Working Papers

2005 12

Candid Cultists

Brad Setser reviews the year that was in ‘Things I Got Wrong in 2005’:

Alas, this list is rather long.

To be fair, this sort of candour is quite admirable and not often seen among pundits.

Don Boudreaux has an extract from a recent interview with Milton Friedman that touched on the subject of global imbalances.  RBA Governor Ian Macfarlane made much the same point in a speech earlier this year, which should have received a lot more attention than it did:

the scenario whereby world financial markets react to the US current account deficit by withdrawing funding has disappointed those who thought it would come into play. It may happen yet, but people have been predicting it for a long time and yet it seems no closer. A large part of the reason for this is that investors who want to get out of US dollars have to run up their holdings of another currency – they cannot get out of US dollars into nothing. They have to take the risks involved in holding some other currency, possibly at an historically high exchange rate, and they may well be reluctant to do so.

posted on 31 December 2005 by skirchner in Economics

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A Little Christmas ‘Bubble’

As usual, blogging will be light at best over the Christmas-New Year period.  Thanks to IE readers, tipsters and advertisers for their support throughout the year.  Hope you had as much fun reading it as I did writing it.

Having spent much the last 12 months rubbishing the notion of ‘bubbles’ in asset prices, I should draw readers’ attention to a bit of asset price inflation in which you are all implicated.  Here is the Institutional Economics stock price at Blogshares since April this year:


It’s all due to fundamentals!  Back in January for another year defending capitalist acts between consenting adults against fever-swamp Austrians, Roubini-Setser doomsday cultists, the AEI’s resident evils, and Economist leader writers.

posted on 23 December 2005 by skirchner in Misc

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20 Million Future Funds

The CIS gets behind the idea that the Future Fund should instead be used to endow individual private saving accounts:

A better alternative to the Future Fund would be to hand back the surpluses to the taxpayers who are funding them, and to remit future receipts from the sale of Telstra to the Australian public who notionally own these assets. In this way, the government could enable ordinary people to start saving for their own futures, rather than have the government doing it for them.

The Future Fund is expected to exceed $60 billion by mid-2007. An equal share-out among all permanent residents in Australia (children as well as adults) could at that time provide everyone with their own personal ‘future fund’ (PFF) worth around $3,000.  Further dividends from the Government as it disposes of surpluses in the future, together with contributions from individuals themselves, could swiftly raise this to around $5,000 per person.

posted on 21 December 2005 by skirchner in Economics

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Don’t Argue With Structural Bears

Stephen Jen on the lessons of 2005:

I have given up trying to convince the structural USD bears about the benign perspective on global imbalances.  After a year-and-a-half of hard marketing, I have come to the realization that investors’ structural views on the USD are deeply entrenched:  the bears will always be bears.

posted on 20 December 2005 by skirchner in Economics

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Public versus Private Saving

Alan Kohler, referring to Greg Smith’s presentation to the Australian Tax Research Foundation’s Tax Leader’s Forum, highlights the extent to which the increased public saving represented by the federal budget surplus has come at the expense of private saving:

of the $47 billion in underlying cash budget surpluses accumulated since 1996, $39 billion, or 83 per cent, came from taxes collected from super funds.

In other words the Howard Government’s accumulated surpluses are largely just a transfer of private savings to public savings. The taxes collected from super funds haven’t even been spent! ...

Greg Smith says: “Australia is one of the very few countries to tax superannuation funds [on earnings and contributions]. This essentially transfers private to public savings, substantially neutralising the national economic benefits of running a budget surplus.”

That is, the budget surplus is not a result of excellent economic management or government administration, but is simply the forced transfer of wealth from private savings to public. Nothing has been created.

This is what makes the impounding of part of the budget surplus and the proceeds from the sale of Telstra in the Future Fund so inexcusable.  The financial assets that will acquired by the Fund should instead be residing in the private retirement accounts of individual working Australians, reducing their future dependence on government.

posted on 17 December 2005 by skirchner in Economics

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The Price of Reserve Bank Secrecy

The RBA is willing to pay a high price to keep its deliberations from public scrutiny:

THE Reserve Bank of Australia spent $304,530 on lawyers to block a Freedom of Information request to release details of its board’s deliberations over interest rates.

The RBA hired a team of lawyers from Clayton Utz to keep secret from The Weekend Australian the central bank’s board minutes for the 12 months to March last year.

Files from the Attorney-General’s Department show Clayton Utz’s bill was $275,458 for solicitors’ fees and $29,072 for legal counsel fees for four months to November last year.

The cost is revealed in the Attorney-General’s FOI annual report…

The proceedings before the AAT were effectively brought to an end when the RBA issued a conclusive certificate, which perhaps offers a hint as to the nature of the legal advice they received. 

