Working Papers

Never Mind the Volumes, Check those Prices

A development often overlooked in the doom-mongering on Australia’s current account is the stunning growth in Australia’s terms of trade, 10% y/y in Q4.  The rising terms of trade were explicitly mentioned in yesterday’s statement by the RBA rationalising its decision to raise official interest rates.

The improvement in the terms of trade reflects strength in export prices relative to import prices, implying an improvement in Australia’s national purchasing power.  Australia has fortuitously become a net consumer of those goods for which prices are in secular decline, like ICT, while remaining a net producer of goods and services for which prices have been rising.

An important implication of the improvement in the terms of trade is that volume based measures such as GDP will understate the gains associated with this improvement in national income.  As import prices fall and volumes rise, this will count as a subtraction from growth, even though we are demonstrably better off from the improvement in national income.

The ABS get some major brownie points for highlighting this in a feature article in yesterday’s national accounts release. Extracts from the article can be found over the fold…

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posted on 03 March 2005 by skirchner in Economics

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‘Gloom & Doom Amid Boom’ Competition Winner!

We have a winner in our competition for the most overwrought commentary on Australia’s Q4 current account deficit. 

Competition was tough.  Stories with headlines screaming ‘banana republic’ were common entries.

I quickly lost count of how many stories made the claim that we are ‘living beyond our means.’  The Opposition Treasury spokesman also claimed ‘we are not paying our way,’ which would come as shock to international investors.  The fact that foreign investors are prepared to underwrite Australia’s consumption and investment make all of these statements demonstrably untrue.  It reflects the mindset behind the old homily, ‘neither borrower nor lender be,’ which taken literally would consign Australia to a state of near autarky.  The implication behind these statements is that we should cut our living standards to match only what we can produce for ourselves, a self-defeating solution to a non-problem.

Variations on this theme were also quite common.  BT Financial Group senior economist Tracey McNaughton said Australia was increasingly reliant on the ‘kindness of strangers’ to fund the deficit.  Tracey needs to brush-up on her Adam Smith: we rely on their self-interest, not benevolence, for our daily bread.

There were also plenty of stories that had the air of moral panic:

Home buyers could be hit by higher interest rates within days after the release of figures showing a nation falling deeper into debt and racking up a massive bill for imported cars, electrical equipment and clothes.

A nation awash in the excesses of cheap clothes from China?  The real story here is of course the enormous expansion in Australia’s consumption possibilities made possible by free trade in goods, services and, most importantly, capital.

The award for the most overwrought commentary, however, goes to…

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posted on 02 March 2005 by skirchner in Economics

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Rust or Bust?  The ‘Bubble’ Brigade Tire of Eating Crushed Glass

If they removed the word ‘bubble’ from the English language, Morgan Stanley’s Stephen Roach and Andy Xie would be left with nothing but sycophantic Sinophilia to irk us with. Fortunately, their colleague Richard Berner is much more level headed and has produced a thoughtful discussion of the outlook for US housing and house prices:

Most macro forecasters — crystal ball gazers all — have eaten a lot of ground glass trying to call a top in housing activity in the past two years, including yours truly.  Likewise, home prices have defied all calls, including mine, for a peak in appreciation, not to mention the bears’ forecasts of a sharp decline…

Importantly, however, a precipitous decline is unlikely: Stronger job and income growth should underpin new and replacement demand…And home prices?  I stick to my view that prices henceforth are likely to rust, not bust.

…neither the pace nor the level of prices is prima facie evidence of a bubble.  As I see it, nationwide housing ‘valuations’ are only back to neutral from being undervalued, consistent with my thesis that home prices will rust, not bust, for the next few years.

I make a similar argument about Australian house prices here.

posted on 01 March 2005 by skirchner in Economics

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The Institutional Economics ‘Gloom & Doom Amid Boom’ Competition!

Australia’s January trade balance has come in with the second largest deficit on record, ahead of tomorrow’s Q4 current account deficit.  I notice Trade Minister Mark Vaile has continued Tim Fischer’s old trick of pointing to exports being at record levels.  The relevant measure is of course the exports share of GDP, which would decline if exports did not keep posting new records in level terms.  It takes alot of cheek to claim credit for a secular trend. 

