, agriculture and industry.
“This is a very, very tough budget,” said one senior government figure. “It’s very tight and there’s not much joy for new (spending) initiatives.”
The linked article gives an interesting insight into the political economy of the ERC process when it says:
[Treasurer] Costello has indicated that he does not want the 2007-08 surplus to drop below its projected level of $9.7 billion, equivalent to 1 per cent of gross domestic product. Any new spending would depend on the economy producing more revenue than expected, although Mr Costello is also committed to preventing any increase in the tax burden.
In other words, the government will spend whatever it can get its hands on, subject to revenue and the budget balance remaining steady as shares of GDP. This hardly qualifies as expenditure ‘restraint,’ something the government has shown no interest in since its first budget.
posted on 04 January 2007 by skirchner in Economics, Financial Markets
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The US Trade Deficit and the Bond Yield ‘Conundrum’
David Malpass, on the US trade deficit and the so-called bond yield ‘conundrum’:
For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America’s imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrialized countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness—they link the younger, faster-growing U.S. with aging, slower-growing economies abroad…
The trade deficit and a low “personal savings rate” are key parts of the bond market’s multi-year pessimism about the U.S. growth outlook. But just as the high level of U.S. savings is likely to add to future growth—the savings rate is only low if you arbitrarily exclude gains—the trade deficit and heavy capital inflows are also positive parts of the growth outlook. Rather than signaling a slowdown, the inversion of the yield curve—“Greenspan’s conundrum,” in which bond yields are low despite solid growth and rising inflation—is probably the result of this deep underestimate of the U.S. growth outlook, plentiful liquidity, and a backward-looking deflation premium for bonds, the reverse of the backward-looking inflation premium that kept bond yields unusually high in the 1980s.
posted on 21 December 2006 by skirchner in Economics, Financial Markets
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‘Tax Cuts Cause Higher Interest Rates,’ But Government Spending Doesn’t?
Treasurer Costello and Finance Minister Minchin are quick to raise the spectre of higher interest rates whenever the subject of tax cuts comes up and a justification is needed for continued Commonwealth revenue hoarding. Apparently, the same logic doesn’t apply to new government spending, as Alan Wood notes in relation to the government’s Mid-Year Economic & Fiscal Outlook (MYEFO):
Peter Costello and Finance Minister Nick Minchin have also been making noises about tightening the reins.
So what about Appendix A of the update, headed “Policy Decisions Taken Since the 2006-07 Budget” - that is, over the past six months.
This runs to more than 130 pages of the 250-page mid-year economic outlook.
And guess what the total spending adds up to over four years - $17.3 billion.
In fact, with the budget balance as a share of GDP little changed over the projection period, there is little reason to expect Commonwealth fiscal policy to have any impact on interest rates. This illustrates the point that when revenue collections are coming in much stronger than expected, tax cuts need not be any more stimulatory than the government’s new spending since the Budget. Yet if the government were to announce $17 billion in tax cuts, the ‘tax cuts lead to higher interest rates’ brigade would be out in force and the next interest rate increase would almost certainly be blamed on tax cuts.
This strange double standard is partly a product of the prevailing prejudice against people being allowed to spend their own money. The commentariat are largely of the view that the public are incompetent to spend tax cuts appropriately. Yet there are good reasons for thinking that a good portion of any tax cuts would go straight to the bottom-line of household balance sheets in the form of debt reduction, rather than being spent. The government’s much vaunted surpluses are simply displacing private sector saving, leaving national saving unchanged, with no implications for interest rates.
posted on 21 December 2006 by skirchner in Economics, Financial Markets
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In Defence of Hedge Funds
Sebastian Mallaby defends the role of hedge funds in the financial system:
the fear of hedge funds is overblown, based more on ignorance or simplistic caricatures than on actual knowledge. Many of the proposals for new regulation are so vague as to be impossible to evaluate or are poorly suited to address the supposed problems at issue. And even the most serious cause for concern—that hedge-fund operations might generate a “systemic risk” for the financial system as a whole—is neither limited to the hedge-fund sector nor best addressed through regulation of it. Rather than seeing hedge funds as sources of dangerous financial fires, in fact, it is more accurate to see them as the financial system’s benevolent fire fighters—and to let them have the tools they need to do their jobs well.
The long-short equity arbitrage fund is arguably an Australian invention. Australia is notable for regulating hedge funds in the same manner as other managed funds, making them available to retail investors, in sharp contrast to the ludicrous restrictions on retail participation in hedge funds in the US.
posted on 20 December 2006 by skirchner in Economics, Financial Markets
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Contrarian Indicator Alert: Roubini’s ‘Structural Gravity Force’
Nouriel Roubini dusts off his US dollar bear call, relying on that old faithful of structural US dollar bears, the current account deficit:
The large, still growing and eventually unsustainable US current account deficit is the structural gravity force that will keep on weakening the dollar over the medium term.
