Econ Amore

Peabody’s bid for Macarthur Coal is hardly a carbon tax endorsement

2011-07-14T07:55:00.000+10:00

An article that a wrote for "The Conversation".

Comments welcome

What happens to the market equilbrium when.......

2011-05-23T13:17:00.001+10:00

Linked is an interesting situation to which the microeconomic principles of demand and supply curves may be used.

I always knew that economists were more knowledgeable than mathematicians and scientists....

2011-02-09T14:57:00.000+11:00

http://economics.com.au/?p=6674

A definition of competition

2011-02-09T11:24:00.001+11:00

I was reading an article whilst traveling home on the train last night. The following definition of competition was noted "a procedure for discovering facts which, if the procedure did not exist, would remain unknown or at least would not be used." Hayek, F.A. 1968/2002 Competition as a discovery procedure (Marcellus S. Snow Trans.) Quarterly Journal of Austrian Economics 5, 9-23.

Therefore, based on this definition, one may assert that were competition is stifled, facts are mysteries waiting to be discovered but forever hidden.

What is economics?

2011-02-08T11:40:00.001+11:00

A question that is often asked is, "what is economics?" Many answers to this question have been presented. For example:
http://www.economicshelp.org/blog/economics/economics-science-or-art/

A recent installment that I found thought provoking was: economics is a science, an art, a competition and politics. (note you may need a NBER subscription to access this article)
http://www.nber.org/papers/w16416 - by Harald Uhlig

Rudd and "National Competitiveness"

2009-07-28T12:17:00.004+10:00

Prime Mininster Rudd's recent essay contains a number of references to global competitiveness.

.... Australia cannot meet the challenges of raising our global competitiveness if we do not lift productivity growth.

The Prime Minister needs to have a read 0f Paul Krugman's classic 1974 article in Foreign Affairs.

competitiveness is a meaningless word when applied to national economies. And the obsession with competitiveness is both wrong and dangerous.

Absolute levels of productivity, rather than levels of productivity relative to our trading partners, are what matters for living standards. The Prime Minister appears to limit his attention to productivity growth in tradeables, but there is no reason to ignore productivity growth in non-tradeables.

Davidson and Kates Make Page 2 of the Oz

2009-07-28T11:48:00.005+10:00

My colleagues Professor Sinclair Davidson and Dr Steven Kates are mentioned on page 2 of today's The Australian.

Rudd fails economic history lesson, Christian Kerr, July 28, 2009 ....PRIME Minister Kevin Rudd has got his economic history in his latest exercise in essaying "exactly wrong". That's the view of RMIT University academic Sinclair Davidson, who says it doesn't augur well for our future......
Davidson wants to know how we can trust a bloke who has got the past wrong to lead us into the future.....
Davidson points to research by RMIT colleague Steven Kates which shows how unemployment in Australia after 1932 fell more swiftly than in the US and Britain. The essay shows how ignorant Kevin Rudd is of Australian economic history.....
All up, Davidson describes the background to Rudd's latest essay as extraordinary. "He's put us into debt to the tune of $300 billion having claimed to have learned lessons that he doesn't know."

Quote of the Day

2009-07-26T20:12:00.001+10:00

Endangered Species for Sale? by David Zetland, posting at Aguanomics

The difference between abundant chickens and endangered tigers is property rights. Chickens are owned by individuals who protect them from others; tigers are owned by "us" and protected by nobody. If you want to save the tigers, sell them.

Can Governments Promote Long Run Growth?

2009-07-24T21:47:00.005+10:00

Looking back to the 2009-10 Federal Budget, much was made of the "infrastructure measures that represent a critical investment in the drivers of Australia's long run economic growth".

A recent paper suggests, however, that promoting long-run sustained growth is much trickier than boosting short-run growth. The paper concludes that "Except for the decades around WWII, there is no evidence of country specific effects on long run growth rates…Growth rates are determined by international factors, and are insensitive to national policies, especially for small countries. This implies severe restrictions on the ability of most governments to increase national long run growth rates". (HT: Stumbling and Mumbling).

Price Elasticity of Marriage

2009-07-24T21:36:00.003+10:00

A new paper concludes that “even small changes in the cost of marriage can have significant effects”, suggesting that marriage demand is quite price-elastic.

Financial Guru

2009-07-24T21:28:00.005+10:00

The Daily Show With Jon Stewart

Mon - Thurs 11p / 10c

Lenny Dykstra's Financial Career

www.thedailyshow.com

Daily Show
Full Episodes

Political Humor

Joke of the Day

The State of Macroeconomics

2009-07-24T21:00:00.007+10:00

These three articles in The Economist, on the state of macroeconomics, make for interesting reading. Brad de Long, Paul Krugman and Stumbling and Mumbling comment. Mark Thoma provided useful discussion on this topic back in April.

Martin Feldstein Lecture by John Taylor

2009-07-24T20:51:00.001+10:00

Martin Feldstein Lecture - 7/12/2009 from NBER on Vimeo.

The Great Moderation no more

2009-07-20T17:01:00.003+10:00

Preparing for this evening's introductory International Monetary Economic's lecture, I re-read Ben Bernake's 2004 speech to the Eastern Economic Association on the decline in macroeconomic volatility, entitled The Great Moderation. How things change, and what an interesting time to study open economy macroeconomics.

Jeff Frankel on Global Currency Issues

2009-07-16T10:55:00.002+10:00

Jeff Frankel delivered the keynote speech at a recent joint Bank of Canada-ECB workshop. "On Global Currency Issues", outlines what's "out" and what's "in" in international finance (Powerpoint presentation here). One of the phenomena he concluded was no longer relevant was "the global saving glut". (HT. Econbrowser)

Iran "at sixes and sevens"

2009-07-03T11:21:00.009+10:00

The phrase at sixes and sevens simply means "state of confusion or disarray"

It is undeniable that Iran is currently experiencing a state of disarray. However the phrase takes on a second meaning when a little bit of statistical analysis is applied to it's the election results.

Basically, there are too many sevens and not enough fives. Chris Lloyd has written a very nice blog on this and I encourage you to read it for yourself. Essentially he concludes that the results are characteristic of a human's attempt to generate numbers.

Interestingly he also suggests a more effective method of fabricating election results.

Forecasting Australian GDP II

2009-06-29T22:31:00.000+10:00

In my last blog I questioned the projections published in the Federal budget documents. Interestingly the OECD has just released its own set of predictions.

The OECD predictions for 2009 and 2010 are -0.4 and 1.2 respectively. The budget projections for 2009/10 and 2010/11 are -0.5 and 2.25. The latest IMF GDP forecasts are –0.5 (2009) and 1.5 (2010). Evidently the budgeted projections are significantly larger than IMF and OECD predictions.

Once again, the real issue is, what impact will smaller growth rates (which are much more likely) have on the economy?

I am not aware of a detailed answer in existence, however smaller growth rates will mean the debt will be larger and around for longer.

Although the prediction periods differ slightly it does not invalidate the concerns outlined above.

Obesity and advertising

2009-06-25T21:02:00.002+10:00

The Age reports that

Australia's fast food industry has agreed to a voluntary code to govern the way it markets products to children.
The code sets new nutrition standards for the foods featured in television advertisements, and other marketing efforts, which target the under-14s.
Seven fast food chains - including McDonald's and KFC - have signed up to the initiative, which will also dictate how they can interact with schools while requiring improved nutrition information disclosure to parents.

An article last year in the Journal of Law and Economics estimated the effects of television fast‐food restaurant advertising on children and adolescents with respect to being overweight in the United States. The paper reported that a ban on these advertisements would reduce the number of overweight children ages 3–11 in a fixed population by 18 percent and would reduce the number of overweight adolescents ages 12–18 by 14 percent.

The voluntary code is clearly less costly in welfare terms than an outright ban on advertising, as it does not impose significant welfare costs on those children and adolescents who consume fast food in moderation and may benefit from the provision of information. The report suggests that the code appears to apply to a range of "marketing efforts" (perhaps including radio and magazines?) and not simply television advertising, which is important given the potential for media substitution (although it could be argued that television advertising is relatively effective when it comes to youth consumption choices).

Quarantine and trust in public health authorities

2009-06-25T20:32:00.007+10:00

Given the risk of quarantine detention in Singapore and China as a result of swine-flu fears, it is useful to consider the different attitudes towards quarantine across countries. A paper in Health Affairs in 2006 reports on a survey of residents of Hong Kong, Taiwan, Singapore, and the United States in relation to their attitudes towards compulsory quarantine during a public health emergency. Some interesting cross-country differences emerge, and may help to explain the different trade-offs that countries are currently making between public health and individual liberties. For example, as reported in the table below, trust in public health authorities is significantly higher in Singapore than in the United States, Hong Kong and Taiwan.

Isolation and quarantine during a pandemic raise important ethical issues, and need to be taken into account in the process of preparedness planning and policy formation. These issues do not appear to have been widely discussed in Australia.

The Sun Also Sets

2009-06-21T19:59:00.006+10:00

Today's Sunday Age reports on the decline of Victoria's solarium industry

VICTORIA'S solarium industry is on the brink of collapse, with increased skin cancer fears and a crackdown on rogue operators sparking a 45 per cent drop in the number of tanning salons.
Government figures obtained by The Sunday Age show that 196 businesses have either closed or removed their sunbeds since State Government regulations were introduced in February last year.
Owners say customers started abandoning tanning salons following the public cancer battle of 26-year-old Clare Oliver, who died in September 2007 from melanoma she and her oncology team linked to solarium use.
Since the introduction of the laws, which ban children from using solariums and force operators to display health warnings or risk $1 million fines, the number of tanning salons across the state has plummeted from 436 to 240. But while cancer experts celebrate the news, the industry claims it is a victim of a scare campaign that saw solarium operators compared to heroin dealers...
"The whole Clare Oliver saga just scared a lot of people off. People were comparing us to heroin dealers … It's one thing to regulate, but another thing to wipe out an entire industry."

Is the dramatic decline in solarium use the result of the regulatory response to some supposed market failure in the solarium industry? Is it the response to new information regarding the adverse health effects of excessive solarium use? Or does it suggest that we are particularly open to influence from people who we like, which may in turn give rise to a dramatic shift in social norms?

Foreasting Australian Gross Domestic Product

2009-06-19T12:49:00.000+10:00

For some weeks I have been growing increasingly sceptical of the projected GDP growth figures published in the Federal Government's Budget. They state consecutive annualised real GDP growth rates of 4.5%.

I remember Mr Swan claiming that these projections were "extremely realistic and conservative." I am also aware that some economists believe that these forecasts are as plausible as any other (though like all such forecasts, they are only ‘best guesses’).

I, however, am not so sure. The more I think of them, the more implausible and unrealistic they become. Consider the chart above, 11 times in the last 47 years real growth in GDP exceeded 4.5%. Only on 6 of these occasions were they consecutive. The last time we experienced consecutive annualised growth rates of 4.5+% was 1985. Before that, mid 1960s to 1970. Therefore recent history suggests these projections are very unlikely.

It is also important to understand the conditions under which these growths were experienced. In 1985 the Australian economy was being deregulated (for example in 1983 the exchange rate was floated) and union power was being curtailed (wages and income accord). These environmental factors are a lot different to what we are experiencing today. One may reasonably argue the current Government is moving in the exact opposite direction as the Hawk government.

This brings me to the real issue, what impact will smaller growth rates (which are much more likely) have on the economy?

Crowding out

2009-06-18T20:44:00.004+10:00

Sinclair Davidson at Cattalaxyfiles provides a useful discussion and overview of the debate surrounding the crowding out implications of public debt.

Thinking more broadly, and casting our minds back to national income accounting identities (which are logically independent of whether or not, and to what degree, crowding out exists) a sudden increase in the public borrowing requirement will be funded by either an equal reduction (increase) in private sector borrowing (saving) or an increase in our current account deficit.

For Australia, much of the increase in public borrowing has, thus far, been matched by a softening in corporate and household borrowing growth. The key uncertainty over the year ahead is whether this change in the flow of private sector savings will continue, or whether our reliance on offshore savings will increase, pushing out our current account deficit.

Public broadcasting

2009-06-10T19:09:00.005+10:00

After a exam marking induced month long blogging break, it's well and truly time for a post.

The recent controversy over The Chaser's "Make a Realistic Wish Foundation" skit on the ABC raises the issue of whether there is any economic rationale for public broadcasting. Public broadcasting could theoretically be justified on two grounds.

A. Missing markets. This is where society is willing to pay for certain programming, but markets fail to provide it, thereby undermining program diversity. Particular programs that attract a relatively small number of viewers with relatively high willingnesses to pay/intense preferences may not generate the number of "eyeballs" required by stations that wish to maximise audience size and associated advertising revenue. Of course, there are weaknesses associated with this argument. It assumes a low elasticity of substitution between free to air television and other distribution channels that generate tremendous information and entertainment diversity. Markets may also be unwilling to provide programs in cases where existing public broadcasts crowd out potential private broadcasts. Furthermore, if the marginal cost of public broadcasting exceed the marginal benefits to viewers, then there is no economic justification for such provision.

B. Externalities and merit goods. Programs that feature explicit violence may be a source of concern either because it may induce violence in viewers (thereby affecting individuals not involved in viewing or broadcasting the program), or simply because policy makers believe that preferences for violence programs should have no weight in the social welfare function. There may also be children's programing, or current affairs programing that have important spillover effects but are ignored by profit maximising commercial broadcasters. The extent to which these effects are in fact internalised by viewers themselves is a matter of debate. Regardless, these concerns can be addressed through regulation, rather than public ownership.

Are there any other economic grounds for public broadcasting?

Zero Growth, only just!

2009-06-04T08:51:00.002+10:00

Yesterday the latest GDP figures were released. Interestingly, the last three quarterly growth rates sum to zero. If you use the original Sept 08 estimate their sum is -0.1.

Yesterday's release demonstrate why we should not rely solely on numbers. They also demonstrate why we shouldn't rely on arbitrary definitions. The debate as to whether we are in a recession or not is futile. Irrespective of the numbers and rules, unemployment is set to rise, businesses are struggling, confidence is down etc.

I believe, although we may not be technically in a recession, we are certainly in the midst of a recessionary environment.

Maths, the key behind a successful business

2009-05-21T12:36:00.000+10:00

Recently this article appeared in the New York Times. It is an interesting glimpse into how important data analytical skills is to one of the most successful companies in our times. I particularly like the statement:

"We let the math and the data govern how things look and feel"

Evidently Google are convinced of the importance of statistics in the world of big business.

A move in the right direction!

2009-05-13T15:23:00.002+10:00

I suggest Mr Swan and company got one thing right last night, increased funding to the ABS. See here for details.

Louise Adler and Australian stories

2009-05-03T10:47:00.006+10:00

I have previously posted on the Productivity Commission's draft report Restrictions on the Parallel Importation of Books. As part of its proposed package of changes, the Commission proposed that the restrictions on parallel imports should apply for only 12 months from the date of first publication of a book in Australia, as opposed to the current arrangements whereby restrictions can potentially apply for the full term of copyright.

In today's Sunday Age, Louise Adler criticises the recommendations, and argues that

.... a marketplace that abolishes the principle of territorial copyright will wind back the clock on a proud and profitable publishing culture, reduce the availability of Australian stories and hand back a monopoly to multinational publishers to make decisions about our market far removed from local realities.

As I have posted previously, parallel import restrictions allow authors and publishers to price discriminate. Restricting supply in the domestic market results in prices for books being higher than elsewhere. While part of the loss of surplus to consumers is transferred to publishers(including foreign owned publishers), part of it is not, and can be considered a deadweight loss. The deadweight loss also includes the extra costs to society of publishing books domestically that could have been imported more cheaply. As CEO and publisher-in-chief of Melbourne University Publishing, Louise Adler obviously has an interest in defending the status quo.

What is also interesting, albeit not suprising, is the way in which the protectionist argument is regularly couched in terms of protecting an "authentic Australian cultural identity" for the benefit of Australian consumers. This argument is without foundation. If an author was concerned about the importation of remainders displacing existing domestic sales, the relaxation of parallel import restrictions on books would primarily affect an author's decision to supply the overseas market, not the domestic market. Furthermore, if there is any relationship between the magnitude of "authentic Australian cultural" externalities and the expected size of the overseas market for particular books, it can be expected to be negative, rather than positive.