I am running a competition to find the most overwrought commentary or reporting on the January trade balance or Q4 current account.  The person(s) submitting the winning entry shall receive a free copy of Robert Prechter’s super-bearish Conquer the Crash to really keep them lying awake at night (no jokes about second place getting two copies!)  Email or post in comments (registration required, click on ‘register’ at top right).  Competition will be open until Thursday, by which time interest rate hike hysteria will have taken over from current account moral panic.

posted on 28 February 2005 by skirchner in Economics

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Globalisation and Current Account Balances

McKinsey’s Diana Farrell on globalisation and the US current account:

Roughly one-third of the current account deficit results from US-owned subsidiaries abroad…

Trade between foreign affiliates (as offshore subsidiaries are called) and US companies and consumers can either inflate or diminish the current account balance. When Ford or General Motors produce vehicles in Mexico they sell many to American consumers, causing US imports to rise. But they also sell a significant number in Mexico, generating a positive income flow to the US current account, and they use technologies and components produced north of the border, boosting US exports.

Any net negative impact on the trade balance caused by foreign affiliates is more of an accounting anomaly than a cause for economic concern. Methods for measuring the current account date back to the 1940s, when few companies had operations outside their home countries.

A similar argument can be made in relation to Australia.  Since Australia has become a net exporter of direct investment capital in recent years, this implies that at least some of Australia’s current account deficit is being used to fund the globalisation of Australian business.

Meanwhile, Cato’s Dan Griswold argues why the last thing you want is a trade surplus:

By the most basic measures of economic performance - GDP, manufacturing output and the unemployment rate - the US economy performs better in years when the current account deficit is rising than in years when it is shrinking. And it performs especially well in years when the current account deficit is rising most rapidly…

Those who seek the Holy Grail of a trade surplus should be careful what they wish for. Germany last year racked up a global surplus of almost $200bn. Not entirely coincidentally, its unemployment rate reached 11.4 per cent in December and the number of unemployed reached a post-unification high of 5m people. The last time America’s jobless rate was that high was 1982 - when its own current account deficit was a measly $5bn.

America’s trade deficit is essentially an accounting abstraction. Our attention should focus on what really matters - economic growth, job creation, industrial output, and the free and open markets that promote real growth.

posted on 26 February 2005 by skirchner in Economics

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The Myth of US Overstretch

David Levey and Stuart Brown’s article in Foreign Affairs, which we linked to earlier in op-ed form.  Read the whole thing, as they say.

posted on 25 February 2005 by skirchner in Economics

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Another US Current Account Beat-Up

You can’t help but be suspicious of a story reporting on a speech by Australian Treasury Secretary Ken Henry with the headline ‘US deficits risk crash: Treasury.’  My suspicions deepened when the report contained only two direct quotes from Henry. 

Henry’s actual speech is nothing exceptional and does not use the word ‘crash’ once.  The Australian Treasury has in fact argued persuasively for the sustainability of large US current account deficits.

Australia routinely experiences cyclical deteriorations in its current account balance as a share of GDP that make the current US deficit look small by comparison.  The Australian Treasury has long been converted to the consenting adults view of the current account.  If it views the US differently, it is because of the public sector contribution to the US deficit, which is a fiscal policy issue, not an external imbalance problem.

Next week, Australia is likely to report a monster Q4 current account deficit.  I will be running a competition for the most melodramatic and silly reporting of, or commentary on, this number.  Send me your sightings by email or post them in comments.

UPDATE:  Terry McCrann also notes that:

Henry was not setting out to ring the alarm on the “coming crash”, and would probably have been surprised—pleasantly or otherwise—to read words on the front of a national newspaper that would inevitably be dished up to the Prime Minister and/or the Treasurer.

posted on 25 February 2005 by skirchner in Economics

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House Price Inflation without the Froth

When confronted with asset price inflation, many economists are all too ready to declare a ‘bubble,’ which saves them the bother of actually having to think seriously about the economics underlying asset prices.  Fortunately, the BoE MPC’s Kate Barker is not one of these people.  In a speech to the IEA, she carefully examines the relevant fundamentals and puts them in a broader context, noting:

In previous speeches I and other MPC members have set out why it is generally undesirable to target asset prices when setting interest rates – particular reasons being the wide range of uncertainty around the equilibrium for any asset price, and the dangers to credibility of diverting policy from the goal of achieving the Government’s inflation target.

