Sunday, August 8, 2010

Debt reduction taskforce - bad timing

Tony Abbott recently announced his plan to establish a debt reduction taskforce to reduce government debt that he believes Labor foolishly incurred. I have no problem with governments paying down debt and aiming to have a zero debt balance over the business cycle, but does he really think that governments should pay down debt while the citizenry is trying to do the same? To me this sounds like a recipe for disaster.

Debt deflation is what happens when indebted households and businesses start to pay off debt after a period of debt accumulation. Money used to pay debts is not used for consumption and no longer circulates in the economy. This decreases demand, but also reduces the money supply. The net effect is to slow economic activity and reduce prices (deflation). To read quality analysis of debt deflation read Steve Keen’s superb articles here.

The government response to this should be to print money. Because a portion of the new money is used to pay debts, a far smaller portion circulates in the economy to cause inflation. If it is done well, it should slow deflation, keeping demand and prices stable, and allow debts to slowly be repaid without the value of debt rising in proportion to incomes.  Whether this will promote further malinvestment (investing in non-productivity improving assets) remains to be seen.

Establishing a taskforce is a clear sign that it is not Abbott’s intention to pay down government debts by printing money. His plan appears to be the reduce government spending to pay debts – the exact same thing households are currently doing.

This will only exacerbate the decline in demand and accelerate our march towards deflation.

Competition Series Part II: Theories, assumptions

Let us look at the theory to see why the productivity gains from Australia’s pursuit of competition reform have been so hard to come by. Oliver Williamson’s 1968 model of the competition-coordination tradeoff is a good starting point.

The assumptions in Williamson’s model are that the monopoly industry has a lower marginal cost than competitive firms, that the monopolist sets their profit maximising price according to traditional economic theory, and that in a competitive market firms set their prices at marginal cost.

The graph below shows the resulting welfare implications of this model.

In this situation, while the competitive firms face higher costs (MC2), they set a price lower than the profit maximising monopolist (at P2 instead of P1). The welfare implication is that the area A is transferred from producer to consumer surplus, area B is the loss of producer surplus due to coordination costs, and area C is the gain to consumer surplus. There is a net loss of social surpluses (including all producer surplus) from competition in this model, however there are significant gains to the consumer surplus (areas A and C).

For a net gain to consumers in this model, two conditions need to be met:

1. The profit maximising price of the monopolist is higher that the marginal cost to the competitive producer (MC2 < P1), and
2. The competitive producers set prices at marginal cost (P2=MC2)

Unfortunately, neither of these conditions can be known in advance. In fact, if we drop just the second assumption, which has been proven many times to be far from realistic, the chances of a competitive market generating greater surpluses than a profit seeking monopolist greatly diminishes. In the above diagram this would mean that P2 is somewhere above MC2 (and of course we still don’t know if MC2 is below P1).

Thursday, August 5, 2010

Scared of deflation?

I have always been puzzled at the assymmetry of 'flation fear'.  A little inflation is good, but a little deflation is a scary thing.

Paul Krugman outlines the general argument as follows:
So the argument that deflation is a bad thing is also an argument saying that some economic problems get worse as inflation falls, and that too low an inflation rate may actually be economically damaging.

For the life of me I can't see how an inflation rate of zero can be damaging in the long run.  Also, if we look at Krugman's argument in reverse, more inflation is better.  Why isn't the optimal inflation rate zero instead of some positive number? Why 3% instead of 10%? Do human have an inbuilt behavioural trait that only we are able to plan and invest knowing that currency in the future will worth less rather than more?

Steve Landsburg on the other hand makes the argument that deflation fears are not justified by economic theory or evidence - I don’t see the problem in theory and I don’t see the problem in practice.

And he concludes that even if deflation is bad, it is easily solved.
Even if deflation is a bad thing, we know how to solve it. Print enough new money and people will eventually start spending it. It’s alleged that no matter how much you print, it can all just fall into the liquidity trap, and it’s alleged that this is what happened in Japan over the past decade. But I am sure the Japanese just didn’t try hard enough. Liquidity trap or not, I guarantee you there’s a central banker in Zimbabwe who knows how to fight deflation. If we really get into trouble, all we have to do is hire him.

