When there is a shock to the economy, it is generally thought to have a multiplied effect on the economy. Some households enjoy higher income, they spend it, increasing the income for other households, who in turn spend it, and so on. The size of the multiplier is finite because there are leakages: some of the increase in income may be saved, used to pay taxes, or used to buy imports, and is therefore not available as income to others.
How big are these multipliers? Menzie Chinn provides some estimates at Econbrowser.
Thursday, November 29, 2007
Causality vs correlation....
When we look at economic outcomes, we observe correlations: event "x" happened along with event "y". There are several possible interpretations of this. First, "x" may have caused "y". Alternatively, "y" may have caused "x". Finally, some other variable "z" may have caused both "x" and "y". Without knowing the causality involved, we cannot answer most relevant policy questions available data.
One specific example from my own research: we observe that members of currency unions trade a lot more than other countries. That's the correlation. If being a member of a currency union induces people to trade more, this might make a compelling case for countries to form currency unions. But if countries trading more tend to form currency unions, then the correlation is reversed, and countries may not see an increase in trade from forming a currency union.
Economists spend a lot of time trying to find "natural experiments," where we can be sure of the direction of any possible causality. Often this is based on an unexpected change in "x" which was clearly exogenous- i.e. was not caused by "y".
One interesting application is to the effects of female leadership rather than male leadership. Read this slate article for more. (Thanks to Marginal Revolution for the link).
One specific example from my own research: we observe that members of currency unions trade a lot more than other countries. That's the correlation. If being a member of a currency union induces people to trade more, this might make a compelling case for countries to form currency unions. But if countries trading more tend to form currency unions, then the correlation is reversed, and countries may not see an increase in trade from forming a currency union.
Economists spend a lot of time trying to find "natural experiments," where we can be sure of the direction of any possible causality. Often this is based on an unexpected change in "x" which was clearly exogenous- i.e. was not caused by "y".
One interesting application is to the effects of female leadership rather than male leadership. Read this slate article for more. (Thanks to Marginal Revolution for the link).
University Rankings....
Earlier this month, the Times Higher Education Supplment came out with its latest university ranking. And if you live in Hong Kong, you would have had to turn off all news media to have failed to learn that my employer, HKU, ranked 18th worldwide! That's an impressive performance by any means, and the University is rightly trumpeting its performance.
But university rankings are inherently problematic. In this case, the THES takes a series of relevant indicators (peer review, employer review, international staff, international students, staff/student ratio, and citations), combines them with a formula, and comes out with a number that can be compared between universities.
In general, these indicators are proxies for latent variables that cannot be accurately measured, and may be poor proxies at that. For example, I suspect the "international" variables are trying to capture the extent to which the university encourages its students to think outside the box, and take into account other viewpoints and perspectives. But just having international students and international staff is neither necessary nor sufficient for this to occur.
There are likely to be significant measurement issues as well. Who exactly are the peers and employers who are asked about their views of different universities? Is the sample biased towards one country, or one demographic? How do we count international students, and international staff? Are mainland students in HK domestic or international? Are exchange students, who come to HKU for one semester or one year, treated identically to international students who come for their complete degree program? Is "international" determined by passport, or birthplace? In the staff count for the staff-student ratio, who is included? Only permanent, tenured staff? Gardeners and cleaners? I could go on....
There are two reasonable responses to these problems. One would be to dismiss these rankings as noisy indicators of very little. The other is to treat the noise in the ranking as sampling error, and try to increase the sampling size, by considering more university rankings.
Unfortunately there's only one other well-known global university ranking, by Shanghai Jiao Tong University. And where does HKU rank here? Somewhere between 203rd and 304th.
Oops.... I guess we need a lot more rankings than two to get any accurate idea of where HKU really stands!
But university rankings are inherently problematic. In this case, the THES takes a series of relevant indicators (peer review, employer review, international staff, international students, staff/student ratio, and citations), combines them with a formula, and comes out with a number that can be compared between universities.
In general, these indicators are proxies for latent variables that cannot be accurately measured, and may be poor proxies at that. For example, I suspect the "international" variables are trying to capture the extent to which the university encourages its students to think outside the box, and take into account other viewpoints and perspectives. But just having international students and international staff is neither necessary nor sufficient for this to occur.
There are likely to be significant measurement issues as well. Who exactly are the peers and employers who are asked about their views of different universities? Is the sample biased towards one country, or one demographic? How do we count international students, and international staff? Are mainland students in HK domestic or international? Are exchange students, who come to HKU for one semester or one year, treated identically to international students who come for their complete degree program? Is "international" determined by passport, or birthplace? In the staff count for the staff-student ratio, who is included? Only permanent, tenured staff? Gardeners and cleaners? I could go on....
There are two reasonable responses to these problems. One would be to dismiss these rankings as noisy indicators of very little. The other is to treat the noise in the ranking as sampling error, and try to increase the sampling size, by considering more university rankings.
