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Rational Choice Theory and the Papal Conclave

Can rational choice theory be used to divine the Will of God?  You bet.

Intrade is running both successor and country of origin markets for the next Pope.  The latter market suggests that the Italians have it.

posted on 05 April 2005 by skirchner in Economics

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China’s Voodoo Accounting

China Economic Quarterly editor Joe Studwell claims:

Beijing has raided tens of billions of dollars of foreign exchange reserves to shore up banks’ capital.

Those who argue that liberalising China’s foreign exchange rate regime would destabilise its financial system may have things exactly backwards.  If what Studwell says is true, then China’s managed exchange rate regime may in fact be perpetuating the systemic problems in its financial system.  Supporting China’s peg to the USD on financial stability grounds could well be a circular argument.

posted on 04 April 2005 by skirchner in Economics

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Debunking ‘Low’ Saving in the US

Bear Sterns chief economist David Malpass rubbishes the notion that the US does not save enough:

Not only are we not running out of household savings, it is growing fast both in terms of the annual additions and the cumulative buildup of American-owned savings. Household net worth, one good measure of savings, reached $48.5 trillion in 2004. Time deposits and savings accounts alone total a staggering $4.3 trillion, versus slow-growing credit-card debt of $800 billion. True, the U.S. is the world’s biggest debtor, but it is building assets faster than debt. Even if household assets took a hard fall, the remaining net worth would still dwarf other countries’. On a per capita basis, counting mortgages but not houses, net financial assets total $89,800 in the U.S. versus $76,900 in No. 2 saver, Japan. Of course, some households don’t have nearly this average, creating risks for them and burdens on others in the event of a downturn. This is an appropriate policy concern, but the macroeconomic issue is aggregate savings, of which the U.S. has an abundance.

According to the Federal Reserve’s flow of funds data, the 2004 additions to household financial assets were a net $590 billion. This was 6.8% of personal disposable income, providing a meaningful measure of the cash flow going into new financial savings. This increased the household’s financial net worth to $26.1 trillion, way above any other country’s savings and plenty to fund profitable domestic investments. If the 2004 appreciation in the value of homes and equities were also counted, the 2004 saving rate was 46% of disposable income. Foreign savings invested in the U.S., the counterpart of the widely criticized current account deficit, is additive to our own large store of savings.

Rather than a “dependence” on foreign savings, the U.S. is an effective user of it, profiting by growing faster than the interest cost of foreign saving. The combination of large domestic and foreign savings allows heavy investment in the U.S. decade after decade, part of the explanation for our fast growth and the world’s highest employment levels. Meanwhile, foreigners are actually losing ownership share in the U.S. despite the $2.6 trillion net debtor position, since U.S. assets are growing faster than foreign savings in the U.S.

A similar analysis would apply in the Australian context.  Malpass also highlights the real dangers associated with the ‘low’ saving view:

However, the bigger harm is not that we expose ourselves to a collapse, but that we allow ourselves and foreigners to underestimate, even mock, our economic system. We apologize for our “low savings rate” and “dependence on foreigners,” turn our foreign economic policy over to the International Monetary Fund’s economic gurus, and contemplate consumption tax increases, forced saving, protectionism, and a weaker dollar (with the consequent increase in inflation). Instead, while working hard to improve our system, we should encourage others to emulate its freedom, flexibility and prosperity.

posted on 02 April 2005 by skirchner in Economics

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The Reserve Bank as ‘Benign Autocracy’

John Garnaut uses next week’s Reserve Bank Board meeting as a hook to consider Australia’s 1920s model of monetary policy governance (Ross Gittins is obviously on leave!):

Professor Adrian Pagan, an economist at the Australian National University, sat on the Reserve’s board for five years to 2001.

Pagan says the bank is a “benign autocracy” where good policy outcomes have obscured the need to look more closely at rules and processes.

By the time of the 1990 recession, the rules that empowered and governed the bank had barely changed in 40 years. Fifteen years later and those rules and structures still have not changed.

“I think that once you become independent, it’s appropriate that you do change the governance structure,” he says. “Most others have changed, it’s unusual that we haven’t.”

Pagan’s reform agenda includes the publication of board meeting minutes, transparent risk-control processes for currency trading and, most importantly, restructuring the board.