Louise Adler supports the retention of a policy that tends to disproportionately benefit those authors who expect large overseas sales, at the expense of domestic consumers. To couch her protectionist argument in terms of ensuring the continued supply of Australian stories for the benefit of Australian consumers is disingenuous at best.

Reporting on property prices

2009-05-02T17:09:00.004+10:00

Chris Lloyd, posting at Core Economics, has a post on the reporting of property prices. The most reliable data on property prices is provided by the RP Data-Rismark Property Indicies, which account for the compositional problems discussed below.

There is something about the way real estate trends are reported that borders on the irresponsible....
.... The common thread in all these headlines is they use a measure of middle sale price (usually the median). The headline figures actually differ significantly depending on the data source (REIV or APM) and are possibly dodgy. But regardless of which figure you take, it occurs to me, and I am sure I am not the first to make this observation, that there is a potentially huge transaction bias in these figures....
We are told that the first home buyer’s market is booming. So there are many more sales in the lower price range. So the median or mean sale price would go down, even in a flat market.....

Financing Australia's current account deficit

2009-05-02T14:41:00.003+10:00

With constraints on foreign borrowing (and in the absence of significant official intervention in the market for foreign exchange), how is Australia to finance its current account deficit during a global recession? Michael Stutchbury provides the answer, and quotes Access Economics' Director Chris Richardson.

“The boom years masked an underlying worsening in Australia’s foreign debt trajectory, but the downturn is now making our vulnerability on this front clearer,” Richardson says. This limits how much more Australia can borrow abroad to get it through the recession. The alternatives are a recession to club local credit demand and increased foreign equity investment in the Australian economy.
With falling oil prices drying up the petro-dollars, China and Japan have the biggest financial surpluses to invest abroad. This is driving the surge of Chinese investment in Australia’s mining sector, capped by Chinalco’s $US19.5 billion bid to double its equity stake in Rio Tinto to 18 per cent.
In opposing Chinalco’s bid as against the national interest, Turnbull yesterday depicted it as a strategic play by the Chinese state to control Australian resources. But debtors can only be so choosy. Blocking an equity investment from the world’s biggest source of savings amid a global credit crunch would increase Australia’s recession risks. “If we didn’t want Chinalco to be buying up bits of Australia, we shouldn’t have bought so many plasma TVs,” Richardson says.

The Australian and Climate Change

2009-05-02T08:44:00.002+10:00

Harry Clarke is less than impressed by The Australian's "ongoing war against climate science". He is not alone.

Economics, a most difficult science.

2009-04-29T09:43:00.002+10:00

In the Higher Ed supplement of The Australian, the following appears:

"Eminent Harvard University economic historian Jeffrey Williamson says Australian economics has forgotten its history and the Government's financial crisis rescue package may be suffering as a result."

Interestingly, in recent times, I have heard the same opinion expressed by other economists (not all economic historians). I believe they are right. I also believe that because economists can only rely on history it also makes our discipline a most difficult science, perhaps even the most difficult science.

Other sciences, such as chemistry, physics and biology, in general evaluate hypotheses using controlled laboratory experiments isolated from the real world. In contrast, economics does not have this luxury. Therefore we use history as our guide.

A major limitation of history is that it is never an exact match. Therefore, debates ensue as to which past experience is most relevant. For example, in relation to the current crisis, I have heard it suggested that the 1890s crisis is more similar than the 1930s depression.

Lindsay Tanner Goes Gaga Over Susan Boyle

2009-04-28T14:34:00.003+10:00

Lindsay Tanner writes that he was "overjoyed" when he first read about Susan Boyle's performance on Britain's Got Talent. A recent post at Stumbling and Mumbling suggests why.

The economics of Susan Boyle ...... 1. The power of the contrast effect. Ms Boyle’s singing talent is magnified by the contrast between it and her ugliness and - yes - mild learning difficulties. ... This contrast effect is a powerful influence upon our perceptions. If you put your hand in a bucket of lukewarm water, it’ll feel cold if your hand had previously been in hot water, but warm if it had been in cold. And it has important implications. In Influence, Robert Cialdini cites research which shows that men shown pictures of average-looking women whilst watching Charlie’s Angels judged them to be uglier than they did if shown the same pictures during other TV shows; women suffered by comparison to Farrah. The damage done by the “beauty myth” is down to the contrast effect.....
2. The ubiquity of statistical discrimination. .... We were prejudiced against Ms Boyle because she was ugly.This is a widespread prejudice. Ugly people, on average and controlling for other things, earn less than good-looking ones, with the penalty for ugliness being generally larger than the premium for beauty. It’s for this reason that criminals are more likely to be ugly; munters have worse labour market prospects, and so are more likely to turn to crime.
However, this bias against the ugly is not pure spite. The audience’s low expectations of Ms Boyle were well-founded, because very few successful singers are ugly - even the ones who aren’t conventionally handsome have charisma; Celine Dion and Barbra Streisand come to mind precisely because they are rare exceptions. Similarly, there’s evidence that good-looking people are genuinely more productive than ugly ones - perhaps because teachers give them more attention in school and so develop their talents.
3. Efficiency vs. justice. The correlation between looks and ability suggests that the rule, “don’t hire the munter” will, generally speaking, be a useful one. It’s a fast and frugal heuristic that saves the decision-maker time and often works. It is, therefore, an efficient rule.But it can be an unjust one, because it penalizes the small number of Susan Boyles. If it’s expensive for these to demonstrate their talents - and it will be in many cases where they can do so only over time, or by working with costly capital - they will not get hired.
There’s therefore a trade-off between efficiency and justice

Behavioural economics and the Obama administration

2009-04-28T13:58:00.005+10:00

Time Magazine had an interesting article earlier this month on how the Obama administration is making use of behavioural economics in policy formation.

... Obama is betting his presidency on our ability to change our behavior. His top priorities — the economy, health care and energy — all depend on it. We need to spend more money now to avert a short-term depression, then save more money later to secure our long-term economic future. We need to consume less energy in order to reduce our oil imports and carbon emissions as well as our household expenses. We need to quit smoking, lay off the Twinkies and avoid other risky behaviors that both damage our personal health and boost the costs of care that are ravaging the nation's fiscal health. Basically, we need to make better choices — about mortgages and credit cards, insurance and retirement plans — so we won't need bailouts down the road.
The problem, as anyone with a sweet tooth, an alcoholic relative or a maxed-out Visa card knows, is that old habits die hard. Temptation is strong. We are weak. We've got plenty of gurus, talk-show hosts and celebrity spokespeople badgering us to save energy, lose weight and live within our means, but we're still addicted to oil, junk food and debt. It's fair to ask whether we're even capable of changing.
But the latest science suggests that yes, we can. Studies of all kinds of human frailties are revealing how to help people change — not only through mandates or financial incentives but also via subtler nudges that preserve our freedom to make choices while encouraging us to make better ones, from automatic-enrollment 401(k) plans that require us to opt out if we don't want to save for retirement to smart meters that warn us about how much energy we're using. These nudges can trigger huge changes; in a 2001 study, only 36% of women joined a 401(k) plan when they had to sign up for it, but when they had to opt out, 86% participated.
It's no coincidence that Obama's budget proposes an ambitious program of automatic-enrollment pensions for workplaces that don't offer 401(k)s or that his stimulus package has billions of dollars for smart meters. Behavioral science — especially the burgeoning field of behavioral economics that has been popularized by Freakonomics, The Wisdom of Crowds, Predictably Irrational, Nudge and Animal Spirits, which is the new must-read in Obamaworld — is already shaping dozens of Administration policies. "It really applies to all the big areas where we need change," says Obama budget director Peter Orszag.
Orszag has been an unabashed behavioral geek ever since he read that 401(k) study. His deputy, Jeff Liebman of Harvard, is a noted behavioral economist, as are White House economic adviser Austan Goolsbee of the University of Chicago, Assistant Treasury Secretary nominee Alan Krueger of Princeton and several other key aides. (Cass) Sunstein has been nominated to be Obama's regulatory czar. Even National Economic Council director Larry Summers has done work on behavioral finance. And Harvard economist Sendhil Mullainathan is organizing an outside network of behavioral experts to provide the Administration with policy ideas.
The first sign of the behavioralist takeover surfaced on April 1, when Americans began receiving $116 billion worth of payroll-tax cuts from the stimulus package. Obama isn't sending us one-time rebate checks. Reason: his goal is to jump-start consumer spending, and research has shown we're more likely to save money rather than spend it when we get it in a big chunk. Instead, Obama made sure the tax cuts will be paid out through decreased withholding, so our regular paychecks will grow a bit and we'll be less likely to notice the windfall. The idea, an aide explains, is to manipulate us into spending the extra cash.....
Behavioral economics doesn't ignore the market forces that were all-powerful in Econ 101, but it harnesses forces traditionally consigned to Psych 101. Behaviorists have always known we don't really act like the superrational Homo economicus of the neoclassical-model world. Years of studies of patients who don't take their meds, grownups who have unsafe sex, and other flawed decision makers have chronicled the irrationality of Homo sapiens. Some of our foibles are quite specific, like overvaluing things we have, overeating food in larger containers and overestimating the probability of improbable events — the quirk that made the Meet Barack Obama fundraising lottery such a smart idea. But in general, we're ignorant, shortsighted and biased toward the status quo....
"We truly want to make better choices," explains Yale economist Dean Karlan. He's a co-founder of stickK.com, where users make binding "commitment contracts" to forfeit money to friends or charities — or even "anti-charities" they despise — if they fail to quit smoking, lose weight or meet other goals they set for themselves. "But we need help to get us there."

Did President Obama Violate Copyright Laws?

2009-04-26T21:01:00.003+10:00

iPods, First Sale, President Obama, and the Queen of England by Fred von Lohmann, April 2nd 2009 ... President Obama reportedly gave an iPod, loaded with 40 show tunes, to England's Queen Elizabeth II as a gift. Did he violate the law when he did so?

You know your copyright laws are broken when there is no easy answer to this question.

Traditionally, it has been the job of the "first sale" doctrine to enable gift giving -- that's the provision of copyright law that entitles the owner of a CD, book, or other copyrighted work, to give it away (or resell it, for that matter), notwithstanding the copyright owner's exclusive right of distribution.

In the digital era, however, first sale has been under siege, with copyright owners (and even the Copyright Office) arguing that it has no place in a world where "ownership" has been replaced by "licenses" and hand-to-hand exchanges have been replaced by computer-mediated exchanges that necessarily make copies. But it's precisely because first sale is central to everyday activities like giving an iPod to a friend, selling a used CD on eBay, or borrowing a DVD from a library, that EFF and others have been fighting for it in case after case.

So, how does President Obama fare in this? It's nearly impossible to figure out. If he'd simply purchased a "greatest hits" CD of show tunes and given it to the Queen, the first sale doctrine would have taken care of it. But because digital technology is involved here, suddenly it's a legal quagmire. (And, for the remainder of this discussion, I am going to set aside the Presidential immunity issues and the UK copyright law issues, which make it even more of a quagmire.)

First, let's imagine that the President (or his staff) bought the 40 show tunes from the iTunes music store. Do you "own" the music that you buy from iTunes? The nearly 9,000 words of legalese to which you agree before buying don't answer that question (an oversight? I doubt it). Copyright owners have consistently argued in court that many digital products (even physical "promo" CDs!) are "licensed," not "owned," and therefore you're not entitled to resell them or give them away. (And the Amazon MP3 Store terms of service are even worse for consumers than iTunes -- those terms specifically purport to strip you of "ownership" and forbid any "redistribution.")

Second, even if the first sale doctrine applies to iTunes downloads, what about the additional copies made on the iPod? iTunes does not download directly to an iPod. So President Obama's staff made an additional copy onto the Queen's intended iPod. How are those copies excused? The iTunes terms of service say that downloads are "only for personal, noncommercial use." Is giving a copy to a head of state a "personal" use? Seems more like a "diplomatic use," doesn't it? So copyright owners could argue that the copy on the iPod was not authorized, because it was beyond the scope of the iTunes "license." And according to the typical rightsholder argument, any use beyond the scope of the "license" is a copyright infringement.

Perhaps it's a fair use? I'd certainly take that view. But does it matter here whether President Obama's staffer first deleted the copy that is still on her computer? Should that matter? (It does not matter for first sale purposes, which is one reason why the first sale doctrine answers questions so much more clearly.)

Third, what about a breach of contract? As I mentioned above, some might argue that this "use" of iTunes downloads breaches the "personal use" limitation in the agreement. And if it is a breach of the iTunes contract, can the copyright owners sue President Obama as "third party beneficiaries" of the iTunes contract? It's not clear. (In the Amazon terms of service, copyright owners are specifically made third party beneficiaries, which appears to be an attempt to clear a path for record labels to sue Amazon customers for breaches of the contract.)

And all of this even before you start asking what happens when the Queen connects her new iPod to her computer, thereby making even more copies (the UK, after all, lacks a fair use doctrine)... UPDATE: Prof. Michael Froomkin points out that the Queen enjoys sovereign immunity under UK law because she is, well, the sovereign.

Of course, no one thinks that copyright owners are going to send lawyers after either President Obama or the Queen over this. But none of us should want a world where even our leaders--much less the rest of us--can't figure out how copyright law operates in their daily lives.

Luck, income distribution and progressive taxation

2009-04-26T20:48:00.003+10:00

Before Tea, Thank Your Lucky Stars, by Robert Frank, Commentary, NY Times: The link between success and luck is stronger than many people think. Analysis of this connection provides a useful framework for weighing ... recent “tea parties,” where orators ... bemoaned their “crippling” tax burdens. ...

Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success..., some people enjoy spectacular success despite having neither attribute. (Lip-synching members of boy bands?...)

Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events. ...

Malcolm Gladwell reports that a disproportionate number of pro hockey players owe their success to the accident of having been born in January, which made them the oldest, most experienced players in every youth league growing up. For that reason alone, they were more likely to make all-star teams, receive special coaching and eventually become professionals.

Although people are often quick to ascribe their own success to skill and hard work, even those qualities entail heavy elements of luck. ... People born with good genes and raised in nurturing families can claim little moral credit for their talent and industriousness. They were just lucky. ...

Even in markets where luck plays no role, minuscule differences in performance often translate into enormous differences in salaries. ... In law, consulting, investment banking, corporate management and a host of other occupations, the ablest performers are often paid hundreds or even thousands of times as much as others who perform nearly as well.

Another important message of recent research is that a person’s salary depends far more on where she is born than on her talent and effort.

For example, as a Peace Corps volunteer in Nepal long ago, I hired a cook who had no formal education but was spectacularly intelligent and resourceful. ... Yet his total lifetime earnings were less than even a very lazy, untalented American might earn in a single year. Well-paid Americans owe an enormous, if rarely acknowledged, debt to the social investments that supported their success.

The president’s proposal is modest: raising the top marginal tax rate from 35 percent to 39.5 percent, its level when Bill Clinton left office and well below the corresponding level in most other industrial countries. There has never been a shortage of talented people willing to work hard for success... And the president’s proposal would not cause such a shortage...

It would, however, promote more efficient provision of public services... For example,... when government levies higher tax rates on the wealthy, we can provide public services that the wealthy and others greatly value but that would otherwise be beyond reach. Under such a tax system, the heavier tax bill becomes payable only if we’re lucky enough to end up among life’s biggest winners.

Financially successful tax protesters seem blissfully unaware of how incredibly fortunate they are. To borrow from the late Ann Richards and her description of the first President Bush, they were born on third base and thought they’d hit a triple.

Luck, Skill, and Progressive Taxes:In the debate over tax policy, the power of luck shouldn't be overlooked, by Hal Varian, NY Times, 2001: President Bush's proposed tax cut has rekindled an age-old debate: how progressive or regressive should the income tax be? ...

Those who argue for a more progressive income tax emphasize equity: a tax dollar paid by a rich person causes less pain than a tax dollar paid by a poor person. Those who argue for a less progressive system emphasize efficiency: the most productive people should face lower tax rates to give them strong incentives to work harder and produce more.

These trade-offs have been examined in the economic literature... This formulation of the optimal income tax problem was first examined by the economist James Mirrlees... In the simplest version of the Mirrlees model, taxpayers differ only in their ability: how much they can produce with a given amount of effort. One striking result of this model is that those at the very top of the income scale should face low marginal rates.