Unfortunately there's only one other well-known global university ranking, by Shanghai Jiao Tong University. And where does HKU rank here? Somewhere between 203rd and 304th.
Oops.... I guess we need a lot more rankings than two to get any accurate idea of where HKU really stands!
Wednesday, November 28, 2007
The Zimbabwe CPI is now Undefined....
According to this article, the Zimbabwe state statistical agency is no longer calculating the CPI, as there are too many empty shelves, and not enough goods left to include in the calculation.
Following from my earlier discussions of Zimbabwe's inflation (the latest being here), I think this new development highlights a potential bias in the CPI that I haven't seen discussed elsewhere. What is the price of a good that is no longer available at any price? The only answer to this question is that it is undefined, or infinite. If even one component of the CPI is no longer available at any price, then regardless of how trivial that component is within the CPI, Zimbabwe inflation now equals infinity!
(This is part of the reason why price controls are such a bad idea: they lower the prices for some consumers but inevitably create shortages, and therefore infinite prices, for others).
But life is not actually quite as bad as infinite inflation would imply. Recall that we often use the CPI as a measure of the "cost of living." To an economist, the cost of living is the lowest cost of attaining a given standard of living, or utility. The CPI is an imperfect measure of this because it ignores substitution effects (consumers substitute away from relatively expensive goods towards cheaper ones), new goods (the weights are only updated occasionally, so ignores the rapid price declines usually associated with new goods), and improvements in quality over time. These three biases tend to result in the CPI overstating rises in the true cost of living.
If we ignore goods that are no longer available at any price due to a collapsing, corrupt, crime-ridden economy, then that introduces a bias that works the other way. It will not in fact result in infinite inflation (since a rational consumer would substitute away from the unavailable goods to those that are still available), but in the case of Zimbabwe is likely to result in measured inflation significantly understating the true rise in the cost of living. True infinite inflation can only arise when there is nothing left available for sale at any price.
So the poor people of Zimbabwe who have been arguing that the prices they pay are rising faster than official CPI figures indicate have a point.
And what is the source of this hyper-inflation? The money supply is growing at 18000% per year! as Friedman said, "Inflation is always and everywhere a monetary phenomena."
Following from my earlier discussions of Zimbabwe's inflation (the latest being here), I think this new development highlights a potential bias in the CPI that I haven't seen discussed elsewhere. What is the price of a good that is no longer available at any price? The only answer to this question is that it is undefined, or infinite. If even one component of the CPI is no longer available at any price, then regardless of how trivial that component is within the CPI, Zimbabwe inflation now equals infinity!
(This is part of the reason why price controls are such a bad idea: they lower the prices for some consumers but inevitably create shortages, and therefore infinite prices, for others).
But life is not actually quite as bad as infinite inflation would imply. Recall that we often use the CPI as a measure of the "cost of living." To an economist, the cost of living is the lowest cost of attaining a given standard of living, or utility. The CPI is an imperfect measure of this because it ignores substitution effects (consumers substitute away from relatively expensive goods towards cheaper ones), new goods (the weights are only updated occasionally, so ignores the rapid price declines usually associated with new goods), and improvements in quality over time. These three biases tend to result in the CPI overstating rises in the true cost of living.
If we ignore goods that are no longer available at any price due to a collapsing, corrupt, crime-ridden economy, then that introduces a bias that works the other way. It will not in fact result in infinite inflation (since a rational consumer would substitute away from the unavailable goods to those that are still available), but in the case of Zimbabwe is likely to result in measured inflation significantly understating the true rise in the cost of living. True infinite inflation can only arise when there is nothing left available for sale at any price.
So the poor people of Zimbabwe who have been arguing that the prices they pay are rising faster than official CPI figures indicate have a point.
And what is the source of this hyper-inflation? The money supply is growing at 18000% per year! as Friedman said, "Inflation is always and everywhere a monetary phenomena."
Thursday, November 22, 2007
The dire outlook for the US economy....
Back to my recurring theme of arguing that the US economy is heading for recession (last installment here), both Roubini and a Financial Times columnist argue that things are worse, and the economy is heading for a generalised systematic financial meltdown.
At some point, perma-bears like Roubini may overstate their case... and if Roubini doesn't, someone else will. Pessimism is like a commodity: there's a market for pessimistic economic projections. And the markets almost always overshoot. In this case, I'll be surprised if Roubini is not still calling for a worsening recession even once the economy starts to recover.
But, for the record, I think that point is still a long way off....
At some point, perma-bears like Roubini may overstate their case... and if Roubini doesn't, someone else will. Pessimism is like a commodity: there's a market for pessimistic economic projections. And the markets almost always overshoot. In this case, I'll be surprised if Roubini is not still calling for a worsening recession even once the economy starts to recover.
But, for the record, I think that point is still a long way off....