The Reserve Bank board structure was established 80 years ago and remains almost unique among central banks.

Representing the institution are Macfarlane and his deputy, Glenn Stevens. Henry, secretary of the Treasury, represents the Government - although Macfarlane has said he still doesn’t know whether the Treasury secretary speaks for the Treasury or the Treasurer.

Five positions have been reserved for business people for most of the period since 1924. Not all have been praised for their contributions.

“They are very non-expert - to very high degree,” [former Board member Professor Bob] Gregory says. “I found that surprising.”

I make similar criticisms of Reserve Bank governance here.

posted on 02 April 2005 by skirchner in Economics

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The Growing Chorus for Tax Reform

Ross Garnaut joins the growing chorus for tax reform:

The most urgent task is to reduce considerably the effective marginal tax rates for social security recipients, the high levels of which contribute to relatively low labour force participation and high levels of part-time employment.

High taxation rates are also significant elements in labour force participation and the attraction and retention of skilled personnel at higher levels—and probably at all but the highest levels of the incomes range.

A reform of taxation rates that established a flat 30 per cent marginal effective tax rate for all corporate and personal income, including capital gains, would be most advantageous for people at the bottom of the income range, and most disadvantageous for Australians on the highest incomes and with the greatest wealth. Contrary to popular perception, it would be progressive, as well as being highly advantageous to incentives for greater labour force participation. It would have the additional advantage of removing the gains from conversion of personal into corporate income. Raising the rate of taxation on capital gains (it would need to be on real rather than nominal gains) would have the incidental effect of greatly reducing the distortions in capital allocation that have spurred the housing and associated consumption boom.

Needless to say, I disagree with Garnaut on capital gains tax and its supposed effects, but a flat 30/30/30 system for personal, corporate and capital gains tax has some appeal and should be readily achievable.  Unfortunately, the government still shows no sign of taking tax and spending reform seriously.

posted on 31 March 2005 by skirchner in Economics

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Disappointing Think Tanks on the Left and Right

The AEI’s John Makin confidently declares housing to be in a ‘bubble’ and lays it all at the feet of Alan Greenspan.  Makin argues that the Fed should toughen up its rhetoric and tighten by 50 bps in June.  This is somewhat at odds with the position Makin held as recently as October last year, when he called for a halt to further rate increases because of what he saw as the risk of recession in 2005.  The AEI has been more dovish and interventionist on monetary and exchange rate policy than many left-liberal think tanks, making any criticism of Greenspan for presiding over a ‘second bubble’ more than a bit rich.

Frank Lowy is to be commended for his philanthropy in establishing the Lowy Institute, but one has to wonder whether he is getting value for money.  The Lowy Institute would seem to be promoting ideas that are already over-represented within academia and among the Labor Party’s foreign policy establishment-in-internal-exile.  As Greg Sheridan notes:

The Lowy Institute, devoted as it is to Australian foreign policy, is a good thing. It’s full of conscientious folk doing useful work. Unfortunately, it does not look like it’s going to inject any fresh thinking into Australian foreign policy or generate any new voices. Rather it will reinforce the sadly quite narrow range of opinions held among professional academic and quasi-academic foreign policy commentators.

The same narrow views that led the Labor Party into a catastrophic abandonment of bipartisanship on foreign and defence policy ahead of the last election.

posted on 29 March 2005 by skirchner in Economics

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The US Current Account and Globalisation

Diana Farrell at the McKinsey Global Institute has been doing some excellent work highlighting the growing irrelevance of a residency-based view of trade, which ignores the increased importance of cross-border ownership of equity capital in driving current account balances.  Farrell estimates that one-third of the US current account deficit is attributable to trade with US-owned foreign subsidiaries.  Moreover, 

For at least the next decade, we would expect foreign investment by US multinationals to go on adding to the current-account deficit as it is currently measured. After all, globalization is in its infancy.