This result emerges from a detailed mathematical analysis, but the intuition is not hard to explain. Let us assume, for the sake of argument, that Bill Gates made $1 billion in 2000, an amount larger than any other American taxpayer. Suppose further that despite the best efforts of his accountants, he ended up paying 40 cents of the last dollar he earned to the Internal Revenue Service.

Consider the following thought experiment: drop the marginal tax rate from 40 percent to zero for all incomes above a billion dollars. The I.R.S. won't lose any revenue from this reduction, since no one has an income larger than $1 billion. And who knows -- the lower marginal rate might encourage Mr. Gates to work a little harder in 2001, producing new products that would make him, and the rest of us, better off.

Of course, the fact that it pays to reduce the marginal tax rate for billionaires doesn't say much about what tax rates should be like for mere millionaires, a point that has been emphasized by Professor Mirrlees himself and confirmed by subsequent researchers, like Peter Diamond ... and Emmanuel Saez... But the intuitive argument presented above is pretty compelling: if income depends only on ability, those at the very top of the income-ability distribution should face low marginal tax rates.

But perhaps this model is too simple. One might well argue that Mr. Gates, as productive as he is, doesn't owe his success entirely to ability: there was a lot of luck involved, too. And, if truth be told, that's probably true even for mere millionaires.

So let's consider a different model: one in which differences in income are a result only of luck and have nothing to do with ability. In this case, the optimal income tax may well involve taxing billionaires at very high marginal rates. True, aspiring billionaires won't work quite as hard, since the after-tax reward from hitting $1 billion has been reduced. But the chances of becoming a billionaire are pretty low anyway, so taxing billionaires at a high rate won't really discourage much effort by those hoping to become one.

Thus a model where luck is the driving force tends to yield a more progressive optimal tax than a model where ability is the driving force. This is about as far as theory can take us, but it highlights the critical question: How much income results from ability and how much from luck?

It is safe to say that this question has not yet been completely resolved by the economics profession. Still, everyone seems to have an opinion about it: if you want to determine whether someone is a Republican or a Democrat, just ask that person whether differences in income come mostly from luck or from ability.

The preliminary evidence available from in-depth surveys like the Panel Study for Income Dynamics at the University of Michigan shows that income varies a lot from year to year for many households. Economists have found that random events like episodes of bad health, accidents, marital dissolutions and family emergencies play a large role in short-run year-to-year fluctuations in income.

A Harvard social policy professor, Christopher Jencks, and his collaborators pointed out many years ago that income inequality among brothers, who share similar genetic and environmental characteristics, is almost as great as for the population as a whole. This suggests that luck is an important factor in the long run as well.

If luck plays a substantial role in the determination of income, it makes sense to have a progressive income tax, creating a form of social insurance in which the lucky subsidize the unlucky. Perhaps the folk singer Phil Ochs had the best answer for why the upper half of the income distribution should pay so much more in taxes than the lower half: ''And there but for fortune, may go you or I.''

Link from Economist's View

Hayek's heritage

2009-04-26T13:21:00.005+10:00

Peter Dorman posting at EconoSpeak blogs about the disproportionate impact Jews have had as academic economists. He writes "Jewish or half-Jewish economists come in all stripes, from Hayek and Friedman ..." Friedrich von Hayek (1974) is here, as elsewhere, misidentified as being Jewish. While he was the cousin of Ludwig Wittgenstein, and was involved with von Mises (who was Jewish) in leading the heavily Jewish Austrian School of economics, and was closely involved with the Jewish intelligensia in Vienna, in Hayek on Hayek Hayek states that "my family is on the purely Christian group" (p. 52) and that he was unable to find any Jewish ancestors through genealogical research (p. 53) .

Emmanuel Saez Wins Clark Medal

2009-04-26T12:46:00.007+10:00

Expert on Wealth Wins a Top Economics Honor, WSJ, April 25, 2009 .. Emmanuel Saez, a leading researcher on the causes of wealth and income inequality, has won the John Bates Clark medal, awarded to the nation's most promising economist under 40 by the American Economic Association.

Mr. Saez, a 36-year-old professor at the University of California, Berkeley, focuses on the very top of the wealth pyramid. He earned his Ph.D. from the Massachusetts Institute of Technology in 1999 and joined Berkeley's economics department in 2002.
Of the 30 other economists who have won the Clark medal, 12 have gone on to win the Nobel prize in economics, including last year's winner, Paul Krugman of Princeton University.
Other past winners include White House National Economic Council director Lawrence Summers and Steve Levitt, co-author of the best-seller "Freakonomics."
Since it was first awarded in 1947, the Clark has been given out every two years, but beginning next year it will be awarded annually.
Mr. Saez and Thomas Piketty of the Paris School of Economics examined income-tax figures from the U.S. and other countries to derive historic estimates of income inequality. Among their findings: Before the onset of the financial crisis, the top 1% of families by income accounted for nearly a quarter of U.S. income -- their largest share since the late 1920s.
Messrs. Saez and Piketty's work has stirred controversy. In a 2006 opinion piece in The Wall Street Journal, Alan Reynolds of the Cato Institute disputed their results on technical points, such as inconsistencies with official Census Department estimates.
The economists countered that Census estimates are based on survey data that can't capture the incomes of the very rich.
Mr. Saez, an easygoing Frenchman who loves surfing, has resisted overtures from the powerhouse economics departments at MIT and Harvard University. He has also made important contributions to tax theory, including how governments can optimally set tax policy and how households behave in response to taxes.

His recent papers are available at his webpage.

IMF interview

2009-04-24T09:20:00.003+10:00

Olivier Blanchard is a co-author of perhaps one of the most influential papers ever written in macroeconomic modelling. He is currently the chief economist of the IMF. Last night he was interviewed on the 7:30 report (Danger as definitely passed) . He makes some very interesting comments. In particular:

About Fiscal policy.
Time bound tax cuts.

Pays to read beyond the headlines

2009-04-22T18:49:00.003+10:00

The Age and The Australian have very, very different headlines related to today's release of March quarter CPI figures. From the headlines alone, you would not know that they are referring to the same set of figures.

The Age: Weak CPI opens way for RBA

The Australian: Inflation rise reduces chances of rate cut in May

We ARE in a recession.

2009-04-21T10:52:00.005+10:00

Last month I posted a blog indicating that I believed we were in a recession. Yesterday, Mr Rudd stated that a recession is inevitable. As a result the media is in a frenzy.

I believe the statement made by Mr Rudd is technically incorrect. (Aside from the fact that the rule of two consecutive quarters of negative growth is a little dubious.) If Mr Rudd and his associates believe the next figures to be released will show Australia recorded negative growth for the first quarter of 2009, then, up until March Australia was in a recession. Furthermore, given the less than favourable outlook, it is more than likely that we will be in a recession for sometime yet.

Inflation Not Anticipated

2009-04-20T12:47:00.007+10:00

More and more commentators are asking the question that has been bothering me for a few weeks now. Given the risk that the large US fiscal deficit will lead to an increase in the supply of money (as opposed to greater domestic or international borrowing or higher taxes as a way of funding expenditure), why does it appear that the market does not anticipate high rates of inflation in the future?

The Road Less Travelled

2009-04-20T12:25:00.003+10:00

Stephen King at Core Economics links to an interesting article in The New York Times, Business Grads Looking Beyond Wall Street

.... For the last decade, a job at Goldman Sachs, Morgan Stanley or another investment bank has been considered the most coveted prize for many of the nation’s best and brightest college students. But the implosion of Wall Street — the vaporization of Bear Stearns and Lehman Brothers, the general humbling of investment banks — has not only shaken a generation’s ambitions, but also unleashed them.
“There was a real herd mentality to get into investment banking,” said Ms. Levy, noting that prestige, peer pressure and parents often channeled students to Wall Street. But because of the crisis, “there was suddenly permission to pursue something you were interested in that your parents three years ago would have said absolutely no to.”....

The optimistic bear

2009-04-18T15:47:00.009+10:00

Consider the following headline: US STOCKS-Economic optimism, GE spur 6th week run-up

The link between "economic optimism" and stock prices is somewhat tenuous. Of course, stock prices increase when the probability of economic recovery increases unexpectedly, as cyclical recoveries are good for corporate profitability. However, this is where the link ends. There are many circumstances where economic growth would not necessarily translate into higher profits accruing to shareholders of existing firms:

- High rates of growth in developing economies resulting from relatively high savings rates coupled with the reallocation of labour away from agriculture.

- Higher rates of growth in developed and developing economies resulting from capital infusion into new firms.

- Higher rates of growth resulting from technological change in a competitive economy (where the benefits would flow to consumers, and the suppliers of labour).

There is also a distributional story to tell in regards to the link between stock prices and "economic optimism". The recent significant declines in stock prices and housing prices in many parts of the world are not good news for shareholders of existing firms or owners of the existing housing stock, but (assuming the declines were not entirely driven by "fundamentals") will benefit those individuals who are considering purchasing a stake in the economy's capital and housing stock, as they will see a better rates of return on funds invested.

Therefore, it is important not to generalise the link between optimism and stock prices beyond the obvious cyclical channel.

Alcopops again

2009-04-17T11:48:00.005+10:00

The Federal Government is planning to introduce legislation into Parliament to restore the alcopops excise at the higher rate.

Putting both the politics and the process of the plan to one side, while I have already posted on the absence of any justification for taxing premixed drinks at a different rate to other spirits, a post this month at Angry Bear provides further food for thought.

It is useful to characterise the findings from analytical models on taxes on externality generating activities in terms of three distinct effects on economic welfare: the"primary welfare gain", a "revenue-recycling effect", and a "tax-interaction effect. The first is simply the familiar net (of costs) partial-equilibrium benefits from the reduction in alcohol related harm. In the presence of pre-existing tax distortions, the revenues that are raised by such taxes can be used to reduce the rates on existing distorting taxes (such as taxes on labour). Hence, there is a second source of welfare gain: the revenue recycling effect. The gain comes from the small reduction in the wedge between the gross and net wage with a resulting increase in the level of employment. The third effect, however, discourages work effort by reducing the real wage. This tax interaction effect reduces welfare.

The effect of the alcopos tax on economic welfare thus depends on the net impact of these three effects. Given that many of those who consume alcopops may not be in the workforce, the optimal tax on alcopops may be somewhat more that the marginal external damages from consumption, depending upon the way in which the revenues are recycled and the degree of substitution between alcopops and other externality generating goods.

Can we have confidence in the Business Confidence survey?

2009-04-17T10:43:00.002+10:00

Earlier this week the NAB released the results of its latest business confidence survey. According to the survey, confidence rose for the second month in a row. However, it is still at very low levels.

Recently, the integrity of the survey was called into question for two reasons:
1. It does not publish a margin of error or say how it is calculated.
2. It is not clear what Business Confidence actually measures.

It seems to me that this is another example of misleading economic information. This is a real problem given we live in an information age. Especially as it seems information like this, more than ever, seems to be driving the economy.

New Mankiw chapter

2009-04-15T21:11:00.002+10:00

The page proofs for a new chapter in Greg Mankiw's intermediate macroeconomics text are online. The chapter, A Dynamic Model of Aggregate Demand and Aggregate Supply, is well worth reading if you are interested in issues surrounding monetary policy design.

Social welfare and macroeconomic policy

2009-04-15T13:12:00.009+10:00

What is the social welfare function that is implicitly being maximised by macroeconomic policy makers? Brad Delong's repost of A Non-Socratic Dialogue on Social Welfare Functions made me think about a March post by David Andolfatto, Multiplier Mischief, regarding government spending multipliers estimated to be greater than 1.

[1] What does this theory predict concerning the optimal level of Y? Is more Y always to be preferred to less? When Y was expanding rapidly above trend during WW2, were people really made materially better off? Were people made happier by their long hours employed in military manufacture and European adventures? Did people really enjoy the rationing of foodstuffs and gasoline associated with the increase in G? Was the general destruction of capital (both physical and human) during WW2 really associated with increasing wealth levels? .....

[6] Should we follow Christina Romer's advice and take employment as a metric of economic welfare? Has she not studied economic theory? (Actually, I know the answer to this last question--it is no). I recall reading an article from the TASS news agency, published in 1957 that "the unemployment rate in the Soviet Union, as in previous years, was equal to zero." Should we seek "full employment" along the old Soviet model? Is this how we are to measure success?

Ignore the obvious straw men. While the empirical literature on happiness reports that unemployment has a negative effect on subjective well being (see Chapter 5 here for the psychological evidence, and here), no policy maker would argue that simply maximising employment will maximise social welfare. Policy makers also need to take into account the value of government spending, the benefits of job search etc. While it is likely that at high levels of involuntary unemployment increasing employment through government spending will increase social welfare, at some point the contribution is likely to become negative.

Monetary policy transmission mechanism and the importance of new loans

2009-04-13T19:55:00.005+10:00

Monetary policy — its all about new loans, by Sam Wylie, Core Economics .. The Big4 banks’ refusal to fully pass on the RBA’s 25 basis point (bp) cut on Tuesday “has blunted the effectiveness of monetary policy” , according to Wayne Swan. I don’t think the Treasurer’s statement is correct.
Through its monetary policy a central bank controls the interest rates, and volume of money in circulation, in an economy, with the objective of stabilising prices and/or economic growth. The conversion of liquidity into credit by commercial banks is the main mechanism of monetary policy. In Australia the banking mortgage channel is a large part of overall credit creation by banks. Ok, that is very standard. But the point I think the Treasurer misses is that monetary policy acts mostly through the creation of new loans, rather than changing the interest rate on existing loans.

Interest rates are the exchange rates between the present and the future. Reducing interest rates makes present consumption more attractive relative to delayed consumption (saving), so consumption spending rises.

Moreover, as the cost of debt and equity capital declines with interest rates, investment projects become more valuable (future cashflows get discounted less heavily) and investment spending rises. Increased consumption and investment occurs through new loans, and therefore monetary policy acts through new loans rather than existing loans.

Consider the effect of the banks not cutting rates on existing mortgages. By not passing on the full 25 bp, the banks are holding on to about $800 million per year ($500 billion of variable rate mortgages times 16 bp held across the four banks). That is, households pay $800 million per annum to the banks that they would otherwise hold onto. That is bad for the households, but why does it blunt monetary policy? The households would spend or save the money. But, the banks will simply lend it on, creating more credit in the economy, or pay it out as dividends. The repricing of existing loans is fairly neutral in monetary policy terms.

New loans are a different story. Lower housing interest rates stimulate demand for credit to buy and build houses. So long as that credit can be supplied (and as money volumes expand with lower rates credit should expand), then lower rates will stimulate economic activity.

The effect of monetary policy in the mortgage market is principally through new loans not existing loans. Existing loan rates are set by bank fiat, but the rates on new loans are negotiated with banks. Households shop for mortgages, and the acheivable discount on a new loan is determined by competition between the banks.

The banks’ pronouncements about passing on the RBA cut, are statements about rates on existing mortgages and therefore not closely connected to monetary policy. Those pronouncements are not statements about the rates on new mortgages because those rates are determined by competition.