Wednesday, November 21, 2007
Too expensive at half the price.... Mainland equities.
I've talked repeatedly here about China's equities bubble (for my last installment, see here). But here's another piece of the puzzle. Bloomberg reported on November 5 that on its first day of trading in Shanghai, Petro China tripled in value, and became the most valuable company in the world by market cap- much larger than any other oil company, even though several of these have significantly higher revenues, oil reserves, and other assets.
Or consider this table published in mid-October. Of the 25 most valuable companies in the world by market cap, 8 were Chinese, while only one Japanese company, Toyota, makes the list- even though Japan is the world's second largest national economy, and many Japanese companies are global brands, with a strong global presence.
Focusing on financial institutions on the same list, there are 4 Chinese companies on the list, and only three from the rest of the world.
Yes, China represents a great opportunity for future growth and therefore future profits. But this great?
Or consider this table published in mid-October. Of the 25 most valuable companies in the world by market cap, 8 were Chinese, while only one Japanese company, Toyota, makes the list- even though Japan is the world's second largest national economy, and many Japanese companies are global brands, with a strong global presence.
Focusing on financial institutions on the same list, there are 4 Chinese companies on the list, and only three from the rest of the world.
Yes, China represents a great opportunity for future growth and therefore future profits. But this great?
Tuesday, November 20, 2007
How Rich is China?
A recent article in the Financial Times (thanks to Marginal Revolution for the pointer) suggests that some soon-to-be released numbers will show that living standards in China are 40% lower than had previously been believed.
Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).
But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.
But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.
One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.
How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.
And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.
I'll be following this story with interest....
Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).
But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.
But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.
One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.
How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.
And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.
I'll be following this story with interest....
Monday, November 19, 2007
Do you buy or sell an appreciating asset?
This must be "undercover economist" day at HongKongMacro. Here's another facinating post by Tim Harford.
The crux of the post: should you buy an asset that has appreciated in price, or not? Clearly if you failed to buy it when it was cheaper before, and you were rational about your decision then, you should be less likely to buy the asset now. But many financial analysts seem to have different ideas. The fact the price has gone up must mean that it's an asset worth holding.... or something like that.
I shouldn't complain. Markets would be far less interesting if we all invested like economists. There would be no bubbles, and we'd have a lot less to talk about! Just look at the Hang Seng Index, which has dropped almost 15% since October 30.
The crux of the post: should you buy an asset that has appreciated in price, or not? Clearly if you failed to buy it when it was cheaper before, and you were rational about your decision then, you should be less likely to buy the asset now. But many financial analysts seem to have different ideas. The fact the price has gone up must mean that it's an asset worth holding.... or something like that.
I shouldn't complain. Markets would be far less interesting if we all invested like economists. There would be no bubbles, and we'd have a lot less to talk about! Just look at the Hang Seng Index, which has dropped almost 15% since October 30.
Benford's Law... and Testing Economics Data
I earlier posted a link on Benford's law, the idea that most data series are likely to have many more observations starting with the digit "1" than "2", and more starting with "2" than "3", etc. The idea was that to get from "1" to "2" requires a 100% increase in magnitude, while getting from "2" to "3" requires only a 50% increase in magnitude.... and so on.
Well, the undercover economist has more... the same principle can be used to assess whether economic statistics are accurate.
Suspician of the accuracy of statistics has a long history. Benjamin Disraeli famously commented that there are three kinds of lies.... "lies, damned lies, and statistics." But maybe this is not fair. At a minimum, most statistics should satisfy Benford's law.
I can think of an excellent application. Many people are suspicious of the macroeconomic numbers generated by Mainland China, especially at the state level. A simple test of whether they're made-up or not would be to see whether the series satisfy Benford's Law.
Of course this would not be a fall-proof test. What if the numbers really were made up, but by statisticians who knew about Benford's law?
Well, the undercover economist has more... the same principle can be used to assess whether economic statistics are accurate.
Suspician of the accuracy of statistics has a long history. Benjamin Disraeli famously commented that there are three kinds of lies.... "lies, damned lies, and statistics." But maybe this is not fair. At a minimum, most statistics should satisfy Benford's law.
I can think of an excellent application. Many people are suspicious of the macroeconomic numbers generated by Mainland China, especially at the state level. A simple test of whether they're made-up or not would be to see whether the series satisfy Benford's Law.
Of course this would not be a fall-proof test. What if the numbers really were made up, but by statisticians who knew about Benford's law?
Wednesday, November 14, 2007
Free Lunch....
"There's no such thing as a free lunch" is an idiom, the title of a book by Milton Friedman, and the substance of a wiki page. It's also the idea behind a paper I wrote a few years ago on monetary policy published in the Journal of Macroeconomics.
More recently, we have more proof that very little is in fact free... as the UndercoverEconomist reports here.
More recently, we have more proof that very little is in fact free... as the UndercoverEconomist reports here.