While RBA Governor Macfarlane has also highlighted the dangers of using monetary policy to target asset prices, the RBA’s public comments on house prices and private sector credit growth have diverted attention from its inflation target and confused the public and markets.  The RBA’s mistake was to express a strong (and arguably mistaken) view on house prices and private sector credit growth, but without being willing to actually take responsibility for outcomes in relation to these variables.  This was the right policy choice, but calls for a more agnostic public stance on these issues so as to keep the inflation target centre stage.

(thanks to Mark Harrison for the pointer)

posted on 24 February 2005 by skirchner in Economics

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Markets in Everything: The PAM Rides Again

Remember the Pentagon’s ill-fated Policy Analysis Market?  Intrade is now offering a contract on the timing of US air strikes against states sponsoring terrorism:

The contract will be expired at 100 if the USA officially launch and execute an overt Air Strike against land facilities in any of the listed countries on or before June 30, 2005.

The countries involved and currently listed as States known to sponsor terrorism are: Cuba, Iran, Libya, North Korea, Sudan & Syria.  Only these six countries count for expiry purposes. An overt Air Strike against a land facility will be defined as an air attack officially announced by the Pentagon or the US Department of Defense. It will not include any covert operations, accidental border clash, etc. The contract will be paused and subsequently expired once such an attack has been reported to have taken place against a land facility in any of the named countries.

The contract has yet to trade, but market depth is pointing to an implied probability in the low teens.  This contract would have been more informative if it were based on individual countries, rather than such a disparate group.

posted on 23 February 2005 by skirchner in Economics, Economics/Financial Markets

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More on Pop Austrianism and the Business Cycle

A key element of the pop Austrian critique of contemporary monetary policy is that the inherent unevenness of the process by which newly created base money and inflation work their way through an economy creates a structure of production that a free market economy would not otherwise support (the Ludwig von Mises Institute has plenty of examples of this sort of claim).  In the Austrian view, growth in broad money, credit aggregates and even asset prices is built on a house of cards: fiat money leveraged through fractional reserve banking.  Even those Austrians who accept fractional reserve banking consequently see almost any central bank policy action as inherently destabilising. 

A major problem with this view is that there is no necessary connection between interest rate targeting by central banks and the money base (although in practice they are usually closely linked by the operating procedures currently favoured by monetary authorities).  In principle at least, we could have a market-determined money supply and even non-centralised clearing of overnight inter-bank lending and yet still have a central bank successfully targeting an official short term interest rate through its willingness to buy and sell relevant instruments at given prices.  Unless we define free banking as the complete absence of a central bank, there is no reason why the two institutions could not co-exist.

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posted on 22 February 2005 by skirchner in Economics

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The US Net IIP: Non-Hysterical Version

Much of the hysteria surrounding the US current account deficit reflects a basic lack of faith in US institutions and growth prospects.  David Levey and Stuart Brown have a refreshingly different perspective:

While the NIIP will continue to grow for many years to come, future dollar depreciation and market adjustments in interest rates and asset prices will mean that its increase will be far less dramatic than many fear. Moreover, focusing exclusively on the NIIP obscures the United States’ institutional, technological and demographic advantages. The classic doomsayer argument - that growing foreign indebtedness results from too little savings by Americans - neglects the fact that savings and investment are seriously undervalued in U.S. economic accounts. When you include capital gains, 401(k) retirement plans, and home values, U.S. domestic saving is around 20 percent of GDP, the same as in most other developed economies. And when you consider “intangible” investment (like new-product development and design experimentation) as part of total, the supposed increase in consumer
spending as a share of GDP turns out to be a statistical artifact.

Indeed, much of the explanation for chronic current account deficits relates to the U.S. economy’s strong fundamentals, not fatal structural flaws.

The country with the world’s strongest external investment position is Japan, which achieved this dubious distinction by trashing its potential growth rate and the returns on domestic investment through state-sponsored forced saving and the overcapitalistion of its economy. 

(thanks to Jack S. for the pointer)

posted on 20 February 2005 by skirchner in Economics

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The Anglo-American Model Delivers

I recently came across a forsaken copy of Peter Brain’s (1999) Beyond Meltdown in a second-hand bookstore.  In the course of a diatribe against ‘neo-liberal’ economics and the ‘American’ economic model in Australia, Brain forecast that the Australian economy would enter a prolonged stagnation in the wake of the 2000 Olympics, during which the unemployment rate would return to the double-digit figures seen during the last recession in the early 1990s.