Solving King Solomon's Dilemma

2009-04-13T09:40:00.007+10:00

David Andolfatto at MacroMania, has a fascinating post on King Solomon's Dilemma

King Solomon's Dilemma and Behavioral Economics, MacroMania, March 29, 2009... When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament.But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon.
The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics."
Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior).
Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king).
So what is the solution to Solomon's dilemma?
One approach might be to adopt the Coase theorem, which states that if transaction costs are zero, then an arbitrary assignment of property rights will lead to the efficient solution. That is, Solomon could just have assigned the baby at random to one or the other woman. If it fell into the hands of the false mother, the true mother (who presumably values the baby more) could then purchase the baby (from the one who values it less). In other words, if there are gains to trade (as would obviously exist in this case), then these gains will be realized--if transaction costs are zero.
The problem with this approach is that transaction costs are obviously not zero (these costs could arise, for example, if the true value of the baby by both women is private information). Moreover, this "solution" violates what most people would consider to be a principle of "fairness" (why should the true mother pay for her own baby?). The Coase theorem is a fascinating theorem, but it should not be applied as a solution to the problem at hand; the theorem simply states what one could expect to happen IF transaction costs are zero. In fact, the Coase theorem should be interpreted as explaining precisely why various institutions emerge to handle the problem of resource allocation in a world where transaction costs are not zero.
One such solution was offered by Solomon. But I have already highlighted the problem with his proposed institution (or mechanism). Another possible solution was offered by William Vickery: a sealed-bid second-price auction (or a Vickery
auction). Assume, as seems reasonable in this case, that only the two mothers know the true value they attach to the baby. A Vickery auction would have both mothers submitting sealed bids for the baby. The woman with the highest bid would then win the auction, but pay the second-highest bid.
This solution is clever because the amount that either woman expects to pay is independent of their actual bid. Accordingly, neither one of them have an incentive to misrepresent how much they really value the baby. If the true mother values the baby more, she will win the auction (it would not be rational for the false mother to bid more than what the baby is worth to her).
Clever indeed. But there is still a problem associated with this solution. In particular, it requires that the true mother actually pay for her baby. Leaving issues of "fairness" aside, a more relevant problem may be that this mother does not have the resources to make the requisite payment. (It is absolutely critical that the payment be forthcoming; if Solomon could not credibly commit to collecting the payment, then rational players will understand this limitation and alter their strategies accordingly).
One solution might be to let the women offer themselves as indentured servants. This sounds feasible and has the desirable property that the true mother gets her baby (she would presumably be happy to offer herself as Solomon's servant, if it means getting her baby). While this solution has its drawbacks, it seems to dominate Solomon's solution--something that risks having the baby split in two.
But is it possible to design a mechanism that "does the right thing" without any cost to the true mother? Several solutions have been proposed in the literature; but each with its own peculiar drawbacks. But I recently came across one proposed solution that seems quite clever; see Bid and Guess: A Nested Solution to King Solomon's Dilemma, by Cheng-Zhong Qin of UC Santa Barbara.
The idea as presented in Qin's paper seems a little more complicated than it needs to be (but I could be wrong). The basic idea, as I see it, is to have the women play a "participation game" just before playing a standard Vickery auction. We could set up the mechanism as follows.
First, Solomon informs the women of the Vickery auction that will be used to allocate the baby. Second, he informs each woman that the price of participating in the Vickery auction will be a half-life of servitude in some miserable occupation. The women are then asked to submit envelopes with ballots that are marked "yes" or "no" (yes, I am willing to participate; no I am not). If both women submit "yes," then the Vickery auction is played. If only one woman submits "yes," then the baby is allocated to her for free (the auction is not played). If neither woman submits "yes," then the baby is disposed of in some manner (perhaps in the King's service).
Now, put yourself in the place of first, the true mother and second, the false mother. How would you play the game? Would you say "yes" or "no?"
Theory suggests that the true mother will say "yes" to the participation game (she knows that she will get the baby if the auction is played; she will pay one half-life of servitude for participation, and the other half-life in payment for the baby). Likewise, the false mother will say "no." Why submit to a half-life of servitude when she knows that she will inevitably lose the subsequent auction? The false mother will rationally bow out of the bidding; she will choose not to participate. And the baby is allocated for free to the true mother.
Of course, this assumes that the people playing this game are "rational" in the sense that they understand the rules of the game and in the sense that they can anticipate how others are likely to play it. One of the great strengths of assuming rationality in this form is that the assumption can be applied as a general condition that prevails in any resource allocation problem. Its weakness is that people may not always possess this assumed degree of rationality.
But the alternative--the "behavioral approach"--suffers from an even greater problem. In particular, the policymaker must be aware of precisely how people are irrational in each and every given circumstance (a great loss in generality). There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner. But if the theorist can identify this systematic pattern of irrationality, it seems hard to know why people cannot discover it for themselves too. But then, it seems clearly in the interest of aspiring philosopher kings prefer to think of themselves as being systematically more rational than the subjects they study.

Encouraging home ownership during a recession 2

2009-04-13T08:28:00.006+10:00

There is concern in some quarters regarding government incentives to encourage home ownership during a recession. I have posted on this previously.

Bank gamble on first homes, by Eric Johnston, April 12, 2009, The Age ...New loans issued to first-home buyers rose 15.9 per cent in February compared with a year ago, to a record 14,484, according to figures released last week by the Australian Bureau of Statistics. The number of loans to owner-occupiers rose 0.4 per cent in February — the fifth consecutive increase in lending activity, with first-home buyers driving growth...

In October, the first-home owners grant was doubled to $14,000 for existing homes and $21,000 for new dwellings. At $21,000 this represents about 6 per cent of the average first-home buyer dwelling price....

Banks insist the boom in firsthome buyer grants does not represent increased risk. Banks do not count the first-home grant as part of the deposit while loan to valuation ratios — that measure the level of debt compared to the asset — are being reduced....

JPMorgan analyst Scott Manning believes first-home buyers are borrowing too much at high initial loan-to-valuation ratios at artificially low interest rates."(This) will ensure that Australian households remain highly geared and highly sensitive to any future increase in interest rates," he said.

Mr Manning said that despite housing prices being relatively flat in the past year, the first-home buyers' average loan size had increased 14 per cent to $283,000.

Unemployment Benefits

2009-04-12T19:00:00.005+10:00

Peter Martin provides this graph comparing unemployment benefits to the single pension, from the Australia Institute's submission to the Henry Review.

The Unemployment benefit is indexed to CPI; the pension is inedexed to faster-growing wages....
Already Australians on disability pensions (already far too many) are afraid to look for work because if it doesn't work out they are cactus.

A further interesting point in relation to this graph is that, as we have seen in Australia and the United States, relatively low unemployment benefits limit the effectiveness of automatic stabilisers and require larger discretionary adjustments in fiscal policy during times of economic contraction.

Bicycle registration fees

2009-04-12T09:33:00.010+10:00

Following on from the Oregon bike registration fee post on this blog earlier this week, The Age reports on a similar idea for Melbourne.

... (R)ecent talk suggests the boom in cycling is accompanied by a similar rise in people who think cyclists should have to pay — and be held accountable — for their time on the road.

In February, 3AW radio host Neil Mitchell called for a registration fee or tax at the point of sale to help pay for the State Government's new $115 million bike strategy.

His call echoed that of then Federal Opposition spokesman on sports, Pat Farmer, who last year said cyclists should pay registration to fund infrastructure and safety campaigns.

Ideally, bike riders should "pay their way" in terms of marginal social cost. Of course, marginal cost pricing does not generate sufficient revenue to cover all costs when there are substantial fixed costs in terms of infrastructure. In this regard, a distinction needs to be made between recreational and transportation bicycle use. In terms of recreational bike use, property owners pay council rates that are used to finance local bike tracks, and therefore local recreational riders probably already pay their way. Recreational riders who ride for longer distances (eg along Beach Road in Melbourne's bayside) do not finance infrastructure in the same way, nor do those riders who use their bicycles for transportation.

Economic theory, however, does not dictate that a rider registration fee should be set at a rate that ensures full cost recovery. While economic theory can assist to identify ways in which the required funds can be raised in a manner that minimises social cost, the ultimate choice as to who should bear the costs is an ideological one, reflecting one's vision of a "good society".

As a result, let's restrict the analysis to marginal social cost. If cyclists were charged a fee for road usage proportional to wear and tear their travel causes, it is likely that the fee would be less than it would cost to administer the charge. In terms of externalities, congestion costs which, on shared bicycle-car roads, can be substantial, need to considered against the benefits from improvements in rider health that are not internalised by the riders themselves (ie are accrued by society in general because of the nature of labour market institutions, the health care system etc).

An important point, however, is that given distortions in other markets (for example, tax benefits on company cars encouraging environmentally damaging car use), it may be inappropriate to set a rider fee equal to marginal social cost. Generally, the chances of government failure in the use of price instruments are considerably larger in a "second-best world" than in a "first-best world". This serves as a warning against the implementation of an ill-thought out cyclist registration fee.

Why is GDP typically revised upwards?

2009-04-09T15:42:00.002+10:00

Philip Franses has recently published an article tackling the question: Why is GDP typically revised upwards? The article investigates revisions to GDP growth over a three year period beginning in 2005 for the Netherlands. The average revision over this period was 0.67.

This is a very interesting article as it reminds us that economic data is not as precise as some people think it is.

Philip Franses suggests two reasons for the imprecision, one, the behaviour of forecasters who have to fill in the missing values and two, the method of collection.

What does this mean for Australia? Can we expect the most recent GDP estimates to be revised up?

I don’t think the findings in this article infer anything about Australian GDP figures. Although, it is interesting to note, despite the overall average adjustment in Netherlands GDP growth being positive, the last two adjustments corresponding to the end of 2007 were negative. Interestingly, this period corresponds to onset of the GFC. Therefore, one may conclude that revisions are up in good times and down in bad times. Only time will tell whether this is also true for Australia.

Health Benefits of Recessions

2009-04-07T14:33:00.005+10:00

A Downturn’s Silver Lining, by Andrew Leigh, Australian Financial Review, 7 April 2009 .. Australia has enjoyed a steady decline in the road toll over the past generation. Thanks to safer cars and tougher road rules, the road toll has fallen about 3 percent a year for the past few decades. But two years stand out from the data: 1983 (down 15 percent) and 1990 (down 17 percent).
Is it just a coincidence that the two biggest drops in the Australian road toll coincided with the last two recessions? Probably not, if research by University of North Carolina Christopher Ruhm is to be believed. In a series of papers, Ruhm and his co-authors have meticulously documented that mortality tends to rise in booms and fall in busts. Recessions make you live longer. With titles like “A Healthy Economy Can Break Your Heart”, “Good Times Make You Sick” and “Healthy Living in Hard Times”, Ruhm’s research challenges the meme that economic downturns are unambiguously bad. We know that losing a job can be a searing experience, so how can a higher unemployment rate improve overall health?

The answer is that losing your job probably is bad for your health, but most people don’t lose their jobs in a recession. If Australian unemployment were to rise to 10 percent, nine-tenths of the labour force would still be employed. Even in severe downturns, most people keep their jobs – they just work fewer hours and earn
less.
At least in the short term, shorter hours and a slimmer pay packet seem to be good for average health. On-the-job injuries fall when there is less work around. We also have robust evidence that there are more alcoholics and chain smokers in good times than in downturns. Even severe obesity seems to drop when the economy hits the skids (suggesting that belt-tightening might be literal as well as figurative). In recessions, families are more likely to eat at home, and there is more time to exercise. People also get more sleep, which may not make you wealthy or wise, but certainly contributes to good health.
To quantify these effects, let’s look at current predictions of unemployment. In early-2008, the Australian unemployment rate was around 4 percent. This February, Treasury’s Updated Economic and Fiscal Outlook forecast that unemployment would rise to 7 percent by June 2010. (Treasurer Wayne Swan has since hinted that it could be higher than this, but has not given an updated figure.) So what would a 3 percentage point increase in unemployment do to mortality in Australia?
To answer this, I used estimates from a cross-country analysis of23 OECD countries (including Australia) by Ruhm and co-author Ulf Gerdtham. Their headline result is that a 3 percentage point rise in unemployment would reduce mortality in Australia by about 1 percent – saving around 1,650 lives per year.Which categories of deaths are likely to fall? In proportionate terms, the largest reduction would be a 6 percent drop in vehicle accidents (about 80 fewer deaths), since less economic activity means fewer cars on the road. We can alsoexpect a 5 percent drop in deaths from liver disease (80 lives saved), partly as a result of reduced alcoholism. A slump would also reduce flu and pneumonia deaths by about 3 percent (90 lives saved).
In absolute terms, the biggest gain from a major downturn would be from heart disease. Although an economic slump would only cut deaths in this category by 1 percent, heart disease is the nation’s biggest killer, so that would represent around 500 fewer deaths per year. There might also be a small rise in suicide – though this was not statistically significant in Gerdtham and Ruhm’s analysis, and its magnitude was too small to offset the other improvements. Overall, those most likely to be kept alive by a downturn are prime-age men.
These results are provocative, but need to be kept in perspective. Physical health may improve in a recession, but mental wellbeing and self-reported happiness decline. Less money reduces the capacity of households to enjoy the good life. And compared with joblessness, the mortality magnitudes are fairly small: a 3 percentage point rise in unemployment might avert 1,650 deaths, but it means that 340,000 Australian workers need to lose their jobs.
As Ruhm firmly notes in one of his papers: “Evidence that health deteriorates when the economy improves is not an argument for inducing recessions, which have overwhelmingly negative consequences even if worse physical health is not one of them.” Or to put it another way, the cloud may have a silver lining, but we’re still going to get wet.

Oregon Bike Tax Proposal

2009-04-04T21:54:00.003+11:00

A rather odd proposal if (1) riding a bike generates positive externalities (in net terms), and/or (2) we live in a second best world where drivers cannot be charged for the full cost of their actions.

Are Bicyclists Free Riders? By Freakonomics .....Do bicyclists contribute their fair share to the transportation network? An Oregon lawmaker thinks not, and has proposed a law requiring cyclists to pay a $54 registration fee every two years. A
Portland bike blog interviewed the lawmaker in question, who explained the proposal this way: “[B]ikes have used the roads in this state forever and have never contributed a penny. The only people that pay into the system are those people who buy motor vehicle licenses and registration fees.” Considering the enormous benefits of investments in bicycle infrastructure, can even a tax-hating bicyclist concede his point, at a registration cost of just over 7 cents a day?

Weekend Shopping Trip

2009-04-03T15:06:00.004+11:00

Whilst walking around the shops this weekend, I encourage you to consider the following:

Do the recent retail sales data support or condemn the Rudd-Labor Government's cash bonus scheme?

I believe neither. I believe sales is only one side of the coin. The other side being profit margins. If Bourke Street is anything to go by, I suspect these profit margins are fairly thin!

A time to hold.

2009-04-02T12:10:00.004+11:00

Earlier this week, I found myself contemplating what decision the RBA will make at its’ next board meeting. In theory there are three options, increase, decrease or hold. After considering the issue carefully I find myself concluding that the cash rate should remain unchanged. I have four reasons why I believe this would be the most appropriate decision.

First, on balance, recent economic news has been relatively good. Second, the full impact of recent rate cuts have still to take effect. Third, the effects of recent fiscal incentives (cash bonuses) have yet to be fully ascertained. Four, I believe it would have a positive effect on confidence.

Some may find my first reason puzzling, perhaps even crazy. However, I believe careful consideration of recent economic data suggests Australia is in a relatively favourable position. This is particularly true when compared to some of our major trading partners and past experiences. For example, Australia’s unemployment rate is no where near the heights of the 1990s recession, nor is it experiencing the gains of the UK or USA.

Sadly, many people appear to be unaware of how much time it takes for a change in the official cash rate to impact on the economy. Research suggests a lag in excess of 12 months. Importantly, much of this research was conducted using data corresponding to economic times. Arguably, cash rate changes have an even less effect in times of hardship. All this suggests that recent changes in the official cash rate have yet to filter through.

The Rudd-Labour Government has placed a big emphasis on cash bonuses. The most recent cash bonus was administered less than a month ago. Not enough time has passed to see whether these incentives have had their desired effect.

Lastly, I believe a decrease in the cash rate would send the wrong signal. Over the last year I have observed that the Australian economy as a whole has been less volatile. In particular, not characterised by the hysteria we see off shore. I think a decision to hold the cash rate would reinforce consumer and producer sentiment.

In conclusion, I confess that I also believe there are harder times ahead. It is my expectation that we will not bottom out for sometime yet. Therefore, I also suggest that it would be wise to preserve some arsenal, even if only for a precautionary measure.

Wall Street Journal watch - Australian edition

2009-04-02T11:37:00.009+11:00

From the usually reliable WSJ, a misleading article.

Australia Retail Sales Fall - Gloomy Data Follow Huge Stimulus Plan and Interest Rate Cut APRIL 1, 2009 .... Australian retailers had their worst month in over eight-and-half years in February despite an aggressive interest rate cut and a mammoth fiscal spending package unveiled by the government.

Wow, sounds pretty serious. Tell us more.

Retail sales fell a seasonally adjusted 2% to 18.87 billion Australian dollars (US$13.10 billion) in February from A$19.26 billion in January, the biggest one-month drop since July 2000.

Consider the retail sales figures released by the ABS yesterday. What the WSJ article fails to mention is that retail sales in February remained close to their record high January levels. I doubt that retailers would consider February to be their worst month in almost a decade, as claimed by the WSJ.

A Green Fiscal Stimulus

2009-03-31T11:43:00.006+11:00

Joshua Gans, in his latest blog refers to a recently released article which advocates Fiscal Stimulus focusing on Green initiatives. This is an interesting article. I particularly liked table 1 on pages 14 and 15 which specifies 24 different options and evaluates their impacts across 7 dimensions.