Housing Prices and Recession...
I keep harping on about the fall in house prices in the US leading to a recession- my last installment was here.
CalculatedRisk have a careful assessment of the argument here, and essentially agree. If you don't have time to read the whole article, this graph illustrates it nicely. Housing values were recently at an all-time high as a percentage of GDP, and so mortgages still are. As house prices start to fall, those mortgages are going to stay at their stratospheric levels, implying that net wealth of households is falling far more dramatically (in percentage terms) than the fall in house prices alone would suggest. And we know the influence of the wealth affect on consumption, and therefore GDP......
CalculatedRisk have a careful assessment of the argument here, and essentially agree. If you don't have time to read the whole article, this graph illustrates it nicely. Housing values were recently at an all-time high as a percentage of GDP, and so mortgages still are. As house prices start to fall, those mortgages are going to stay at their stratospheric levels, implying that net wealth of households is falling far more dramatically (in percentage terms) than the fall in house prices alone would suggest. And we know the influence of the wealth affect on consumption, and therefore GDP......
Mainland Futures...
There's a new feature that may be introduced shortly that may have a profound effect on mainland equities. I've argued before that Mainland Chinese equities represent a bubble, and that one day it must burst. One reason why it's lasted so long is that there are no instruments available for investors in the mainland to short equities. Thus people who think that the market is overvalued remove their money from the market, but can do little more. Investors who remain are by definition optimists, who believe that the market will continue to rise- otherwise they wouldn't invest in the first place!
In an economy where the number of new investors is growing at incredible rates (remember those reports about hundreds of thousands of new equity accounts being opened every day?), there's no stortage of optimism.
But now that pie cart may be about to be overturned. From today's South China Morning Post:
"The imminent launch of index futures in the mainland is increasingly spooking investors who fear it could herald a sharp correction in a market that has almost doubled this year."
The response?
"The mainland's stock benchmarks slipped for a fourth day yesterday as investors braced for the introduction of a system that will allow big funds to bet on a market decline. The losses contrasted with a rebound in the Hong Kong market."
So mainland investors may be able to short mainland equities soon, and that's enough for the market to drop? Chalk that up to additional evidence of a bubble...
In an economy where the number of new investors is growing at incredible rates (remember those reports about hundreds of thousands of new equity accounts being opened every day?), there's no stortage of optimism.
But now that pie cart may be about to be overturned. From today's South China Morning Post:
"The imminent launch of index futures in the mainland is increasingly spooking investors who fear it could herald a sharp correction in a market that has almost doubled this year."
The response?
"The mainland's stock benchmarks slipped for a fourth day yesterday as investors braced for the introduction of a system that will allow big funds to bet on a market decline. The losses contrasted with a rebound in the Hong Kong market."
So mainland investors may be able to short mainland equities soon, and that's enough for the market to drop? Chalk that up to additional evidence of a bubble...
Monday, November 12, 2007
Oil, Gold, Exchange Rates, and Inflation....
Does the rapid appreciation of the price of oil and gold signify increased inflation? Here's a careful analysis by James Hamilton on Econbrowser.
Japan's Phillip's Curve....
.... looks like Japan. That's from my former PhD Supervisor and co-author, Professor Gregor Smith of Queen's University. The same is apparently true of the Marshal Islands, the Netherlands, and the Czech Republic (see the links on Smith's homepage). It's not true for HK.... I checked.
Friday, November 9, 2007
What will happen to the USD?
The value of the USD has been falling dramatically against all major currencies. What is the likely future direction? Well, that's the billion dollar question.... literally. If I knew, I would not be writing it here, but would use my information to speculate on the currency! But alas, I'm not sure which way the dollar will move. (As I've argued earlier, part of the reason why we can't predict exchange rates well is the ease with which we can speculate on them). So instead, I'll write a blog entry about it!
I'm not alone. Menzie Chinn provides a very careful survey of academic thinking on the behaviour of exchange rates here, and ends up being about as non-committal as me.
For the record, I think we can predict the exchange rate with a little success. First, high interest rate bearing currencies tend to appreciate relative to low interest rate ones- the motivation for the "carry trade" (see my earlier posts here and here).
Second exchange rates tend to over-correct in the short run, like most other assets- thanks perhaps to "momentum traders" who tend to buy assets that are appreciating simply because they're appreciating, rather than due to underlying fundamental value. So ultimately someone will make a lot of money by buying USD at the bottom of the market. (That person will probably not be me, as we have no way of knowing when we're at the bottom until after the fact!)
And third in the long run, purchasing power parity is an important driver of exchange rates. Based on this, I still consider my earlier position to be reasonable: the USD will have appreciated a long wayt from its current value (and even its value as of 6 months ago) within 5 years.
I'm not alone. Menzie Chinn provides a very careful survey of academic thinking on the behaviour of exchange rates here, and ends up being about as non-committal as me.