Instead, the Australian economy has gone from strength to strength, with the unemployment rate hitting multi-decade lows, precisely because it has generally avoided the policy prescriptions favoured by the likes of Brain.

The Anglo-American economies currently look a whole lot better than those countries that have followed less liberal policy prescriptions.  Japan has just gone back into recession for the third time since 1998.  Germany is just shy of its third recession in four years.

Meanwhile, the UK, Australia and NZ are all enjoying their lowest unemployment rates in decades.  This is particularly telling, since the ‘neo-liberal’ policies supposedly favoured by the Anglo-American economies are often stereotyped as anti-employment.  The evidence suggests otherwise.

Of course, there is no reason why the Anglo-American economies cannot also experience a downturn in the near future, but even in recession, they will fare much better than those economies outside the Anglo-American bloc, due to their greater commitment to liberal policy prescriptions.

UPDATE:  My Google ad strip is now rather amusingly showing “Discount GDP Forecasts: New and Used GDP Forecasts.”  It is of course an ad for Ebay, not Peter’s book.

posted on 18 February 2005 by skirchner in Economics

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Get Paid for Economics Blogging!

If you are a recent graduate and would like to be paid to work on an economics blog, Peter Jonson at Henry Thornton has a job opportunity for you.

posted on 17 February 2005 by skirchner in Economics

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The House Economics Committee Gets a New Chair

Those of us who argue for greater central bank transparency can only cringe when the Reserve Bank Governor fronts the House Economics Committee.  You have to admire the patience and politeness Governor Macfarlane displays in the face of the Committee’s woeful displays of economic illiteracy and ham-fisted attempts at point scoring. 

Things are not going to get much better under the Committee’s new chair, Bruce Baird, who has rather helpfully put out a press release alerting us to what is on the Committee’s collective mind.  Baird says:

I’m also interested in what incentives the Reserve believes are needed to encourage greater private investment and whether there should be a diversion away from investing in private housing.

This is of course well outside the Governor’s mandate and, dare I suggest, also outside the realm of legitimate public policy concern.  The implication that investment in housing is excessive is particularly galling coming from people whose own homes are, at a wild guess, a cut above average.  It is fine for them to invest in housing, but a dangerous ‘bubble’ when everyone else gets in on the act.

Baird is also a coordinator of the informal government committee, the Friends of Tourism Group.  This sits rather uneasily with his current efforts to deny Singapore Airlines access to the Australia-US route in order to protect Qantas jobs in his electorate, which includes Sydney Airport.  The sort of ‘friend’ tourism could do without.

posted on 17 February 2005 by skirchner in Economics, Politics

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Myth Busting the House Price ‘Bubble’

The prevailing mythology surrounding the Australian economy in recent years is that economic growth has been driven by consumption, which in turn has been driven by a house price boom.  It is true that consumption has largely accounted for headline GDP growth in recent quarters.  But as John Edwards has pointed out, consumption and national saving as a share of GDP have been remarkably steady.  What has changed is the investment share of GDP (including dwelling investment), which in real terms is currently the strongest it has been during the post-war period.  In this context, the deterioration in the current account balance is a cause for celebration, because it represents an investment boom, not a collapse in saving.

In the chart below, I have shown real Sydney house prices and GDP as percentage deviations from their linear trends.  It is remarkable the extent to which the cycle in real house prices has lagged the business cycle.  GDP has been consistently at or above trend since the end of 1997, but real house prices in Sydney only exceeded their own trend from the beginning of 2002, after a decade of below trend growth.  The chart puts the supposed ‘bubble’ in Sydney house prices in cyclical perspective.  Of course, some would argue that the secular trend in house prices is itself a bubble and one can take issue with the detrending methodology, but the notion that house prices have been leading the economy looks rather strained.

If there is anything to the stylised Australian house price cycle (turn of the decade booms, followed by middle of the decade slumps), then the cycle in house prices should bottom at the end of 2006 (as it did in 1986 and 1996), but only after the economy has already slowed for reasons that have little to do with house prices.


posted on 16 February 2005 by skirchner in Economics

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