Whilst I do not totally agree with the economic rationale of this article, I strongly believe that if the Government is going to borrow and spend billions of dollars, this is an option hard to beat.

Calls for public ownership make a comeback in Australia

2009-03-30T12:32:00.006+11:00

Mark Crosby in his post Whose job really matters criticises the Australian Government's decision to block a bid by China Minmetals Corp for Oz Minerals.

The defence minister is accused of being too close to Chinese officials. Wayne Swan knocks back Minmetals proposed takeover of Ozminerals so as to not look too close to the Chinese. Seems to me like trying to save the Defence Minister’s job at the potential expense of several hundred mineworkers jobs. There can be surely be no sensible explanation for this bizarre decision. If you wanted to spy on the Instrumental range at Woomera the pub in Glendambo, or my Grandfather’s pub in Kingoonya, are much closer - or just try google earth.

China Minmetals is backed by the Chinese government. Unlike the case of foreign governments holding domestic government bonds, foreign investors have a say in how the corporations they own are run. Would Mark Crosby be just as supportive of government ownership to preserve jobs in the mining industry if it was the Australian government that was planning to nationalise Oz Minerals?

Correlation versus causation

2009-03-29T15:32:00.005+11:00

via Andrew Leigh

Voluntary payment transactions - the case of live organ donations

2009-03-28T21:24:00.018+11:00

Hong Kong papers today reported that the Hospital Authority has decided to waive the medical fees of live-organ donors. At the same time, they have stressed that they were not following US, UK and recent Singaporean legislation under which recipients can financially compensate donors.

There are two separate issues here: who compensates the donor, and what 'costs' does the compensation cover. In the Hong Kong case, taxpayers are subsidising the donor by covering only the transplant-related medical and surgical expenses. This is analogous to the treatment of blood donors in most countries. Of course, economic costs of blood donation are largely limited to medical costs. In the case of live organ donation, relevant economic costs would also include forgone income. In the case of Singapore, the recipient can financially compensate the donor, and this compensation is not necessarily limited to medical and surgical expenses.

Concerns about 'organ trading', commodification, financial inducements etc are vastly overstated given the regulatory environment, and distract from the more interesting aspects of the Singapore experiment. One needs to remember that in the case of Singapore, compensation is voluntary (the amendments to the legislation were required so that such payments were not longer illegal), whereas all donors in Hong Kong will have their medical expenses waived.

What I am interested in are the social norms that are likely to develop in Singapore in relation to the 'appropriate price' paid by recipients to donors, and how (if at all) this will interact with the motivations of organ donors. Voluntary compensation in market transactions is not, of course, limited to live organ donation. Tipping at restaurants is an obvious example. Closer to home, a local restaurant, Lentil as Anything, allows customers to determine the price of their meal. While repeated play considerations may come into these examples (which would be largely irrelevant in the case of organ donation), one may find an analogy in the case of donations to software developers who make their software available at a zero price.

A Future of Promise?

2009-03-27T09:21:00.008+11:00

Earlier this week, Wayne Swan made a speech titled "A Future of Promise".

Having read through this speech, I find myself at odds with many of the assertions made. Some of which I have articulated:

Assertion 1: “There was a clear commitment from the world's 20 largest economies to substantial fiscal stimulus, because Finance Ministers from across the political divide understand the importance of boosting demand to avoid a damaging loss in output and much higher unemployment.”

No doubt, this is in reference to the 3^rd point of the G-20 communiqué dated 14^th of March. Interestingly, this point ends with the following statement

“We will ensure the restoration of growth and long-run fiscal sustainability.”

If fiscal sustainability is important, we must ask ourselves, whether or not cash bonuses are the most effective means of stimulating the economy. Many economists (for example, consider Tony Mankin's recent article) question the effectiveness of this policy.

It appears many economists throughout Europe and America also do not believe that fiscal approach is not the best way forward. The chorus of criticism and concern seems only to be getting louder.

Assertion 2: “Consider that we were among the first to announce a major stimulus package. Likewise, our moves on bank guarantees and special purpose vehicles have been in place ahead of the crisis point arriving.”

I am not sure if being first, is something to be proud of, especially in this instance. At the time, the package was criticised as being rushed, ad hoc and lacking a thorough analysis of its impacts.

Interestingly, one of the two initiatives cited, bank guarantees, proved to be less than successful. Recall the many pension funds that were frozen days after the ‘bank guarantee’. Recall the many people who could not access their money.

What made this policy initiative particularly bad was that it was totally unwarranted. Essentially, the Rudd Labour government enacted a policy that is practically meaningless. Furthermore, I believe it also had a negative impact on our confidence as it needlessly raised hysteria regarding our banks and economy.

Assertion 3: “... This is the model – act early; minimise the depth of the problem; be in a position to recover faster. In short, stay on the offence.”

Recall the countless examples in history when acting early, staying on the offence etc, has proved to be disastrous. Perhaps, one of the most well known is "rumble in the jungle". The world heavy weight championship was won by a man, who stood firm, took a few hits and then defeated his opponent by landing well-aimed blows.

Assertion 4: “The results of our first stimulus package, mostly delivered in December, speak for themselves. Despite the full horror of the global recession, consumption in Australia still held up in the December quarter.

Retail trade figures in Australia increased by 3.8 per cent in December – the biggest monthly increase since August 2000 – a standout result in a world where consumption has slumped elsewhere.”
Retail sales exceeded expectations marginally for one month. Surely there is more to show given the amount of money handed out.

Also,

What about the dramatic increase in the savings ratio that we also witnessed?

What about the recent factory closures linked to this so called retail success?

Assertion 5: “And while there's no telling how many people kept their jobs as a result of this stimulus, we do know this is a turnaround of more than 30,000 jobs on the previous three months.”

The effectiveness of economic policy cannot be judged on something that cannot be accurately measured, or as in this case measured at all!

Assertion 6: “That's why, when the global economy took a turn for the worse early in the new year, the Government did not hesitate to act again.”

“Unfortunately some fall back on ideology. Some think we should let events run their course. Some opportunistically deny our economy is being buffeted by global forces. Unfortunately, no matter what the changing circumstances, their answer is always the same: don't intervene; let it rip; let the cards fall as they may.”

“This isn't sound economic policy; it's a failure of policy courage. Or worse, the false prescriptions by people actually willing Australia to fail.”

Let me be frank, I am not against fiscal stimuluses per se. I do however object to economic mismanagement. It must be remembered, that for every dollar spent now, it means a dollar plus interest must be paid back in the future. Therefore, every dollar borrowed now must be done intelligently with careful consideration. Budget Deficits (Fiscal Policy in our current climate) = Borrowing from the future.

Dishwasher Duties

2009-03-26T08:53:00.004+11:00

According to a report released by the ABS yesterday, it appears that I, along with the rest of the male population, are not pulling our weight when it comes to household duties.

Of particular interest is the last column which presents the ratio (female/male) of time spent performing certain tasks. It clearly indicates that the fairer sex is carrying out most of the home duties.

Payroll tax reductions and employment generation?

2009-03-25T12:49:00.008+11:00

Another contribution to the payroll tax debate, this time by Wayne Kayler-Thomson in today's The Age, Why tax the jobs we're trying to create?

IN THE flurry of a crisis, the blindingly obvious is often overlooked, and the current economic crisis is no exception. Everyone - employer groups, unions and governments - agrees that the mantra should be "jobs, jobs, jobs", but why do we tax the jobs we are seeking to create?Australia is a country with a $14 billion tax on jobs that impacts especially on labour-intensive industries.
For many years, payroll tax as rated as the No. 1 nuisance tax among members of the Victorian Employers'Chamber of Commerce and Industry (VECCI). It cuts in at a headcount of about 10-15 employees in Victoria. Even smaller employers regard it with dread, seeing it as a brake on future growth and a disincentive to hire. Some companies actually stop hiring so as not to incur payroll tax.....

A more competitive payroll tax rate is a headline indicator that states can point to when seeking local or overseas investment, and Victoria's relatively competitive payroll tax rate has been in no small part a factor in our superior investment and jobs performance against NSW over the past decade.

The funding of the reduction and eventual abolition of payroll tax should be a major priority for the Federal Government in light of the current economic crisis and should be the focus of any future stimulus measures, as well as the Henry review into taxation. One possible long-term solution is a lower payroll tax/higher GST scenario, with some economists estimating that a 12 per cent GST would enable this.....

The central problem with this analysis is that the author ignores something discussed in Economics 101, the distinction between the legal and economic incidence of taxation. In this article, the author makes no distinction between the legal and economic incidence of the payroll taxation, and his policy conclusions are therefore undermined.

Consider a world of flexible wages, where the demand for labour is downward sloping with respect to the real wage and the supply of labour is upward sloping. In such a world, employers do not bear the entire burden of payroll tax. So just as the current payroll tax is passed on in the form of higher prices, lower wages and lower returns to shareholders, any reduction in the payroll tax will result in lower prices, higher wages and higher returns. Higher wages and lower prices, coupled with the existing levels of excess capacity, will limit the employment generating impact of a payroll tax reduction. Of course, in order for a decrease in the payroll tax to have any significant effect on employment the decrease would have to be permanent, otherwise firms will not be willing to hire workers on a long-term basis. How much bang for the buck would such a payroll tax reduction generate?

A narrow focus on the legal incidence, as opposed to the economic incidence, of taxation leads to a further error in the discussion of a revenue-neutral tax mix change (reduction in payroll taxes accompanied by an increase in the consumption tax). A basic principle of the economic incidence of taxation is that any tax taxes the jobs we are trying to create! A GST-induced jump in the CPI will produce a corresponding jump in wage demands, which will have an adverse effect on employment.

While I don't have time to comment in detail on the tax-competition part of the article, it is clear that no consideration was given to economy wide implications for tax revenue, efficiency of resource allocation etc. Beggar-thy-neighbours policies are not what is needed to address the challenges faced by the Victorian economy.

Studying economics in 2009

2009-03-25T08:55:00.003+11:00

Stephen Matchett writes in today's The Australian on studying economics in the wake of the financial crisis. The whole piece is worth reading, I have included a few highlights.

Dismal science of economics faces dilemma.... THE ability of economists worries Craig Emerson. The Small Business Minister, whose PhD in trade policy is "very orthodox economics", says the profession should have seen the global financial crisis coming.
"After the Berlin Wall came down there was no alternative ideology to the free market and deregulation became a 'monology'," he says.......
But while he is concerned by the quality of economists' expertise, other people are worrying whether we will have enough of them. It certainly seems Australia is short of economists.
Treasury is recruiting graduates in other disciplines and has hired Monash University to teach them high-level economics. Productivity Commission chief Gary Banks says there are not enough people "skilled in quantitative methods" in the public sector.
As Joshua Gans, a professor from the citadel of academic economics, the Melbourne Business School, puts it, "everybody wants policy-based research, but nobody does the work". This is all bad news for the public service's capacity to provide government with the hard data and analysis the policy process depends on, according to Banks.

And it's also bad for business. According to HSBC chief economist John Edwards: "Economics honours graduates are very employable but not enough of them are being turned out."
Critics say the shortage of economists demonstrates difficulties in a discipline where the intellectual orthodoxy has long ignored new ideas and, ironically, what the market wants. The big issues in economics now are not explorations of the way economies work in perfect worlds, where consumers are rational and markets never fail, but exploration of the impact of neuroscience and human behaviour. And above all there is eco-economics, which argues humanity's impact on the environment makes traditional economics irrelevant......
"The real advantage of neo-classicism is that it is mathematically tight and teaches skills. But when you need to teach real-world economics it's a lot harder," UNE's McNeill argues. "Students don't like the hard-core maths of the neo-classical approach," says Sandra Hopkins, who wrote her PhD on exchange rates and is now a professor in health economics at Perth's Curtin University. She says that in a two-year appointment to the Organisation for Economic Co-operation and Development in Paris, she met many policy specialists who didn't model everything, which showed her "you don't need maths to advise government".

Two popular trends based on these ideas have opened the discipline to enormous audiences. Economists such as Steven Levitt, co-author of probably the bestseller on economics, Freakonomics, and Tim Harford, who claims to "uncover the new economics of everything", popularise the discipline's principles by applying economic laws to real life. Behavioural economics takes this one step further, testing how our brain chemistry, rather than our supposed constantly calculating conscience, shapes our economic behaviour.
But Gans says the discipline has seen it all before and rejects the idea economics is imprisoned by the false paradigm of the omniscient market. "Everything that has happened in the global financial crisis is in economics 101. The idea that economists are obsessed with markets is wrong, very few people believe markets are always rational," he says. And although he rejects the idea that an emphasis on the environment is either new or outside the scope of conventional economics, he argues it is not his role to decide what people should do with their lives. "People want bigger houses, cars with more features. Is my job as an economist to say 'No, you can't have that'? Or is my job to work out how to efficiently provide resources? In my role as an economist I don't want to be a parent. I am reluctant to tell people what they can't
have.".......
Meanwhile, after 20 years behavioural economics appears to be an established research interest for mainstream economics, with the Productivity Commission sponsoring a conference on the discipline 18 months ago.
In fact, Gans says, we need more research on core aspects of economics on essential issues, such as what the Government's stimulus packages will do. "We don't do nearly enough work on measuring things. For example, we don't know what government spending multipliers are. What studies there are were done in good times in Australia or in the US." And Australia needs more intellectual ammunition, such as the cost benefit analyses produced by the Council of Economic Advisers in the US, "the boring stuff that doesn't generate press releases".......

Quiggin on the Reallocation (Not Reduction) of Emissions Under the CPRS

2009-03-24T13:33:00.007+11:00

The uselessness of additional action under the CPRS, by John Quiggin, March 23, 2009 ... There was a bit of dispute a month ago over the claim, made here and elsewhere, that the design of the CPRS made both voluntary action to reduce CO2 emissions, and government initiatives such as the Rudd government’s home insulation scheme, have no effect except to reduce the price of permits.
The issue seems to have been settled by this Victorian government brief, leaked to the Age, which states:
The Victorian government’s policies to cut carbon emissions will make no difference in achieving national greenhouse targets …The leaked brief, obtained by The Age newspaper, says the government must rethink policies including subsidising solar farms and buying hybrid cars for its fleet because they will not assist in meeting targets in the proposed federal Carbon Pollution Reduction Scheme (CPRS).
The Rudd government can and should fix this.

Happy Birthday Catterpillar!

2009-03-24T09:26:00.004+11:00

Al Roth posts on the 40th birthday of the "The Very Hungry Catterpillar". This book, about a caterpilliar who eats his way through the book leaving a trail of holes behind, was a favourite in our house.

Market for childrens' books ... Bestsellers in any category are what make publishing profitable. But childrens' books must be very special, because a bestseller can have high sales for a long time, as new generations of the target audience are born. I've always thought that this must be especially true for those books made of thick cardboard, suitable for chewing on as well as reading, since each new reader needs a new copy (chewing cuts down on the used book/hand me down market). But I hadn't guessed just how big the revenue stream is. .... 'The Very Hungry Caterpillar,' ..... has sold 29 million copies and has licensing deals, Newsweek reports, of $50 million annually......

Allocation mechanisms in Scrabble

2009-03-24T09:02:00.004+11:00

Earlier this semester Applied Microeconomics students compared the efficiency implications of allocating goods and services through a competitive price mechanism, a random mechanism and a queuing mechansism. Allocations generated by a random mechanism are considered to be generally Pareto-inferior to competitive price based allocations. While not discussed in class, it is important to recognise that random allocations are used widely in games of chance (or those that have a significant element of chance).

Professor Jeff Ely at Northwestern University provides an innovative suggestion with regards to allocation mechanisms in Scrabble! Some background - "Za" and "qi" have recently been added to the game's official word list for its original English-language edition. Given that the traditional high scoring leters are more versatile, should they be revalued?

Let’s kill two birds with one stone. Eliminate the role of chance in scrabble by having players buy their letters rather than draw them at random. Whenever a player needs to replenish his tiles, a tile is turned over and put up for auction. Players bid for the tile with points. A player who already has seven tiles who wins the auction selects one of his tiles to replace and puts that tile up for auction. This continues until all players have seven tiles.
This removes chance from the game and also eliminates the need to revalue the tiles because that will be taken care of endogenously by competitive bidding.