For the record, I think we can predict the exchange rate with a little success. First, high interest rate bearing currencies tend to appreciate relative to low interest rate ones- the motivation for the "carry trade" (see my earlier posts here and here).
Second exchange rates tend to over-correct in the short run, like most other assets- thanks perhaps to "momentum traders" who tend to buy assets that are appreciating simply because they're appreciating, rather than due to underlying fundamental value. So ultimately someone will make a lot of money by buying USD at the bottom of the market. (That person will probably not be me, as we have no way of knowing when we're at the bottom until after the fact!)
And third in the long run, purchasing power parity is an important driver of exchange rates. Based on this, I still consider my earlier position to be reasonable: the USD will have appreciated a long wayt from its current value (and even its value as of 6 months ago) within 5 years.
Thursday, November 8, 2007
The Economics of Remittances....
Every year, domestic helpers in Hong Kong send money home to support their families. In this post, I want to briefly examine the economics of these remittances. (This post is motivated by this story about the remittances of polish truck drivers from the UK).
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
Wednesday, November 7, 2007
Has the Fed lost the plot?
"I am afraid that the Fed Reserve, which regards its loose monetary policy can overcome potential recession, has missed the point. The underlying problem with US' economy is the unbelievable deficit! With high deficit and high oil price, I am reminded of the stagflation of 1970s. What do you think?" - Wallace
The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.
That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).
Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.
And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!
So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!
On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.
The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.
That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).
Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.
And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!
So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!
On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.
Monday, November 5, 2007
Pressure on the HKD peg...
The HKMA has been intervening regularly lately to maintain the HKD peg. The currency is nominally fixed at 7.80 HKD per USD, but allowed to fluctuate between 7.75 and 7.85. When it hits the weak side of the band (7.85), the HKMA is obliged to buy HKD in exchange for USD. And when it hits the strong side, the HKMA sells HKD in exchange for USD.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Good or bad news about the economy?
Just a few days back, the latest employment data for the US was released, and the data was surprisingly good, as this Bloomberg story reports. But how exactly should we interpret a single piece of evidence? The data is volatile, and as a result, there are lots of conflicting pieces of evidence, as Nouriel Roubini discusses here. The rational thing to do is to take moving averages through the data, to drop out some of the volatility (and if we have 12 month moving averages, drop out any distortions caused by seasonal factors or- more likely- poor adjustment for seasonality), and then interpret the smoothed data, as James Hamilton proposes here. The conclusion? The news is not good.
Thursday, November 1, 2007
The US dollar de-internationalisation....
The US dollar is the most internationalised of all currencies at the current point in time. But it is loosing ground, especially to the Euro. Psychology plays a role here, and the large depreciation of the USD relative to most other currencies over the last 18 months has not exactly helped the dollar's case. According to this Bloomberg article, the USD is becoming less acceptable in some economies.
Studying the Dismal Science....
Economics is often referred to as the "Dismal Science," a label which is not exactly supposed to reflect positively on economists. But is it a fair label? Are economists really dismal people? Does studying economics increase your dismal-rating, or do dismal people self-select into the discipline?
How about the converse? Maybe economists are a happy lot, deriving pleasure from using economic analysis to understand the world around us, and as a result of our outlook on life, gaining insights that are a mystery to most of the world's population.
Marginal Revolution, one of the most popular economics blogs, recently put this question to their many readers. Does studying economics make you happier? Read more and offer your comments here.
My conclusion: Maybe we're not such a dismal lot afterall!
How about the converse? Maybe economists are a happy lot, deriving pleasure from using economic analysis to understand the world around us, and as a result of our outlook on life, gaining insights that are a mystery to most of the world's population.
Marginal Revolution, one of the most popular economics blogs, recently put this question to their many readers. Does studying economics make you happier? Read more and offer your comments here.
My conclusion: Maybe we're not such a dismal lot afterall!
Price Controls make a Comeback...
Price controls are making a comeback, in Argentina, Russia, and China. as I've argued before this is a bad idea. Let me recount my two main objections briefly.
First, price controls do not generally work. If they succeed in preventing prices from rising, then shortages will inevitably result. I'd rather pay "too much" for a good or service than fail to be able to buy it at all because the supplier has run out! (If a supplier runs out of a product, the effective price is infinity- which can hardly be thought of as successful if your objective was to prevent prices from rising! Normally, however, the black market ensures that one can still purchase price controlled goods- perhaps at an inflated price- even when shortages result).
Second, even if they did "work" by prevening prices from rising, they do so from distorting the price signals that are essential for efficient resource allocation.
In the end, too high inflation results from one and only one cause: too lax monetary policy. As Milton Friedman famously said "Inflation is always and everywhere a monetary phenomenom." Indeed, for high inflation countries there is approximately a 1-for-1 relationship between money supply growth and inflation, although the link is less than proportional for lower inflation economies.
See my earlier post for more.