These ‘structural gravity forces’ must work differently for Japan, which runs a structural current account surplus while its real effective exchange rate is making 21 year lows:
It seems that ‘gravity force’ doesn’t work at short horizons either:
I am not in the business of predicting high frequency movements of currency over the horizon of a week or a month. But my macro and medium-term perspective tells me that fall of the dollar – over the medium term – has still a very long way to go.
posted on 19 December 2006 by skirchner in Economics, Financial Markets
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More of What Nouriel Roubini Won’t Tell You About the US Economy
Larry Kudlow notes that the US November retail sales report almost single handedly tanks Roubini’s call for zero US growth in Q4:
The key point here is that it virtually eliminates the zero percent Q4 scenario from recession bears like Nouriel Roubini. You can’t get zero here - toss that scenario in the garbage.
This is what my associates at Action Economics had to say about the report:
The U.S. retail sales report should be a game-changer for those positioned for an imminent hard landing for the U.S. economy, with sizable housing sector “pass-through.” Hard landing estimates increasingly need to address why pass-through during the first 15-18 months of the housing correction is taking so long to materialize if it is really going to prove more dramatic than most economists assume.
And time is not on the side of those with a near-term doom-and-gloom view, as both the firming evident in most housing market data since the big June-August downsizing, and the robust uptrend in the MBA mortgage data over the last three weeks and other recent signs of reversal in the real estate market suggest that the correction for sales is likely approaching the end, though there will be lagged construction sector effects.
To be sure, most economists, as well as most FOMC members, have stuck to their guns that pass-through of weakness from the housing sector is thus far limited even if it remains the risk, and that the slowdown is proving orderly, with growth “at a moderate pace” as described in yesterday’s FOMC statement.
Today’s U.S. retail sales report removes much of the controversy associated with this view.
posted on 14 December 2006 by skirchner in Economics, Financial Markets
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The Future Fund Revisited
Alan Wood references my Policy article on the Future Fund in this weekend’s Australian.
posted on 10 December 2006 by skirchner in Economics, Financial Markets
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‘Irrational Exuberance’ 10 Years On: History Exonerates Greenspan
Jeremy Siegel considers Alan Greenspan’s ‘irrational exuberance’ speech 10 years on:
Now that we have 10 years of economic and financial data, we can now accurately determine whether the market was indeed “irrationally exuberant” in December 1996. The answer is decidedly no. Had the market been overvalued, it would have shown poor return in the following decade. But it did not.
The compound rate of return from Mr. Greenspan’s speech through the end of November 2006 on the broadest index of U.S. stocks, the Dow Jones Wilshire 5000 Index, was 8.2% per year, while the return on the Dow industrials was even higher. International stock returns have been almost as good, with the Morgan Stanley EAFE index of international stocks returning 7.6% per year. All these returns include the bear market of 2001-2002 and were far greater than what was available on government bonds or cash over the last 10 years. Even taking inflation into account, these rates of return were very close to that achieved in long-term equity studies. There is no evidence that the market was overvalued at the time of Mr. Greenspan’s speech…
Looking back in August 2002, Mr. Greenspan was perfectly right when he said, at the annual Kansas City Fed economic conference in Jackson Hole, that “Historical data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion.” Had the Fed tightened further in late 1999 or early 2000, there would be little doubt that “brick and mortar” firms, as the non-tech stocks were called, would have borne the brunt of the tightening and pushed their valuations even lower. The subsequent recession when the tech bubble finally burst would have been far worse.
History has exonerated Alan Greenspan’s policy during the late 1990s. There is no good evidence that the market was in a bubble when he uttered his famous line 10 years ago, and he was wise in stepping back from it. Irrational exuberance finally did hit the stock market, but not at the time or in the scope envisioned by his critics.
For my own defence of Greenspan, see here.
posted on 06 December 2006 by skirchner in Economics, Financial Markets
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The US Dollar: Cyclical versus Structural
Stephen Jen, on why it’s dangerous to write-off the USD:
For two-and-a-half years, I have strenuously warned investors not to under-estimate the dollar. The current dollar sell-off is, to me, a cyclical, not structural development. The dollar index is fairly valued, and financial globalization should keep the US external imbalance well-financed. Many investors worry about wholesale central bank diversification. I am more skeptical: it is still hard to find good liquidity in markets outside major economies. Even compared to Euroland, the US offers much larger risky asset markets. Also, if central banks really have begun to diversify out of USD assets, there should be traces of this in US bond markets.
On the cyclical front, the US is likely to go through several quarters of sub-potential (i.e., sub-3.0%) growth. What this means is that the unemployment rate is likely to rise in the period ahead, which is likely to be another negative for the dollar. But I believe that the Fed is right that the US economy will eventually re-assert itself, most likely in the second half of 2007: I keep reminding myself that, since 2002, the Fed has had the best record of anyone at forecasting US growth.
posted on 05 December 2006 by skirchner in Economics, Financial Markets
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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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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 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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