Public transport overcrowding 2

2009-03-23T20:25:00.002+11:00

One strategy to reduce overcrowding on trains was discussed in today's Applied Microeconomics honours class - limit the use of 60 plus concession fares to non-peak times. While unrestricted fares may improve social welfare when trains are underutilized (the basic idea being that price discrimination improves social welfare if total consumption increases), they clearly do not where trains are full. In this case, commuters with higher willingnesses to pay than those on concession fares may be displaced. In a Kaldor-Hicks sense, introducing time restricted concession fares may result in an increase in efficiency.

Public transport overcrowding

2009-03-22T12:01:00.002+11:00

Yesterday, The Age reported significant overcrowing on Melbourne's trains.

Melbourne's big squeeze, by Clay Lucas .. As passengers crush on to the city's overcrowded trains in record numbers, figures reveal the extent of the daily squeeze Melbourne's rail commuters endure.

Head counts carried out for the State Government over the past five years, obtained under freedom of information, show a dramatic surge in passengers during peak hours.

Melbourne's suburban six-carriage trains are considered overcrowded when they have more than 798 passengers, or 133 per carriage. Yet trains regularly carry 1200 passengers, the head counts show, and one in six of the city's suburban trains is considered overcrowded....

The squeeze has led to an increase in passengers fainting and collapsing, and Connex has told passengers they must take responsibility for their own safety, advising them to drink more water to avoid dehydration. In the past six months, ambulances have been called to stations at least 12 times because passengers have collapsed because of overcrowding. In one instance this week, a Dandenong train was cleared at South Yarra and an ambulance called after a passenger fainted.

During peak times, where train passenger numbers are close to, or at, capacity, short run marginal costs of the servicing additional passengers on the system increase dramatically. This is both in terms of 'private marginal costs' to the operator and 'external marginal costs' (the costs imposed on existing commuters, such as lost productivity, adverse health outcomes, discomfort etc).

One obvious solution is time-differentiated fares, with peak surcharges and/or off-peak rebates to encourage passangers to change their trip timing. At the moment, there are two time differentiated train fares for weekday 'Zone 1' travel.

1. Off-Peak Daily (Zone 1+2) Metcards (Reduced price). Valid on all trains, trams and buses in Zones 1 and 2 after 9am on weekdays.
2. Early Bird Metcard (Zero price). It may be used for journeys between any two stations on electrified train services operated by Connex. It can be used on weekdays for journeys that reach their destination prior to 7am.

Such time differentiated fares (particularly off-peak rebates) are also used widely overseas. The problem with this arrangement is that one would expect peak passengers to have a relatively low price elasticity of demand, given fixed work and school start times. While in the longer-run, increased capacity may address some of the most acute peak overcrowding problems, this may in fact encourage people to substitute away from private vehicles and towards train travel. A peak travelling period will still remain, as will the need for effective time-differentiated fare arrangements. Creative ideas, anyone?

Arnold Kling on fundamental attribution errors

2009-03-21T18:48:00.006+11:00

Two of my favourite economic bloggers, Mark Thoma and Arnold Kling, have referred to my earlier post on Andrew Leigh and Mark McLeish's paper on fundamental attribution errors in economic performance. Arnold Kling provides a pointer to a related piece he wrote in 2003. While the entire piece is well worth reading, the following section had a certain resonance

The economic attribution error means that people assign too much credit or blame for economic performance to the President and other officials. But shouldn't the President be held accountable, just as a corporate CEO is held accountable for corporate performance?
... I believe that we commit attribution errors in our evaluation of corporate CEO's.
... If CEO's really make enough of a difference to merit their centerfold spreads in business magazines, then they are badly underpaid. On the other hand, if context plays the dominant role in determining corporate profitability, then CEO pay is biased upward by the attribution error. I suspect the latter.

Losing and winning

2009-03-21T15:01:00.003+11:00

When Losing Leads to Winning, By Justin Wolfers, Freakonomics Here’s my favorite new fact about N.C.A.A. basketball: teams that are behind by one point at halftime are actually more likely to win than teams that are one point ahead. This striking finding comes courtesy of a terrific new paper by my Wharton colleagues, Jonah Berger and Devin Pope....

Berger and Pope are two of the brightest young behavioral economists around, and they posit a behavioral explanation. Losing can lead to winning because of the strong motivating effects of being close to your goal. You can link some of this to Prospect Theory — loss aversion suggests that you may be willing to work harder to avoid a negative outcome (a loss); the leading teams, by contrast, aren’t focused on the losing domain. And in fact, most of this “catch-up” occurs in the first 10 minutes after halftime.

But how can we tell whether this is the losing team working harder, or the halftime leader easing up?

Here, they move from field evidence to the Wharton behavioral lab, setting up a very simple experiment in which their subjects were challenged to a trivial task — how many times they could type “a” then “b” in half a minute. The subjects were told that if they beat their opponent, they would get a bigger payout.
After the first round of competition, some were given feedback, and others weren’t. And here’s the key to the experiment: they randomly told some folks that they were a long way behind their opponent, others were told they were a little bit behind, or exactly tied, a little ahead, or even a long way ahead. Those who were randomly told they were a little bit behind improved their performance dramatically, while the other groups improved by about the same amount as the control condition (that is, the same improvement as those given no feedback at all).

It’s an intriguing finding: being behind by a little yields the greatest possible effort. And while these researchers measure these effects on the basketball court, or on pounding keyboards, their implications for the rest of our lives are even more intriguing. Want your workers to work harder? Tell them that they are running a close second in the race for promotion.

One cheer for the Productivity Commission?

2009-03-21T07:28:00.007+11:00

The Productivity Commission yesterday released its draft report Restrictions on the Parallel Importation of Books. As part of its proposed package of changes, the Commission proposed that the restrictions on parallel imports should apply for only 12 months from the date of first publication of a book in Australia, as opposed to the current arragements whereby restrictions can potentially apply for the full term of copyright. One cheer for this recommendation.

A brief overview of the welfare costs of parallel import restrictions to start with. Parallel import restrictions allow authors and publishers to price discriminate. Restricting supply in the domestic market will result in prices for books being higher than elsewhere. While part of the loss of surplus to consumers is transferred to producers (including foreign producers), part of it is not, and can be considered a deadweight loss. The deadweight loss also includes the extra costs to society of publishing books domestically that could have been imported more cheaply. In the absence of parallel import restrictions, while the prices for copyrighted books in Australia will not fall sufficiently to reflect long run marginal costs of production, we can expect that they would fall from their current levels, thereby removing the current deadweight losses.

Given these deadweight losses, what is the justification for parallel import restrictions (PIRs)? The report states that the main justification is the existence of 'cultural externalities':

While much of the total cultural value of a book will ... be reflected in its market value, there is also likely to be a component that is not. In particular, whereone person’s purchase and consumption of a book generates benefits for others (asidefrom the author, publisher etc, who of course receive payment for their work),unpriced benefits, or ‘externalities’ in economic parlance, can be said to arise. It is these external benefits (and costs) of activities that provide the strongest rationalefor governments to support (or, in the case of external costs, discourage) activities (p 6.9).

The existence of cultural externalities is also used to justify local content rules for television. Professor Sinclair Davidson and I have written on this previously. Local content rules and PIRs are equivalent in the blunt way that they are used to create and disseminate domestic 'culture'.

What is important to note in this case, however, is that the elimination or relaxation of PIRs on books would primarily affect an author's decision to supply the overseas market (where cultural externalities are not generated), rather than the domestic market where the external benefits of 'cultural valuable literature' are policy relevant! This is because it is the importation of remainders that displace existing domestic sales that will reduce total author income in the absence of PIRs.

Given that there is no necessary correlation between the size of cultural externalities for particular books and the expected size of the overseas market for these books , it is surprising that the Comission supports the retention of a policy that tends to disproportionately benefit those authors who expect large overseas sales, at the expense of domestic consumers.

While this is a crucial point, it seems to be overlooked in parts of the draft report. Consider the proposal to remove PIR protection for educational books, a proposal that is rejected in the report.

The report states that

This option would evidently increase the scope for price competition across the entire educational books market. To the extent that the cultural externalities in significant segments of this market appear to be limited, and the opportunities for low cost sourcing from overseas substantial ... there would be the prospect of a net gain for the community.
However, the boundary between educational and other books is often far from easy to delineate, with many books both read for pleasure and used in an educational context.Books prescribed for literature studies are an obvious example. Also, a significant number of educational texts embody a strong cultural component, with learning assisted by the presentation of ideas and arguments in Australian settings (italics mine).

This issue is irrelevant to the discussion of PIRs for books. Educators and students will be willing to pay a premium for textbooks that appropriately contextualise theory (Australian students of introductory macroeconomics would prefer to purchase a text discussing the RBA rather than the US Fed if they are to be examined on the implementation of monetary policy within the Australian context). These texts will not be affected in any way by the existence or non-existence of PIRs, as these texts are unlikely to have a large expected overseas market.

Let's hope that the Comission gives consideration to these issues in the final report.

Fiscal Policy?

2009-03-20T11:48:00.005+11:00

Yesterday, the IMF released a statement, part of which is quoted below:

"Moreover, fiscal policy must play a central role in supporting demand while remaining consistent with medium-term sustainability. The report provides a careful assessment of the fiscal stimulus that is being provided by G-20 countries that suggests that while substantial stimulus is being provided in 2009, additional initiatives will be needed to sustain fiscal support for the global economy in 2010 by countries with fiscal space."

Interestingly, last night an interview on Lateline Business was conducted with Desmond Lachman (ex-deputy director of the IMF's Policy and Review Department). The closing comments of this interview were:

"But right now, it doesn't look good, you know, in the sense that there's no money forthcoming for the banks, and it looks like the fiscal stimulus package, really, was not as front loaded and as well designed as it should have been. The Obama Administration seems to have got sidetracked with a long-term agenda when the short term problems aren't being properly addressed."

Can the same be said about the Rudd's Government $42 Billion Nation Building Package? I think it can, two of my reasons are

Bonus payments didn't work properly last time. Arguably, because of the deterioration in economic conditions they are even less likely to work properly now.
Most of the initatives listed are described as "Long Term Nation Building Investments".

Negative real interest rates

2009-03-20T07:43:00.005+11:00

Let's say that in the current macroeconomic environment a negative real interest rate is required to ensure full employment (ie where desired savings equals desired investment), given that all countries cannot export their way out of recession. One way to generate a negative interest rate is to have the central bank credibly commit to inflation. Greg Mankiw provides another strategy.

Reloading the Weapons of Monetary Policy Some people are concerned that in the the fight against recession, the weapons of monetary policy are nearly out of ammunition. That is certainly the case for the standard monetary weapon--cuts in short-term interest rates. Afterall, short-term interest rates are already about zero, and the Fed cannot cut interest rates below zero.

Or can it? In a discussion at a Harvard seminar recently, a clever grad student proposed a solution to the zero-lower-bound problem.

Let's begin with the basics: Why can't the Fed cut interest rates to below zero?

Why can't the Fed announce, for example, an interest rate of negative 2 percent? You borrow $100 today and repay $98 a year from now. A negative interest rate would certainly encourage people to borrow and spend, thereby expanding aggregate demand. And if negative 2 percent wasn't enough to get the economy going, we could try negative 3 percent. And so on.

The problem, you might reply, is that no one would lend money on those terms. Rather than lending at a negative interest rate, you could hold onto cash by, for example, stuffing it in your mattress. In other words, the interest rate on loanable funds cannot fall below zero because holding cash guarantees a rate of return of zero. If the Fed tried to cut interest rates below zero, money would dominate debt instruments as a portfolio investment.

With this background, I can now state the proposed solution: Reduce the return to holding money below zero. Imagine that the Fed were to announce that, one year from today, it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 2 percent. Losing 2 percent is better than losing 10. Of course, some people might decide that at those rates, they would rather spend the money by, for example, buying new car. But since expanding aggregate demand is precisely the goal of the interest rate cut, that incentive is not a bug but a feature!

Okay, I understand that this plan is not entirely practical. But you have to give the student credit for thinking out of the box. And his plan does address a fundamental problem facing the economy right now: Given the fall in wealth, increases in risk premiums, and problems in the banking system, the interest rate consistent with full employment might well be negative.

Kill Bill

2009-03-19T11:07:00.007+11:00

The alcopops tax has been defeated in the Senate, and as a result premixed spirit drinks will no longer be taxed on the same basis as spirits.

What was the Opposition and Senator Fielding's justification for re-instating this loophole? Was it that:

1. The current rate of taxation on externality generating activities is generally too high (perhaps because of (i) the welfare argument that in an economy already distorted by a high initial level of taxation, it may be efficient to tax these activities at a lower rate than in a distortion free world or (ii) taxes crowd out the intrinsic motivation to internalise externality generating behaviour)?
2. The current rate of taxation on spirits is too high compared to the rate of taxation on other kinds of alcohol (ie volumetric pricing based on the volume of ethyl alcohol across all classes of beverages is wise policy, and the tax rate on spirits should be reduced to match the much lower rate on beer)?
3. There are grounds to treat premixed spirit drinks on a different basis from spirits (eg a lower proportion of externality generating consumers in the case of premixed drinks)?

I haven't seen any discussion of these issues.

Golden handshakes

2009-03-18T15:03:00.005+11:00

The Federal Government has announced planned legislation that would require shareholder approval for executive payouts of more than 1-yr base pay.

The ministerial comments reported below, do not make clear what the justification for the legislation is. Is it related to the amount of the termination payment, the relationship (or lack of) between compensation and performance, or both? While the amount of the payment independent of performance is a broader distributional/social norm issue ("community standards"), the Pacific Brands case appears to be more of a traditional corporate governance/separation of ownership and control issue ("good governance").

Swan to curb 'obscene' salaries, The Age, 18 March 2009 . ... "It is very important that we ensure executive pay is in step with good governance ... and meets decent community standards,'' he told reporters.
Mr Swan said in some instances the size of golden handshakes was "obscene''.
"The government will curb golden handshakes in the form of excessive termination payments,'' he said.
Superannuation Minister Nick Sherry cited the example of former Pacific Brands chief executive Paul Moore, who received a bonus $3.5 million retirement payment when he stood down halfwaythrough 2008 financial year despite the company floundering.

Fundamental attribution error

2009-03-18T13:58:00.005+11:00

Andrew Leigh has a fascinating post at Core Economics, discussing Lee Ross's 'fundamental attribution error' in the context of the relationship between economic performance and election outcomes

... In a paper that we released last year, Mark McLeish and I showed that Australian state governments were more likely to lose office when the national economy turned sour. To check that our results weren’t being driven merely by the modest contribution that state leaders make to economic performance, we were able to show that our results held up even if we only used a purely unrelated source of growth – the US economy.
Why do Australian voters turf out their state governments when the US economy tanks? The answer seems to lie in something psychologists call ‘the fundamental attribution error’, which is the fact that humans aren’t very good at separating situational factors from ability when making assessments. So for example managers tend to be bad at taking task difficulty into account when assessing their workers, sports fans don’t appropriately adjust for field conditions when judging ability, and shareholders tend to overpay CEOs when the market booms. Consequently, it isn’t all that surprising that voters aren’t very good at separating out the component of economic growth that lies within the control of state politicians from factors outside their control.

CBA homeloan repayment deferrals

2009-03-18T12:13:00.007+11:00

The Australian reports that the Commonwealth Bank of Australia has announced deferrals of up to 12 months on repayments for homeowners who lose their jobs. This may cushion the economy from short-term increases in unemployment by preventing customers from falling into arrears on payments and being forced to sell their homes (I have posted on this previously). If, however, house prices fall regardless, eligible homeowners who experience an extended (ie beyond 1 year) period of unemployment may find themselves worse off, as they will be forced to sell in a depressed market, with the interest capitalized on the loan.

Automatic stabilisers

2009-03-16T19:13:00.013+11:00

Brace Bradbury is concerned about Australia's relatively weak automatic stabilisers

Is Australian social protection ready for the great recession? by Bruce Bradbury, Club Troppo .. Australia doesn’t really do social insurance. For many years income protection policy has focussed on poverty alleviation rather than protection against negative income shocks. The forthcoming recession might be a time when we begin to regret this model. As the graph below shows, Australian average income workers losing their jobs face a larger drop in income than in most other OECD countries.