Opposition Treasury spokesman Wayne Swan said the legal bill seemed “an extraordinarily large amount of money”.

“We need more transparency and openness when it comes to Reserve Bank appointments and their deliberations,” Mr Swan said yesterday.

The ALP backed away from reforms to the RBA Act ahead of last year’s federal election.  It remains to be seen whether they can put up a meaningful reform proposal before the next one.

posted on 17 December 2005 by skirchner in Economics

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Malcolm Turnbull as De Facto Treasurer

The increased budget surplus reported in Mid-Year Economic & Fiscal Outlook has seen the usual spate of calls for further tax reform.  However, the budget surplus should in no sense be viewed as defining the scope for further reform.  Meaningful reform needs to go well beyond a handing back of a portion of the surplus and extend to a complete overhaul of the current system of tax concessions and Commonwealth government spending, particularly the middle class welfare churn, which sees many households paying no net tax.  This makes wholesale tax reform readily affordable out of existing government spending programs.

This point is clearly understood by Malcolm Turnbull, who (perhaps not coincidentally) gave a speech on tax reform yesterday coinciding with the Treasurer’s release of the MYEFO.  Turnbull draws on President Bush’s Tax Reform Panel to argue for what amounts to a radical re-think of the tax system.  Turnbull is even willing to put a flat tax and the abolition of taxes on saving, such as capital gains tax, on the table:

A flat tax is not, of course, truly flat. Flat tax systems impose a single tax on income with the broadest possible definition and with very few deductions. Progressivity, or vertical equity, is maintained by having a tax free threshold which can be adjusted for family size. There is no need whatsoever for a flat tax to be regressive.
The greatest economic benefit claimed for so called flat taxes is that income is taxed only once: either at the business level or at the household (or wage earner) level. This means that income from investments be it interest or capital gains is not taxed in the hands of the recipient, although of course when it is spent it is taxed because it becomes income in the hands of the business or individual who receives it. This reduces the bias against savings and investment which slows capital formation and as a consequence wage growth.

Compare and contrast Treasurer Costello’s most recent speech on tax to the Global Tax Forum, which was essentially arguing for the cartelisation of international taxation and enhancing ‘national tax sovereignty.’  Who would you rather have as Treasurer?

posted on 16 December 2005 by skirchner in Economics

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Pricing Clinton, McCain and Rice

US Senators make lousy Presidential candidates, but John Fortier argues that Hillary Clinton and John McCain are the exceptions to the rule:

Senators who look in the mirror think they see the next president of the United States. History, however, has shown that the reflection is that of a losing candidate…

Only two sitting senators have ever won the presidency—John F. Kennedy and Warren Harding—and both had short and relatively undistinguished Senate careers. By contrast, consider the success of governors. Not only have four of our last five presidents been governors but incredibly none had even held a real job in Washington before entering the presidency.

Clinton and McCain are currently the highest priced Intrade contracts for securing their party’s nomination.  Unfortunately, the market is giving a very low probability to the Hillary-Condi contest favoured by Dick Morris:

Rice is the only figure on the national scene who has the credentials, the credibility, and the charisma to lead the GOP in 2008…a race between these two commanding, but very different, women is a very real possibility - and would inevitably prove one of the most fascinating and important races in American history.

posted on 15 December 2005 by skirchner in Politics

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RBA Governor Macfarlane’s Long View on Rates

It is unfortunate that RBA Governor Macfarlane does not speak in public more often.  He has made only seven public presentations this year, including two before the House Economics Committee.  What makes Macfarlane so interesting is his deep understanding of the importance of institutions and his broad historical perspective.  Both were in evidence in his speech to the Australian Business Economists, in which he highlighted the importance of institutional change in contributing to the resilience of the Australian economy in recent years, even going so far as to suggest that Australia served as a model in this regard (for Chile anyway!)

Being something of an economic history buff, Macfarlane produced the following chart, showing the unprecedentedly low level of nominal interest rates among the world’s major economies in recent years.  He also produces a table showing that world interest rates have been very low even in real terms.


posted on 13 December 2005 by skirchner in Economics

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Can You Distinguish a Random Walk?

Test your ability to distinguish between a real stock price and a random walk, along with your forecasting ability.  Most financial time series satisfy statistical tests for a random walk, so the two data generating processes should be very similar.  The efficient markets hypothesis and technical analysts or chartists both make the assumption that price discounts everything, but techies claim the ability to make forecasts based on historical dependencies in market prices.  The test includes trading volume, which techies would claim is useful additional information.

The students involved are also collecting some basic data on the people doing the test, so it should be interesting to see if any group manages to outperform.

(via Mahalanobis)

posted on 13 December 2005 by skirchner in Economics

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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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