As I have noted before, the world survived just fine for a long period of time with inflation at zero on average. Positive inflation in the long run did not occur until post WWII. Some might even argue that this is simply the longest ever business cycle stimulated by enough debt to keep inflation positive, and that the next fifty years, subject to international politics, might see prolonged deflation.

Avoiding deflation in the short run may have made the global economy far less stable in the long, long run.

Maybe it is just that with high debt levels adjusting to deflation from a persistent inflationary environment will unsettle much investment, and mean a transition period were many jobs are lost.  Any thoughts?

Wednesday, August 4, 2010

Competition Series Part I: Experimentation

The annual ACCC Regulatory Conference was held last week at the Gold Coast. At a time when various governments are intervening to separate Telstra’s business, sell public railways, subsidise a fibre broadband network, and introduce competition in water markets, any evidence on the effectiveness of competition reforms in such network industries would be helpful. Yet my take home message was that nobody is sure if competition reform has provided, or even can provide, the social benefits it was designed to achieve.

Ironically, in the second session of the conference the following findings were put forward: most circumstances, profit maximising vertical integration decisions are efficient, not just from the firms’ but also from the consumers’ point of view. The vast majority of studies support this claim,.. even in industries which are highly concentrated…

However, the thrust of competition reform is directed at unbundling vertically integrated monopolies to reduce potential abuse of market power.  Railways, electricity, and telecommunications are classic examples, yet a quarter century of evidence shows that vertical integration is in fact the efficient outcome for both producers and consumers. I would note however, that even where market structures appear to be competitive, price competition and innovation may still fail to eventuate.  On the other hand, monopolies may innovate simply due to a the threat of competition. Arguing that competitive outcomes will be achieved based on market structure alone is flawed.

That got me thinking. Is competition reform more about ideology than social gains through efficiency? Are we just swapping government incompetence at regulating and incentivising its monopoly with incompetence at developing sufficient regulation for a competitive market operate while still relying on government owned monopolist components of the value chain?

This post is the first in an August series on competition which will follow my emerging understanding of this controversial topic. I hope to investigate key theoretical assumptions, investigate the history of competition reform, compare theoretical outcomes with real evidence, and identify regulatory shortcomings. In doing so my personal opinions will become known, yet I hope that some debate will challenge these opinions. Any comments and criticisms are welcome.

Sunday, August 1, 2010

Quick housing update and forecasts

The residential property bears breathed a sigh of relief with the release of the monthly RPData hedonic price index for June - down 0.7% (with Brisbane prices down 1.3%). The bulls however are happy enough with the 20% capital growth performance since June 2009.

In light of this, Steve Keen has laid out his forecast of things to come in residential property:

Firstly, with an increased stock of unsold houses on the market, buyers are likely to take yet more time to make a decision—which will add further to the backlog. If prices are falling, why hurry? The urgency will leave the buy side.

Secondly, so-called investors—whom I prefer to call speculators, since 90% of them have bought existing properties rather than built new ones—will start to consider whether they should swap from the buy side to the sell side. After all, no-one in their right mind buys an investment property in Australia for the rental returns: it’s capital gains or nothing DownUnder. Do you capitalize on gains to date, or hang on hoping that the upward trend will re-assert itself once more?

I expect these two processes to lead to an accelerating rate of decline in house prices now, as they did in the USA when “Flip That House” ceased being a winning trade.

Chris Joye has made a typically broad prediction:

Rismark had been forecasting a substantial deceleration in housing conditions back to single-digit annualised growth rates since October 2009. Over the long-run, house prices track purchasing power quite closely. Disposable household incomes were only projected to rise by about 5 per cent in 2010. We’ve had 4.7 per cent growth in dwelling values in the year-to-date. We do not, therefore, expect to see the market rise much further over the remaining year subject to labour market conditions and the course of monetary policy.

Interestingly, Joye notes the decline in housing credit outstanding, but does not seem to believe this will strongly influence prices in the near term.

Finally, over at Delusional Economics we have this gem:
There is no "soft landing" for a debt driven economy that suddenly decides to shun debt

Tuesday, July 27, 2010

Economic myths - another dose

Population growth

I have written at length on why population growth does not improve welfare. Mark Crosby over at Core Economics reiterates these fundamental arguments.