... At the macroeconomic level, this suggests that the ‘automatic stabilisers’ will be weaker in Australia than in most other rich countries. At the household level, it will mean greater short-term income shocks than experienced elsewhere. This will play out in terms of mortgage arrears, increased debt and household stress, and perhaps most importantly, political discontent.

What can be done? We cannot build an unemployment social insurance model overnight – and maybe we shouldn’t. But we cannot expect that an income support system based on poverty alleviation will be a suitable response to an economic shock of the size of the one we are about to experience. In the absence of automatic stabilisers manual action is required. Small actions could include further relaxation of liquid assets tests (beyond those won by the Greens) and reductions in Newstart waiting periods. Temporary increases in the payments to Newstart recipients – who have been conspicuous in their absence from government handouts to date - are the most obvious response.

The RBA got it right!

2009-03-16T14:05:00.006+11:00

Tomorrow the RBA will release the minutes to the board meeting held two weeks ago. It was at this meeting the RBA decided to hold the official cash rate at 3.25%.

The decision to hold, breaks the pattern of recent months. Since September 2008 the decision at each board meeting has been to cut the official cash rate. In fact the cuts of recent months appear unprecedented in terms of steepness and depth (see graph).

I believe the RBA got it right!

I believe this for a number of reasons. One of the main reasons can be summarised in one word: timing. It is an aspect of monetary policy that is often forgotten.

The influence of the official cash rate on the economy is best described by a phrase coined by Milton Freidman “Long and variable lags”. Specifically, it takes time for inflation (and the economy in general) to respond to changes to the official cash rate. Research indicates that a whole year may elapse before the full effect of a change in the official cash rate may be felt.

This means, the recent cuts, all of which have occurred since September 2008, have yet to exert their full influence over the Australian economy. In fact, only six months has passed since the first cut was made.

Politicians and the convenience of round numbers

2009-03-15T16:40:00.005+11:00

What is it about politicians and round numbers? Queensland Premier Anna Bligh committed to creating 100,000 new jobs over three years at Labor's official campaign launch today.

In the last few months, this 100,000 job creation figure has been used elsewhere.

In the UK:

Gordon Brown: I'll create extra 100,000 jobs, by Alastair Jamieson, Telegraph, 22 December 2008. Government spending programmes brought forward to soften the effects of the economic crisis will provide at least 100,000 jobs, Gordon Brown said.

And the US:

Salazar Says Interior Stimulus to Create 100,000 Jobs, by Daniel Whitten, Bloomberg, 20 February 2008. U.S. Interior Secretary Ken Salazar said a department “stimulus czar” and task force will help direct the spending of about $3 billion in economic-recovery funds, which may create 100,000 jobs.

China's holdings of U.S. debt

2009-03-15T15:42:00.004+11:00

Chinese Premier Wen Jiabao has expressed concerns that the U.S. government's attempts to stimulate economic activity may result in a reduction in the value of U.S. Treasury bonds, as the U.S. dollar weakens and U.S. interest rates rise. The Wall Street Journal reports on the U.S. government's response.

U.S. Insists China Fears Over Debt Unfounded By ANDREW BATSON, ANDREW BROWNE and MICHAEL M. PHILLIPS, Wall Street Journal, March 13, 2009. The Obama administration rejected China's concerns that its vast holdings of U.S. assets might be unsafe, in an unusual diplomatic exchange that underscored the global importance and the potential fragility of the Sino-U.S. economic relationship.In a coordinated response to blunt comments from ChinesePremier Wen Jiabao, White House officials said Friday that Mr. Obama intends to return the country to fiscal prudence once the crisis passes.

"There's no safer investment in the world than in the United States," said presidential spokesman Robert Gibbs.

That view was reiterated by the president's chief economic adviser, Lawrence Summers, who defended record U.S. deficit spending as a salve to the nation's economic woes. "If you don't prime the pump and you allow the processes of decay and decline and de-leveraging to continue, it's much more costly to do it later," he said.

The U.S. offensive came after Mr. Wen said earlier Friday in Beijing that China is worried about its huge stock of U.S. Treasury securities, an ominous warning given U.S. reliance on Chinese borrowing.

"We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets," Mr. Wen said in response to a question at his annual news conference.

"Frankly speaking, I do have some worries."....

Mr. Wen's public airing of his concerns -- and the U.S. government's fast response -- highlight China's extraordinary role in the U.S. economy as the largest holder of U.S. Treasury debt. For years, the U.S. has tried to strong-arm China into allowing the yuan to rise and liberalizing its financial system. But in the last year, Beijing has become increasingly vocal about what it sees as U.S. economic mismanagement making U.S. investments riskier....

The premier's comments were unusually pointed and raised the possibility that Beijing's appetite for U.S. debt could wane. In the worst-case scenario, a significant new aversion to U.S. investments could drive down the dollar and drive up interest rates, worsening the U.S. recession. Mr. Wen indicated China wouldn't be rash in making changes to its $1.946 trillion stockpile of foreign reserves. While China is looking out for its own interests, it will "at the same time also take international financial stability into consideration, because the two are inter-related," he said......

In September, China surpassed Japan as the largest foreign holder of U.S. Treasury debt. As of December, it owned $727.4 billion in such securities, according to the latest Treasury Department data. That marked a 52% increase from a year earlier, according to the Treasury, whose figures are thought to understate China's stock of U.S. government securities.

China also has limited options for its investments-outside the U.S., there aren't many other assets that can soak up the amount of capital it needs to invest.....

Greenhouse gas emissions and policy instruments

2009-03-14T21:56:00.015+11:00

Ross Gittins writes in today's The Age on the relative merits of taxes versus permits.

To cut emissions start by capping windy economists, by Ross Gittins, The Age ... According to a growing band of economists, we'd be better off using a carbon tax to reduce greenhouse gas emissions, not the emissions trading scheme the Rudd Government introduced to Parliament this week......

(I)f there's a reason for economists preferring one system, I think it's which objective they give higher priority: minimising economic cost or maximising environmental certainty.

If your concern is emissions reduction you control emissions quantity; if your concern is minimising economic loss then you control emissions price.

These last two sentences provide a potentially misleading picture of how economists think about greenhouse gas emissions and policy instruments to reduce these emissions.

1. When economists consider the "economic" costs of pollution or pollution control, they not only include the costs of pollution abatement. They also include the costs of environmental damages such as health impacts, lost output from climate change, lost producer and consumer surplus from degradation of environmental resources and amenities etc. As is often the case, if economists are interested in minimising the (unweighted) sum of these costs (formally, this occurs at the level of emissions reduction where the marginal costs of abatement equal the marginal benefits from abatement), policy prescriptions do not depend on economists' vision of a good society, or "which objective they give higher priority".

2. While permits do minimise uncertainty with regards to the level of emissions reduction (with taxes, the level of emissions reduction depends on polluters own cost-benefit calcuations), they do not "maximise environmental certainty". Uncertainty with regards to how rapidly atmospheric greenhouse gas concentrations will grow given the expected level of future greenhouse gas emissions with and without emissions reduction, and how higher greenhouse gas concentrations will affect global temperatures, is a given regardless of which policy prescription is adopted.

3. Taxes and pollution permits are equivalent policy instruments if there is no uncertainty with regards to pollution control costs. If the optimal number of permits are issued, the price will be bid up to the level of the appropriate (Pigouvian) tax. The choice of policy instrument will only yield different outcomes if uncertainty exists. In this case, following Martin Weitzman's classic 1974 paper in the Review of Economic Studies:
- Permits will be preferable if the marginal benefits from emissions reduction are highly sensitive to the actual quantity of emissions (such as the case of tipping points in the case of hazardous waste, when small changes in emissions have a large effect on environmental damages); and
- A tax will be preferable when the marginal abatement or pollution control cost increases sharply with emissions reduction (in this case incorrect costs estimates and subsequent excessive or inadequate supply of permits will have a large effect on total costs); therefore
- If the absolute slope of the marginal cost of abatement curve is greater than that of the marginal benefit from emissions reduction curve, taxes will lead to higher social welfare than will permits.

Of course, many of these issues are empirical in nature, and policy makers often lack the required information. I share Mr Gittins concern that, given the possible existence of tipping points in relation to greenhouse gas emissions and their impact on the environment, an emissions tax would lead to too little emissions reduction if the costs of abatement are higher than policy makers expect.

Cost? What cost?

2009-03-13T10:23:00.007+11:00

Mark Thoma spots an absolute howler on Fox News.

Republicans Propose 'No Cost' Stimulus, Fox News: SEAN HANNITY, HOST: And in "Your America" tonight, another economic plan is also emerging tonight. The Republicans have proposed an alternative to the president's $787 billion stimulus package, and it costs a little bit less. Zero dollars. And it also promises to create two million new jobs without any of your money.

Hmmm, a 'no cost' stimulus?

JOHN SHADEGG (R), ARIZONA CONGRESSMAN .... With unemployment rates going up how can we produce American jobs? And the answer is we have had a non-energy policy in this country for a very long time. The reality is we are giving jobs to oil fieldworkers and natural gas fieldworkers in Russia and Saudi Arabia and Venezuela, when we should be putting those people to work here in the United States.

It doesn't matter how you define costs: explicit production costs, implicit opportunity costs of the resources involved in production, environmental costs. etc, there is no such thing as a 'no cost' stimulus to economic activity. On the opportunity cost story, while there are idle resources in the US economy, opening the Arctic National Wildlife Refuge to oil exploration will require specialised resources that will be diverted from other activities, reducing the net number of jobs created.

Encouraging home ownership during a recession?

2009-03-12T17:04:00.009+11:00

The proportion of dwelling purchases financed by first-home buyers has increased to the highest level since records started in 1991. Undoubtably, the State Government's First Home Owner Grant scheme and the Australian Government's First Home Owner Boost Scheme have contributed to this result. From a policy perspective, is this a positive outcome during difficult economic times, with the expectation of worse to come? There is reason to suggest that the Federal Government should not extend the boost beyond June 30.

The positive impact that the induced increase in building activity has had on economic activity needs to be balanced by concern for first home buyers who find themselves taking on more debt than they otherwise would. Consider the following graph on housing affordability from the RBA.

There are three factors that drive changes in the measure of housing affordability: home prices; household incomes and interest rates. The decline in housing affordability from the mid-1990s until the mid-2000s largely came about through an increase in house prices. The recent improvement in housing affordability in Australia has come primarily from lower interest rates.

While in the past real incomes were increasing so that households were able to devote a greater share of income to housing, the situation today is dramatically different. If the level of unemployment increases and average household disposable income falls in the months ahead, measured household affordability will decline and, unlike in the mid-1990s to the mid-2000s, this can be expected to have real implications for levels of mortgage stress and arrears. (In the past, the latter was not an issue, primarily because of relatively low levels of unemployment and growth in real incomes.) This in turn may have implications for house prices in areas dominated by first home owners.

Will a temporary downturn in economic activity have any significant impact on relatively young households' ability to pay off a home loan over the life of the loan? Possibly. Studies (see here and here) suggest that temporary macroeconomic shocks can have persistent effects. The timing a of person's entry into the labour market appears to have an impact on his or her lifetime earnings. If this year's first home buyers are also new entrants into the labour market, the Federal government is encouraging households to take on debt precisely when their capacity to repay debt is diminished.

Lies, Statistics and Employment Data

2009-03-12T10:46:00.014+11:00

Earlier today the Australian Bureau of Statistics published employment data relating to the month of February. Recent budget cut-backs however makes the data unreliable.

Last month in an interview conducted on ABC's PM program the February release of employment data was critically analysed. The critical analysis was a direct result of figures indicating the (full-time) employment and participation rate had actually increased. These results startled many economists as it contradicted all the information published leading up to the release. Specifically, it showed the number of employed had increased by 1200.

How can this be possible?

The explanation of this result can be attributed to statistics. More specifically, the lack of (federal Government) appreciation for robust statistical analysis. Closer examination revealed that employment may have decreased by as much as 60 000, or possibly gained nearly 62 000. The reason for this imprecision is sampling error. The reason for the sampling error was a cut to the budget of 24% which meant the ABS slashed the size of the labour survey. The coverage is now nearly half of what it was the same time last year (down to 0.24 from 0.45)

Does it matter?

Yes, for three reasons:

Employment data is one of the most featured variables in gauging economic well being.
Without reliable employment data it is much harder to critically assess Government policy. That is transparency and accountability suffers.
The information is disseminated all over the globe so that governments and businesses can use this information in decision making.

Therefore, it is absolutely imperative that when employment data is published it is reliable. The current arrangements mean it is not. I believe this damages the reputation of the Australian economy and possibly even raises questions about its integrity.

Appropriate fiscal stimulus, and Ricardian equivalence

2009-03-11T20:58:00.009+11:00

My colleague, Professor Sinclair Davidson, is now posting at catallaxyfiles. He draws attention to a summary of a new paper by Matthew Shapiro and Joel Slemrod in the latest NBER digest.

In Did the 2008 Tax Rebates Stimulate Spending? (NBER Working Paper 14753), Matthew Shapiro and Joel Slemrod analyze evidence from a rider on the University of Michigan Survey Research Center’s Monthly Survey, also known as the Survey of Consumers, which was included each month from February through June 2008. The rider asked: “Thinking about your (family’s) financial situation this year, will the tax rebate lead you mostly to increase spending, mostly to increase saving, or mostly to pay off debt?” Only one-fifth of the survey respondents said that the 2008 tax rebates would lead them to mostly increase spending. Most respondents said they would either mostly save the rebate or mostly use it to pay off debt. The most common plan for the rebate was debt repayment.

These responses imply that the aggregate marginal propensity to spend from the rebate was about one third and that there would not be substantially more spending as a lagged effect of the rebate. Because of the low spending propensity, the rebates in 2008 provided low “bang for the buck” as economic stimulus, Shapiro and Slemrod conclude. Low- income individuals were particularly likely to use the rebate to pay off debt. Shapiro and Slemrod speculate that adverse shocks to housing and other wealth may have focused consumers on rebuilding their balance sheets. The authors note that, given the further decline of wealth since the 2008 rebates were implemented, the impetus to save a windfall might have become even stronger since their survey was conducted.

The overall results, that the rebate provided a very limited stimulus to aggregate demand, are similar to those found in Shapiro and Slemrod's study of the 2001 US federal income tax rebates. This earlier study is interesting for a number of reasons.

1. They found, somewhat counterintuatively, that individuals who were most likely to be liquiditiy constrained (i.e. lower income) were more likely to mostly save, rather than mostly spend, the rebate.
2. They found that the propensity to spend the tax cut was not associated with expectations of lower government spending. As a result, Barro/Ricardian equivalence, whereby a temporary reduction in taxation will not lead to an increase in aggregate demand (as Ricardian consumers will save more now to compensate for the higher taxes or lower government spending they expect to face in the future), was not supported.

In the Australian context, these two points reinforce the importance of direct government spending in stimulatating economic activity. Of course, even if Barro/Ricardian equivalence holds with regards to an increase in government spending, such an increase in spending can still be expected to generate an immediate increase in aggregate demand. This is because if there is a given increase in government spending of $X this year, consumers will not need to internalise the entire present value of the future tax liability this year. As a result the immediate offsetting reduction in consumption will be less than $X, ensuring an immediate, positive impact on aggregate demand from the increased government spending.

The Great Multiplier Debate

2009-03-11T10:19:00.008+11:00

Menzie Chinn at Econbrowser comments on a post by Greg Mankiw, who cites a study by Cogan, Cwik, Taylor, and Wieland that suggests that fiscal multipliers are small, especially when considering New Keynesian models. According to the authors:

We first show that the assumptions made by Romer and Bernstein about monetary policy -- essentially an interest rate peg for the Federal Reserve -- are highly questionable according to new Keynesian models. We therefore modify that assumption and look at the impacts of a permanent increase in government purchases of goods and services in the alternative model. According to the alternative model the impacts are much smaller than those reported by Romer and Bernstein.

Cogan et al. use a New Keynesian dynamic stochastic general equilibrium (DSGE) model. Chinn then contrasts these results to result obtained from the IMF's New Keynesian DSGE (The Case for Global Fiscal Stimulus).

...the effect on U.S. GDP of investment expenditures is 3.9 when there is global fiscal expansion and only 2.4 when the United States acts alone. Similarly, the effect on Japanese GDP of targeted transfers is 1.5 when there is global fiscal expansion and only 1.0 when Japan acts alone. Differences in multipliers across regions relate to the size of leakages in the different areas, including leakages into saving and imports.