Record current account deficits should not be a surprise in this context, since globalisation should bring about a structural deterioration in the measured current account balance.  Insofar as this deterioration is symptomatic of globalisation, it should be welcomed rather than feared.  Farrell suggests moving to an ownership-based measure of trade balances, which might help defuse current account deficit angst.

posted on 25 March 2005 by skirchner in Economics

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Freakonomics

It is now increasingly common to set up a blog to accompany the release of a new book.  Steve Levitt and Dubner have done this for their new book Freakonomics.  One of their first posts deals with why real estate agents are like the Ku Klux Klan.

I think the title of the book is unfortunate, because while Levitt’s interests are unconventional for an economist, he often explores issues that are of wider social interest and importance.  Too often economists are engaged in work that is of only limited interest, even to other economists.  I often get invited to economics conferences where I cannot find a single interesting paper on the conference program. 

Hopefully, this effort by the two Steves will help popularise econometric approaches to social and other issues that are often neglected by economists, leaving debate dominated by those from other disciplines that do not have a coherent theory of human behaviour and have limited interest in empirical testing.

posted on 23 March 2005 by skirchner in Economics

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‘After the House Price Boom’

Peter Saunders (the CIS one, not the hairy lefty) has an article in the latest issue of Policy on ‘After the House Price Boom.’  Peter credits me with commenting on an earlier version of his paper, without implicating me in the argument.  Here I highlight some of my disagreements with the final version.

continue reading

posted on 21 March 2005 by skirchner in Economics

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Basil Fawlty Economic Commentary

One of Basil Fawlty’s favourite bits of hyperbole was “This is just how Nazi Germany got started!”  Over at the otherwise respectable On-Line Opinion, James Cumes, a former Australian diplomat, makes the same claim in relation to the RBA’s latest rate rise:

Hitler came to power in early 1933. So did Franklin Delano Roosevelt but even the “New Deal” was too little and too late to turn the economic tide around - or the drift into world war. Unfortunately, we are doing the same thing now. We are persisting with policies that can only be self-destructive. That applies not only to Australia but especially to the United States - and indeed to many other countries.

The rest of the piece is as economically illiterate as it is overwrought.

posted on 19 March 2005 by skirchner in Economics

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Howard and Minchin as Revenue Hoarders

If recent comments by the Prime Minister are anything to go by, we can rule out a meaningful reduction in the overall tax burden in the May Budget and probably for the life of the current Parliament.  The government remains wedded to the view that tax cuts can only be funded out of the surplus, with the PM saying:

If we are able to give further tax relief after we have provided for essential spending, and that’s defence, health and roads and all of those things, and provided we have a strong budget surplus. (emphasis added)

In the government’s view, tax relief is a residual that can only be paid for out of the surplus.  The surplus is simply too small to accommodate a meaningful tax cut.  Tax cuts out of the surplus would only serve to hand back a portion of bracket creep, not reduce the overall tax burden.  The only way in which the government can fund a meaningful reduction in taxes is through reductions in government spending.  Unfortunately, the government’s record on expenditure restraint leaves much to be desired.

Equally disturbing is Finance Minister Nick Minchin’s proposal to take the proceeds from the privatisation of Telstra and invest them in a managed equity fund at arms length from the government.  The alternative of paying down debt would entail the effective elimination of the Commonwealth government bond market.  I have no objection to the elimination of the bond market, but since we are only a recession away from the government again having to raise funds in capital markets, we might as well keep it in place.  But selling equity in Telstra only to acquire an equity portfolio run by private fund managers shows that the government’s primary motivation is to hoard the income stream from this asset. 

If the government were genuinely interested in using the proceeds from the sale of Telstra to offset future demands on government spending, then it could simply deposit the proceeds from the sale of Telstra into the private superannuation accounts that every working Australian already owns.  A formula could be devised to ensure that low income earners benefited most from this process.  This would be very similar to privatisation by lottery and would constitute a transfer of wealth from the public sector to the private sector that would reduce the future demands on government from an aging population much more reliably than an income stream that simply accrues to consolidated revenue.

posted on 16 March 2005 by skirchner in Economics

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Throw the Book at China

The IIE’s Fred Bergsten says it is time the IMF and US Treasury started enforcing the rule book on China’s manipulation of its exchange rate:

key industrial countries and international institutions have done virtually nothing to counter these blatant market distortions. Despite their professed fealty to market principles, the US and European governments have limited themselves to ineffectual consultations with the perpetrators. Massive currency interventions by the Asian countries directly violate the charter of the International Monetary Fund, which calls on members to avoid manipulating exchange rates in order “to prevent effective balance of payments adjustment”. The chief culprit is China, whose continued dollar peg has helped weaken its currency by more than 10 per cent since 2002…