The pro-population growth arguments are theoretically flawed, and empirically dismissed. Below is a chart of the relationship between population growth and GDP per capita for around 200 countries and localities, showing a distinctly inverse relationship. If I was in the business of improving welfare, low population growth would be a key avenue.
Another emerging myth is that population growth will decrease interest rates. Renowned property spruiker Chris Joye has created plenty of media fanfare recently with his spurious connection between population growth and interest rates. This table shows the interest rates in 23 countries, and if I’m not mistaken, shows that countries with the lowest population growth (and highest GDP per capita) also have the lowest interest rates.


Food myths are widespread. The environmental movement wants us to believe that vegetarianism is better for the environment and that ‘organic’ (what does that mean?) food is more nutritious and can solve hunger around the world. The agricultural lobby would have us believe that food self-sufficiency is of utmost importance, although their argument is shallow at best.

The latest myth to be busted is that chickens are pumped with artificial hormones and steroids to make them grow faster and larger. However, it appears that hormones are not part of the poultry picture at all.

While I firmly believe that raising animals for food should be conducted in a humane manner, those who push for change would garner more support if they were fully informed of current practices - their message could then be taken seriously by industry and government. Furthermore, the organic food movement could concentrate on promoting farming practices that reduce externalities, as a result of chemical use for instance, and improving land quality. The incentives for such change often align with the long term goals of the agricultural industry and may attract wider public support.


Under the rebound effect banner I have discussed how some innovations to improve safety can backfire if peoples’ behavioural response is to take on more risk. For example, the vigorous uptake in sunscreen use has led to a culture of sun exposure, offsetting the intended consequence of reduced skin cancer rates. The name for this behavioural response in the context of risk taking is the Peltzman Effect.

You can find this type of response in broad range of situations. Most recently, in trials of automatic lane correction technologies in cars, one participant noted:

...that she would love to have this feature in her own car. Then, after a night of drinking in the city, she would not have to sleep at a friend’s house before returning to her rural home

Minimum wage

The business lobby loves the textbook response to minimum wage laws, but even world renowned economists are sceptical.  No doubt this debate will continue.

Thursday, July 22, 2010

Stay informed for Election 2010 - Labor Factions: Basic Questions Answered

By Andrew McMicking

Why does the ALP have factions? What are the benefits?

Factions have been set up to serve a useful purpose in the ALP. In brief they:

• Allow support to be readily marshalled behind candidates and ideas.
• Provide for a sharing of power between different philosophical or ideological interests in the party.
• Serve as a mechanism to settle disputes.

Any organisation or group of people – be it the workplace, a golf club, church group or school classroom – will always see groups of like minded people associate more readily together. The ALP has recognised this and, through factions, has formalised such groupings. Members and unions in the ALP can now formally apply and join a faction. Each faction usually has a membership list, executive, AGM, bank account, fundraising activity and negotiation committee for dealing with other factions. This formalised nature allows the principle of solidarity to be applied i.e. a decision is made within a faction and all members are bound to abide by that decision.

What is Right and what is Left?

You often here the terms ‘left wing’ and ‘right wing’ applied to factions by both the media and in public discussion. In political/philosophical terms, ‘right wing’ means you tend to take a more conservative and pragmatic view of policy issues, whereas ‘left wing’ means you tend to take a more reformist or progressive view. Support for a budget surplus, tax cuts as opposed to more government spending, a close defence relationship with the US, free market economics, less red tape for business and uranium mining is regarded as ‘right wing’. Support for greater government spending on health, education, disability services and infrastructure, an Australian Republic, recognition of the rights of indigenous people and other minority groups, and opposition to the war in Iraq is regarded as ‘left wing’.

What do we currently have in Qld? Federally?

The ALP, in each State, have factions which can be classified as either Left or Right.

In Qld we have The Left as a left wing faction. However we have two right wing factions: Labor Unity known as the ‘Old Guard’ (refer page 3) and Labor Forum known as the ‘AWU’ faction (as the AWU, Qld’s biggest union, dominates this group). These two factions are now in close alliance together and many view them as one right faction. They technically remain separate entities, though, and many in Labor Unity would not see themselves as a right wing faction, but more in the centre between The Left and Labor Forum.