First, price controls do not generally work. If they succeed in preventing prices from rising, then shortages will inevitably result. I'd rather pay "too much" for a good or service than fail to be able to buy it at all because the supplier has run out! (If a supplier runs out of a product, the effective price is infinity- which can hardly be thought of as successful if your objective was to prevent prices from rising! Normally, however, the black market ensures that one can still purchase price controlled goods- perhaps at an inflated price- even when shortages result).
Second, even if they did "work" by prevening prices from rising, they do so from distorting the price signals that are essential for efficient resource allocation.
In the end, too high inflation results from one and only one cause: too lax monetary policy. As Milton Friedman famously said "Inflation is always and everywhere a monetary phenomenom." Indeed, for high inflation countries there is approximately a 1-for-1 relationship between money supply growth and inflation, although the link is less than proportional for lower inflation economies.
See my earlier post for more.
Wednesday, October 31, 2007
US recession round-up....
Some recent posts on the coming US recession....
Here is the insightful Nouriel Roubini taking stock of the dire state of the US economy, and the path it is on to recession.
Here is James Hamilton explaining why the oil price is so high. It's a simple case of supply and demand. We've got lots of the latter, and not quite enough of the former.
In the past, any major rise in oil prices has lead to a recession- no questions asked. Hamilton continues here with why the economy need not be as sensitive to the price of oil as it was in the past, which may be cause for a little optimism.
And his fellow Blogger, Menzie Chinn, continues here with a roundup of recessionary causes, and the historical inability of growing trade to keep the US economy out of recession.
Here is the insightful Nouriel Roubini taking stock of the dire state of the US economy, and the path it is on to recession.
Here is James Hamilton explaining why the oil price is so high. It's a simple case of supply and demand. We've got lots of the latter, and not quite enough of the former.
In the past, any major rise in oil prices has lead to a recession- no questions asked. Hamilton continues here with why the economy need not be as sensitive to the price of oil as it was in the past, which may be cause for a little optimism.
And his fellow Blogger, Menzie Chinn, continues here with a roundup of recessionary causes, and the historical inability of growing trade to keep the US economy out of recession.
The Collateral Damage of Trade....
Yesterday I posted on the link between trade and disease. Trade results in other risks as well... like creating racial offense from poor translations!
Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!
As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.
Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!
As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.
Monday, October 29, 2007
Trading Diseases.....
Economic integration, in the form of the flow of goods, people, and capital is generally perceived to be unambiguous good to economists. Non-economists are sometimes more skeptical, pointing to increased carbon dioxide output due to shipping goods across the globe, and loss of cultural uniqueness as the world becomes increasingly homogenous.
The first of these could be easily rectified with an appropriately implemented carbon tax, while the second is very hard to quantify, or rectify. And since economic integration is a natural phenomena that occurs when individuals are able to freely trade with each other, it's impossible to argue that preventing such integration is not itself costly to society.
But there are other unintended effects of integration as well. Remember SARS? It started in southern China and spread into Hong Kong, one of the most globally integrated regions anywhere. From there it spread far and wide, with over 8,000 patients falling ill in 25 countries in short order.
An even more serious case of integration leading to the spread of disease can be found in Africa. According to a recent study from Emily Oster (thanks to Marginal Revolution for the link), "a doubling of exports leads to as much as a quadrupling in new HIV infections" in Africa. Increasing trade flows result in increased movements of transient workers, who themselves are high risk, and take their diseases with them.
I wouldn't interpret this as evidence that trade is bad per se- it's just one more component to weigh up when deciding how to steer an economy. And remember that HIV infections are just one component of economic welfare. Trade also allows many members of society to improve their living standards, and in poor parts of Africa, this is likely to have a large positive effect on overall health and welfare.
The first of these could be easily rectified with an appropriately implemented carbon tax, while the second is very hard to quantify, or rectify. And since economic integration is a natural phenomena that occurs when individuals are able to freely trade with each other, it's impossible to argue that preventing such integration is not itself costly to society.
But there are other unintended effects of integration as well. Remember SARS? It started in southern China and spread into Hong Kong, one of the most globally integrated regions anywhere. From there it spread far and wide, with over 8,000 patients falling ill in 25 countries in short order.
An even more serious case of integration leading to the spread of disease can be found in Africa. According to a recent study from Emily Oster (thanks to Marginal Revolution for the link), "a doubling of exports leads to as much as a quadrupling in new HIV infections" in Africa. Increasing trade flows result in increased movements of transient workers, who themselves are high risk, and take their diseases with them.
I wouldn't interpret this as evidence that trade is bad per se- it's just one more component to weigh up when deciding how to steer an economy. And remember that HIV infections are just one component of economic welfare. Trade also allows many members of society to improve their living standards, and in poor parts of Africa, this is likely to have a large positive effect on overall health and welfare.
Froth and Bubbles....