The US and the Europeans, the IMF’s leading shareholders, must insist the fund start implementing its rules. This calls for the managing director to send a consultation mission to each member country suspected of “manipulation” and, if resolution is not prompt, then to refer the problem to the fund’s executive board. The list of target countries should start with China. In addition, the Treasury Department must start fulfilling its legislative requirement to label these countries, most notably China, as “currency manipulators” in its next semi-annual report to Congress on the topic due later this month.

Fred Bergsten even goes so far as to call for IMF counter-intervention in foreign exchange markets and the erection of trade barriers under WTO auspices.  This is dangerous and unnecessary in my view.  But if the IMF will not enforce its own rule book, we have to ask, what is it good for?

posted on 15 March 2005 by skirchner in Economics

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Ross Gittins’ Martyrdom Operation

The Treasurer’s conspiracy to black-ban Ross Gittins has apparently widened to include two other Fairfax economics writers:

When I wrote last week that I was the only economic journalist not invited to attend the dinner for a closed Treasury conference, I didn’t know my colleague John Garnaut, and Tim Colebatch, Economics Editor of The Age, had also been given the treatment.

The fact that governments play favourites with journalists is not exactly news and hardly a scandal.  I don’t recall Ross complaining about being invited to closed RBA conferences at the H C Coombs Centre, from which other journalists were excluded.

posted on 14 March 2005 by skirchner in Economics

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Ben Bernanke Right on the Money

I have long been a fan of FRB Governor Ben Bernanke.  In his Sandridge Lecture, he advances what he calls an ‘unconventional’ interpretation of the deterioration in the current account balances of the Anglo-American economies (as Bernanke reminds his American audience, this is not a phenomenon unique to the US).  Bernanke is probably being ironic, because there is nothing at all unconventional about his interpretation, except in the sense that it goes against a conventional wisdom that is thoroughly mistaken. 

Despite underselling his case, he makes many good points, but most importantly, he firmly points the finger at the role of forced saving in East Asia as a contributing factor in global imbalances:

current account surpluses have been an important source of reserve accumulation in East Asia.  Countries in the region that had escaped the worst effects of the crisis but remained concerned about future crises, notably China, also built up reserves. These “war chests” of foreign reserves have been used as a buffer against potential capital outflows. Additionally, reserves were accumulated in the context of foreign exchange interventions intended to promote export-led growth by preventing exchange-rate appreciation…

In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets. Effectively, governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets.

Highly recommended reading.

Deepak Lal suggests China could do something more useful with its foreign exchange reserves.

posted on 13 March 2005 by skirchner in Economics

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Current Account Deficit Angst and Behavioural Finance

Terry McCrann on current account deficit angst:

Did any of you spend even a single day in the actual December quarter worrying whether the deficit would be funded by foreigners? Whether “today’s” $230 million had come in on any single business day, so you could retire to the plasma TV that evening “knowing” that Australia was safe from bankruptcy for another day; and another $230 million?

Of course not. That $15 billion was not only funded, but over-funded. More money wanted to come than we needed - so the RBA had to take some of the foreign coin and the Aussie dollar was pushed higher by the excess demand.

The reason most of us don’t lie awake at night worrying about the current account is that we rightly figure that we have taken prudent decisions in relation to our personal finances.  Yet we are also prone to the belief that collectively we are behaving irresponsibly.  Most of those who express public concern about the current account deficit would have personal balance sheets that differ only in degree rather than kind from the current account deficit.

Much of the air of moral panic that surrounds the current account deficit probably stems from the commentariat’s belief that there must be something wrong when the lower middle-class start moving into large, debt-financed homes and enjoying cheap imported goods that were once considered minor luxuries.  When the masses start tapping into what were previously perceived as positional goods that helped set the commentariat apart, there is a natural tendency to assume that economic corners have been cut.

Who said insights from behavioural finance couldn’t be used to support free markets?!

posted on 12 March 2005 by skirchner in Economics

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