Monday, July 19, 2010

Is residential property Super?

The retirement plans of working families may soon succumb to Australia's residential property mania. If Chris Joye had his way, Australian super funds would invest in the emerging residential equity market to diversify their portfolios against highly correlated domestic and global equities markets. The argument for this move is summarised below.

Investors, such as super funds, get extremely low-cost, highly enhanced and very long-dated exposures to what has, during the past three decades (including the recent calamity) been the largest and best performing of all investment classes: residential real estate. Historically, investors have only been able to access highly concentrated, risky development-style holdings comprising small parcels of properties that incur heinous transaction costs of about 12.5 per cent. By investing in a portfolio of thousands of shared equity interests, super funds could avoid all of these costs and secure the low risk diversification that they have never had before. Independent actuarial analysis suggests that about 15 to 30 per cent of all super fund capital should, in theory, be allocated to housing, in part because its returns are so unrelated to the performance of other investments. Compare the 50 per cent plus losses in shares and listed property trusts in the past year with the fact that the RP Data-Rismark Australian House Price Index has tapered by only -0.8 per cent. (emphasise added)

Is this idea worth embracing? Or to put it another way, how many people would actively choose to invest superannuation in the residential property market?

Super funds investing in residential property equity face a couple major of problems in my view:

1. decreasing the diversity of investor portfolios, and
2. moral hazard associated with residential equity finance.

Tuesday, July 13, 2010

Skilled labour immigration removes incentives for Australians to invest in education

The shrill from commentators warning of Australia’s apparent skills shortage is deafening. But there are a number of reasons why this claim, and the inevitable recommendation for government to increase quotas of skilled migrants, is flawed, and why the solution is not in the best interests of Australia in the long run.

For the acute observer the transparent falsehood of the claim jumps right out at you.

… skilled labour in an area like project construction is an international problem, so poaching what we need from overseas is not going to be easy.

ACIL Tasman points out that LNG project specialist workers are globally mobile, moving from site to site (and often between projects at varying stages of development) – wherever their services command the highest price. As the consultants warn, opting for less-experienced personnel carries with it the dangers of higher error rates in construction and resulting delivery delays and still more expense.

Translation: if you want the skills you need to pay.

A government with backbone, and an eye on long term prosperity, would tell industries crying poor to sort it out themselves. Large mining and gas projects have very long lead times - long enough in fact to train some of the existing workforce in skills that may be required for future projects. If you need the slam-dunk of skills and experience, you are inevitably poaching people from another project - experience only comes from a finite number of places.

Sunday, July 11, 2010

Generations of housing affordability

The degradation of housing affordability is widely acknowledged, but unfortunately mainstream explanations miss the fundamental stories of easy credit and tax rules encouraging property speculation.

One of the best collections of Australian residential property analysis on the web has emerged at The Unconventional Economist.  Leith's latest article explores changes to housing affordability since the 1970s and the key drivers behind the change. 

He summarises the article as follows:
  • It is the demand for, and supply of, credit that is the key determinant of house prices. Whilst demand-side factors such as tax concessions, benign economic conditions, and population growth might increase people's willingness to borrow for property, ultimately, if you cannot obtain the finance, you cannot pay a high price. Similarly, tight housing supply would have little impact on house prices when credit is not readily available.
  • Lower interest rates and easy credit do not make houses more affordable. Rather, they quickly get capitalised into house prices, increasing the amount that home buyers must borrow.
  • When examining interest rates and their effect on housing affordability, it is real interest rates (i.e. the mortgage interest rate less inflation) that matters. Whilst mortgage interest rates averaged a seemingly high 9% in the 1970s, due to high inflation (averaging 11%), real interest rates were negative, resulting in borrowers' mortgage debt being 'inflated away'.
  • Importantly, be very weary of offers of more credit and the promise that it will "improve housing affordability". Any scheme that increases home buyer's borrowing capacity, such as shared equity loans and the Never Ending Mortgage, will instead fuel further house price growth, thus eroding affordability.
  • Beware the property spruiker. Always be sceptical when reading property-related articles in the press, or when listening to politicians talk about housing affordability. Whilst they might, on the surface, sound reasonable, they are often talking their own book. Instead, think critically about their motives and who their constituents really are.