"What should China do to try to reduce excess liquidity and inflation" - Qin
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China's Growing Reserves....
"China has accumulated huge USD reserves. How might these affect the US in future?" -Arun
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
Understanding Hyperinflation
Zimbabwe has the highest inflation rate in the world today, and provides an illustration of the effects of inflation. Consider this news article on CNN on inflation in Zimbabwe, which has picked back up to 7982% in the year ended September.
Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.
To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!
Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.
To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!
Thursday, October 25, 2007
Measuring The Contribution of Labour and Capital to Growth
"When we analyse the source of economic growth, we include the capital stock (K) and the labour supply (N), and total factor productivity (A). Sometimes adjustments are made to K and N, reflecting changes in quality or prices. Should such adjustments be made?" - Candy
You're referring to growth accounting- using a simple production function to figure out how much of economic growth is due to growth in the labour supply, how much is due to growth in the capital stock, and how much cannot be explained by growth in these most basic factors of production. This final left over part may be thought of as a measure of how efficient the economy is, and it is variations in this variable (A) that explain the huge variation in economic wealth between poor and rich countries.
Often we do adjust measures of the capital stock and measures of the labour supply. Whether this is a good idea or not depends on the source of the adjustment, and what exactly we're trying to measure. Sometimes the adjustments are due to measurement problems, and should rightly be made. For example, when we measure the capital stock, ideally we want a measure of the total physical quantity of capital that is used in production. We can't easily measure this; instead we measure the market value of the capital stock. But the market value can change because of a change in the quantity of capital, or a change in the price of capital. Clearly correcting our measures of capital for changes in the price of capital is a good idea.
Similar adjustments in the labour supply may also be warranted. For example, as the demographic structure of the economy changes, measuring the total number of workers or the total number of hours worked may be a poor measure of the total contribution of the labour force to production. If more experienced workers are replacing less experienced ones, then ignoring this fact will exaggerate the rate growth rate of A, the part of economic growth that is not due to labour or capital.
But some adjustments might not be a good idea, because the quality of labour or capital is itself an endogenous variable that responds to the growth of the economy. For example, as the economy's growth rate increases, workers are induced to increase their level of education and learn new skills to take advantage of new job opportunities. Is this an increase in the level of the labour supply (N) or an increase in productivity (A)? In truth, it is both. A similar argument can be made for capital. There are greater incentives to buy better quality capital the more developed the economy is, and the greater are the possible returns to using high quality capital.
So I end up sitting on the fence. If you want to know how much of the growth of the economy cannot be explained by labour and capital, maybe you should adjust away to your heart's content. If instead you want to know how much of the growth of the economy is "endogenous" - i.e. not directly due to changes in the quantity of the factors of production, you should limit adjustments to correcting more meaurement errors, and not quality changes.
You're referring to growth accounting- using a simple production function to figure out how much of economic growth is due to growth in the labour supply, how much is due to growth in the capital stock, and how much cannot be explained by growth in these most basic factors of production. This final left over part may be thought of as a measure of how efficient the economy is, and it is variations in this variable (A) that explain the huge variation in economic wealth between poor and rich countries.
Often we do adjust measures of the capital stock and measures of the labour supply. Whether this is a good idea or not depends on the source of the adjustment, and what exactly we're trying to measure. Sometimes the adjustments are due to measurement problems, and should rightly be made. For example, when we measure the capital stock, ideally we want a measure of the total physical quantity of capital that is used in production. We can't easily measure this; instead we measure the market value of the capital stock. But the market value can change because of a change in the quantity of capital, or a change in the price of capital. Clearly correcting our measures of capital for changes in the price of capital is a good idea.
Similar adjustments in the labour supply may also be warranted. For example, as the demographic structure of the economy changes, measuring the total number of workers or the total number of hours worked may be a poor measure of the total contribution of the labour force to production. If more experienced workers are replacing less experienced ones, then ignoring this fact will exaggerate the rate growth rate of A, the part of economic growth that is not due to labour or capital.
But some adjustments might not be a good idea, because the quality of labour or capital is itself an endogenous variable that responds to the growth of the economy. For example, as the economy's growth rate increases, workers are induced to increase their level of education and learn new skills to take advantage of new job opportunities. Is this an increase in the level of the labour supply (N) or an increase in productivity (A)? In truth, it is both. A similar argument can be made for capital. There are greater incentives to buy better quality capital the more developed the economy is, and the greater are the possible returns to using high quality capital.
So I end up sitting on the fence. If you want to know how much of the growth of the economy cannot be explained by labour and capital, maybe you should adjust away to your heart's content. If instead you want to know how much of the growth of the economy is "endogenous" - i.e. not directly due to changes in the quantity of the factors of production, you should limit adjustments to correcting more meaurement errors, and not quality changes.
Tuesday, October 23, 2007
You're not as old as you think....