Chin then asks "The obvious question -- why the disjuncture? They're both New Keynesian DSGEs?" , and provides an explanation:

I think New Keynesian DSGEs -- like any other large models incorporating many equations -- can yield differing results depending on the assumptions made, some of which might seem inconsequential or conventional; what I have in mind include those assumptions regarding the nature of asset markets..... (j)ust because a model has microfoundations, intertemporal optimization, model consistent expectations, and so forth, doesn't mean it necessarily provides more plausible estimates. It matters what assumptions are made (is "complete asset markets" a good assumption, for instance? And if they were three years ago, are they still now? And I'll bet the proportion of "rule of thumb consumers" or "liquidity constrained consumers" is probably higher now than three years ago...).

What do "complete assets markets" have to do with fiscal policy effectiveness? If asset markets are imperfect, in that some households would like to borrow but cannot find credit, then these households will adjust consumption to temporary changes in lump sum payments. As I suggested in a previous post, as borrowing constraints will have the largest impact on those closest to the constraint, it is no suprise that lump sum payments targeted to relatively poor households tend to exhibit relatively larger multipliers. It is precisely these households that tend to exhibit rule-of-thumb consumption behaviour, as opposed to consumption consistent with the permanent income hypothesis.

Are we in a recession? Probably!

2009-03-10T10:43:00.010+11:00

The definition of a recession is arbitrary. The common definition of two consecutive quarters of negative growth in real GDP is but a ‘rule of thumb’. Interestingly, as recent as 2001 the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) declared a recession despite not observing two consecutive quarters of negative growth (www.nber.org/cycles/recessions_faq.html).

So an interesting question is, from where did this definition originate?

It appears that the definition dates back to 1974. Julius Shiskin ¹, in an article published in the New York Times suggested there are three characteristics of a recession, duration, depth and diffusion. Two quarters of consecutive negative growth is but one of two criteria relating to duration. Arguably, many of the features suggested by Shiskin are not relevant to the modern era. (It is important to note that at the time of this article the world economy looked remarkably different from what it does today.)

Therefore, how do we know whether we are in a recession?

More recently, Lakshman Achuthan and Aniran Banerji of the Economic Cycle Research Institute argued that GDP should not be the sole means of identification. They argue that a recession is characterised by a pronounced, pervasive and persistent downturn in a broad set of measures. These measures include jobs, income and spending.

Is Australia in a recession?

It is undeniable that recent economic data show a pronounced and pervasive downturn in the broad measures of the economy. Arguably this downturn has been persistent also, given the first signs of a downturn began in September of last year. Therefore, I suggest, we are in a recession.

However, I strongly believe, a debate about whether we are in a recession is futile. The fact is that the economy is in trouble (GDP down 0.5% according to figures released last week). Also, the future looks bleak given the plight of our economic partners. Therefore, it is absolutely necessary that government policy (proposed or otherwise) be critically assessed.

It is my opinion that the policies and ideas suggested by the federal Government are less than inspiring. Furthermore, I believe the Opposition has not been as effective as they need to be in presenting a sound alternative. The end result being, we are likely to experience a downturn more pronounced, pervasive and persistent than should otherwise be.

The demise of fractional reserve banking in the United States

2009-03-10T07:28:00.010+11:00

The Demise of Fractional Reserve Banking, via Mark Thoma

We don't have fractional reserve banking anymore.

In statistics-speak, since last November, the monetary base has exceeded M1, which means, more or less, that bank reserves (plus surplus vault cash) exceed liquid deposits

What about the Australian experience? There has been a significant decline in the money multiplier in Australia since last October. Utilising RBA data on the money base and M1, the money mutiplier (M1/money base) from January 2000 - September 2008 averaged 4.5, with a minimum of 4 in December 2002. The multiplier fell from 4.7 to 3.8 from September 2008 to October, then to 3.5 in November and 3.2 in December.

Jon Stewart's takedown of CNBC

2009-03-09T20:19:00.004+11:00

Satire as Jon Stewart does best. Of course, with clips taken out of context, don't expect a sober or balanced assessment of the issues. Enjoy it for the entertainment value.

The Daily Show With Jon StewartM - Th 11p / 10c

CNBC Gives Financial Advice

Daily Show Full Episodes
Important Things With Demetri Martin

Political Humor
Joke of the Day

The Financial Crisis and the Principal Agent Problem

2009-03-08T20:16:00.010+11:00

Christopher Joye discusses the "far-reaching flaw sitting in the foundations of the US credit creation system"

Dismantle and Start Again, by Christopher Joye, Commentary, Business Spectator....The problem is a simple one: the vast bulk of all home loans in the US(around 70 per cent) are funded not using the balance-sheets of large transnational banks, and in turn the regionally diversified deposits of their customers, but via the far more complex, unstable and sometimes conflicted process of “securitisation”.

In contrast to the rest of the world – where securitisation, if it exists at all, has been a small yet valuable part of the housing finance mix – the process completely dominates home loan funding in the US.....
When a mortgage is securitised, the lender that originates the loan does not keep it on their balance-sheet and hold it to maturity – the whole point of this exercise is to take assets “off balance sheet” and sell them to third-party investors, thus enabling the lender to recycle the original capital and embark on a new round of financing.

Indeed, most regulators around the world have noted approvingly over the years that securitisation allows lenders to alleviate balance-sheet stresses and share some of their risks with third-parties, such as pension funds, who in turn get exposure to typically low volatility “mortgage-backed securities” that yield higher returns than conventional cash instruments. The very low risk and robust long-term performance of securitised home loans in Australia has been testament to the merits of this diversification process for consumers, lenders and investors.

Trouble nevertheless arises when you create artificially strong incentives, as US governments repeatedly did, to predicate your entire housing finance edifice on securitised forms of funding to the detriment of the traditional deposit-taking market. Over and above stunting the growth of a nationally-integrated banking sector, synthetic incentives that instill securitisation as the preferred source of funding expose the overall financial system to a number of potentially destabilising conflicts. The most obvious of these is that the organisations that source new home loans and which are responsible for assessing their credit risk are removed from the institutions that ultimately own the assets and hence bear that risk. We have, therefore, a classic principal-agent problem....

Mark Thoma provided a similar analysis of the principal agent problem in a post last year, but also argues that "the mis-pricing of risk and the failure of securitization to distribute risks across the financial system" contributed to the financial crisis.

Fannie and Freddie Did Not Cause This Crisis, by Mark Thoma, Seeking Alpha.... With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a bank or mortgage broker, either one.

Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans.

The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably...
Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? ..... The mis-pricing and mal-distribution of risk played a key role here ....

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. .....

(I)f the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of $2T(rillion) - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the mis-prediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped....

The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.

Fiscal Policy - Comparing Apples with Apples

2009-03-07T15:03:00.027+11:00

In today's The Australian, Federal Oppostion leader Malcolm Turbull writes

The gross domestic product numbers for the December quarter showed growth was negative. It was perfectly plain that the $10 billion December cash splash had been almost entirely saved: household savings were higher than they had been for many years....

So the cash splash had failed as an economic stimulus. .....
Rudd has chosen to borrow tens of billions of dollars to spend in ways that simply will not deliver an effective boost to the economy: too little bang for too much buck....
We have offered the Government the opportunity to agree on measures that would cost less and be more effective because, like tax cuts and investment incentives, they would benefit every business across the board.
Because, whether it be fiscal measures or investments in infrastructure, the priority must be to spend money to improve the productivity and efficiency of the whole economy and every business.

Shaun Carney argues in today's Age that such comments are "at best unproved and at worst nonsense".

The Opposition's claim, for example, that the December quarter national accounts prove that the $10 billion stimulus package — which it supported — had made a bad situation worse is at best unproved and at worst nonsense.
The money from the package did not reach taxpayers and consumers until the final three weeks of the quarter. And the Government expected, based on Treasury modelling, only about 10 per cent of the money to be spent around Christmas time. That is equivalent to $1 billion.
At this stage it looks like something close to that amount or more was spent. It's true that the December quarter accounts did show a substantial rise in savings, suggesting that a fair whack of the stimulus package went into paying off mortgages and credit cards. But the Government expected all along that about $3 billion would go into savings during the six months in which the package was to have effect. And savings are, in reality, deferred spending anyway, so it's too early to tell if the package was a dud.
Few in the Government made much of a fist of making these points this week.

And just as well. While it is correct to point out

the complete absence of a counterfactual in Turnbull's argument (ie what would have the December retail sales figures have looked like in the absence of the lump sum payments?), and
as payments commenced in the week of December 8th, one would not expect a significant portion of those payments to be reflected in the December retail sales figures, and
even though only a small proportion of the payments were immediately spent, the increase in retail sales appear to have been sustained into January, and
it was the decline in inventories in the December quarter that led to the negative growth result

Carney's claim that "it's too early to tell if the package was a dud" misses the point. Effective fiscal stimulus policies share two features: they are implemented in a timely manner (ie when the stimulus is most needed to employ idle resources), and; they increase economic activity as much as possible for a given budgetary cost. While Turnbull emphasises the latter point, he confuses long term productivity growth with short term aggregate demand expansion.

The fact that fiscal policy is subject to lags (both in terms of recognition and implementation) is well known. Even if the recognition lag can be overcome, policy makers are likely to find the implementation of effective short-term fiscal stimulus to be particularly challenging. As a tool of expansionary fiscal policy, an advantage of immediate lump sum payments is that they are associated with shorter implementation lags than, for example, infrastructure spending, and therefore have the potential to increase aggregate demand, and hence output and employment, in the short run. David Gruen, executive director of the Macroeconomic Group in the Australian Treasury argued in February that

we think without this package the greatest period of weakness for the economy is the whole of 2009 and that there are benefits in spending some significant proportion of money earlier

The benefits referred to here are clearly the potential short run increases in output and employment.

Where does this leave Turnbull's 'bang for the buck' or cost-effectiveness concept. Let us assume that Turnbull is referring to the value of the fiscal policy multiplier, ie the change in real GDP over a given period divided by its lifetime budget cost (ie reduction in tax revenue or increase in spending).

It is relatively uncontroversial, based on consistent empirical evidence as well as economy theory, that the multipliers associated with lump sum payments or rebates are smaller than government spending multipliers. The size of the lump sum payment multiplier will depend on factors such as the proporption of households whose consumption depends on perceived permanent income, and the expected cyclical position of the economy. Indeed, last October, following the limited expansionary impact of mid-year tax rebates in the United States, Paul Krugman called for a major fiscal stimulus that would

... take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

However, when we are discussing a 'bang for a buck' we need to compare apples with apples. Only the cost of fiscal stimuli that have the same intended temporal outcomes should be compared, ie we should compare the impact of lump sum payments to those policies that are also designed to have a short run impact on income and output. If policy timing matters (which it does) it is inappropriate to compare the multiplier associated with lump sum payments to the multiplier associated with infrastructure projects.

The US Congressional Budget Office published a paper in January 2008, Options for Responding to Short-Term Economic Weakness which attempted to compare apples with apples, by considering the cost-effectiveness of policies with similar enactment-stimulus lags. Only two policies with short enactment-stimulus lags were identified: across-the-board tax cuts and direct transfer payments to households. The conclusion? The cost-effectiveness of the tax cuts was estimated to be 'small', while the cost-effectivess of the transfer payments was estimated to be 'large'. As the range of transfer payments to households considered by the CBO appear to be more narrowly targetted than those in December stimulus, this points to the limited number of fiscal policy options available to generate both rapid and substantial increases in output and employment. Coupled with the fact that other components of spending in the economy are likely to be relatively weak over the next few months, all available fiscal policy tools, particularly direct government spending, will be required.

Brad DeLong and Michele Boldrin debate Obama's stimulus

2009-03-06T18:27:00.003+11:00

University of California, Davis Debate between Brad DeLong and Michele Boldrin

Revenge of the savings glut

2009-03-05T20:56:00.000+11:00

Paul Krugman (following on from Brad Setser earlier this year) revisits Federal Reserve Chairman Ben Bernake's 2005 speech, The Global Saving Glut and the U.S. Current Account Deficit, in light of current economic circumstances. ECON1082 International Monetary Economics students will be covering this material next week. In a nutshell, Bernake's thesis is that the principal causes of the U.S current account deficit is located outside of the country's borders, with the rest of the world, particularly the Asian region and oil exporters, consuming too little and saving too much. Krugman and Setser argue that without this savings surplus, rising US interest rates would have constrained the US housing bubble.

Revenge of the Glut, by Paul Krugman. How did this global debt crisis happen? Why is it so widespread? The answer, I’d suggest, can be found in a speech Ben Bernanke, the Federal Reserve chairman, gave four years ago. At the time, Mr. Bernanke was trying to be reassuring. But what he said then nonetheless foreshadowed the bust to come.

The speech, titled “The Global Saving Glut and the U.S. Current Account Deficit,” offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

The result was a world awash in cheap money, looking for somewhere to go.

Most of that money went to the United States — hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflowsthat, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.....

For a while, the inrush of capital created the illusion of wealth in these countries, just as it did for American homeowners: asset prices were rising, currencies were strong, and everything looked fine. But bubbles always burst sooner or later, and yesterday’s miracle economies have become today’s basket cases, nations whose assets have evaporated but whose debts remain all too real. And these debts are an especially heavy burden because most of the loans were denominated in other countries’ currencies.

Nor is the damage confined to the original borrowers. In America, the housing bubble mainly took place along the coasts, but when the bubble burst, demand for manufactured goods, especially cars, collapsed — and that has taken a terrible toll on the industrial heartland. Similarly, Europe’s bubbles were mainly around the continent’s periphery, yet industrial production in Germany — which never had a financial bubble but is Europe’s manufacturing core — is falling rapidly, thanks to a plunge in exports.

If you want to know where the global crisis came from, then, think of it this way: we’re looking at the revenge of the glut.

Timing the market

2009-03-04T22:47:00.000+11:00

When it comes to homeowners' mortgage financing decisions, expect discussion about 'timing the market' to increase over the weeks ahead.

With rates at extraordinarily low levels there has been speculation that the bottom of the cycle in cash rate levels must be near. And some borrowers have already moving towards fixed rate loans in anticipation.

Accurately predicting interest rate movements in the short-term, let alone the medium-term, is extremely difficult, to put it mildly. Does economic theory provide any guidance? Theory suggests that, on average, variable interest rates should be lower than fixed interest rates.

The explanation is as follows: Banks lend long and borrow short. There is always a chance that interest rates could rise, and, once lent out at a fixed interest rate, financial institutions cannot lend out these funds at a higher interest rate. Indeed, any given increase in interest rates will have a larger adverse impact on the value of the banks' assets the longer is the maturity. Therefore, banks require compensation in the form of higher interest rates if they are to 'lock-up' their funds in the form of fixed rate loans. This is consistent with the more general principle that assets with a longer time to maturity usually carry a higher interest rate.

Changes in Inventories

2009-03-04T19:06:00.000+11:00

The ABS reports that, in terms of expenditure, the largest negative contribution to GDP in the December quarter of 2008 was from inventories. Does the significant reduction in inventories provide any information as to where the Australian economy is headed? It depends, of course, on why firms reduced their inventories. On the one hand, the reduction in inventories may have been intentional, in response an anticipated reduction in demand. On the other hand, the reduction in inventories may have been unintentional (due, for example, to unanticipated strength in retail sales), and firms will need to increase inventories next quarter to restore them to some target level. The latter bodes well for economic activity next quarter, the former does not.

With improvements in inventory management, and the associated reduction in stock levels to sales over the last three decades, the recent reductions in inventories suggest reason for pessimism. As far back as 1993, the Reserve Bank of Australia noted that:

when firms expect demand to increase they also expect their stocks to increase. There is no evidence that firms have a strong desire to smooth production and meet expected changes in demand out of stocks. Instead, when demand is expected to increase, both output and inventories are also expected to increase. While the effects of unexpected demand changes on inventories have become more muted, the response to expected changes has increased.

What a difference a day makes

2009-03-04T14:50:00.000+11:00

According to Australian Bureau of Statistics figures released today, gross domestic product for the December quarter of 2008 fell 0.5 percent from the third quarter of 2008. And just yesterday:

Westpac chief economist Bill Evans said the positive data should mean gross domestic product figures due out Wednesday would show the economy grew 0.5 percent in the quarter, rather than contracting.