As many of my students know, one of my pet concerns is the demographic transition that is affecting most of the developed world, and some of the developing world (China) as well. For the first time, we're facing a rapidly aging population, and in the fullness of time a shrinking population as well. This may have profound implications for asset markets (see, for example, this paper on the effects of demographics on real estate prices), aggregate savings, and therefore interest rates. Higher interest rates in turn may reduce investment, lowering the capital stock, and future economic growth. You can't get much more of a profound chain of events in economics than that.
The big unknown in all my doomsdaying is how our aging population will respond to their predicament. If people start working longer, and remain economically productive later in life, in principle this could offset a large part (or all) of the negative effects. And indeed, as marginal revolution and the Economist point out, this paper by John Shoven at Stanford suggests that there is room for some optimism on these fronts.
See the links for more....
The big unknown in all my doomsdaying is how our aging population will respond to their predicament. If people start working longer, and remain economically productive later in life, in principle this could offset a large part (or all) of the negative effects. And indeed, as marginal revolution and the Economist point out, this paper by John Shoven at Stanford suggests that there is room for some optimism on these fronts.
See the links for more....
Monday, October 22, 2007
How will the USD depreciation affect the US economy?
"What is the benefit of a depreciating USD? In particular, will it reduce interest in investing in US assets, as they will offer a lower return? And does it make the US better off?" - Catherine
I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.
On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.
More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.
This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.
Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.
I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.
On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.
More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.
This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.
Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.
Thursday, October 18, 2007
Oct. 19 1987: Could it happen again?
Oct. 19 1987 remains the largest one-day correction in world equity markets. The DJIA lost 22.6%, and the S&P 500 20.4%. Closer to home, the drop in the HSI lagged that in New York due to the time difference. But drop it did, from 3362.40 at close on Oct. 19 to 2241.70 at close on Oct. 26- a staggering 33.3% drop. (For the data, see here. This NYT story explains the lack of data for the intervening days: the market had already dropped 11.1% on Oct. 19, ahead of the US melt-down, and was closed for the following four trading days as a result).
Could such a melt-down happen again? Nouriel Roubini of NYU and Roubini Global Economics draws the parallels between 1987 and 2007 here.
My take: yes, there are some strong parallels, and a major melt-down is certainly possible. But timing any such melt-down is extremely difficult. It could happen tomorrow, next week, next month, next year, or even next decade.
Could such a melt-down happen again? Nouriel Roubini of NYU and Roubini Global Economics draws the parallels between 1987 and 2007 here.
My take: yes, there are some strong parallels, and a major melt-down is certainly possible. But timing any such melt-down is extremely difficult. It could happen tomorrow, next week, next month, next year, or even next decade.
Wednesday, October 17, 2007
The current account and the exchange rate...
"What is the effect of the current account balance on the exchange rate?" - Vincent
To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.
Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.
Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?
The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.
To put this another way, the current account balance may be defined as
CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)
The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.
We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.
To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.
Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.
Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?
The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.
To put this another way, the current account balance may be defined as
CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)
The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.
We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.
Tuesday, October 16, 2007
Nobel Prize Winners in Economics
Hurwicz, Maskin and Myerson won the nobel prize in economics for "Mechanism Design." What on earth is that, I hear you ask? Alex Tabarrok of Marginal Revolution provides some excellent examples here.
Monday, October 15, 2007
Why have a currency board?
"Notwithstanding the fact that the currency peg is very political, are there any compelling reasons why the HKD should not be "unpegged" from the USD, particularly in view of expected further depreciation of the greenback?"
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
Sunday, October 14, 2007
Mis-measuring Trade
While we're on the subject of mis-measurement, what do Mongolia, Papua New Guinea, Angola, and Libya all have in common? According to the World Trade Organisation they all trade a greater value of goods and services than they produce- see this link, for example.
This is news to me. The only way a country is likely to trade in excess of production is if it is a major re-exporter, like Hong Kong or Singapore. Yes it is possible for other countries to enjoy a trade:GDP ratio exceeding 100%- if you export every good and service you produce, and import every good and service you consume, the ratio could theoretically hit 200% without any re-exports- but I hardly think that is likely for the countries listed here.
If the ratio is incorrect, it is most likely due to mis-measurement of GDP, with the countries concerned exporting goods produced in the informal sector that slip under the radar of the statistics agency beancounters, and paying for imports with income earned in that same informal sector.
Thanks to Lolita for the pointer.
This is news to me. The only way a country is likely to trade in excess of production is if it is a major re-exporter, like Hong Kong or Singapore. Yes it is possible for other countries to enjoy a trade:GDP ratio exceeding 100%- if you export every good and service you produce, and import every good and service you consume, the ratio could theoretically hit 200% without any re-exports- but I hardly think that is likely for the countries listed here.
If the ratio is incorrect, it is most likely due to mis-measurement of GDP, with the countries concerned exporting goods produced in the informal sector that slip under the radar of the statistics agency beancounters, and paying for imports with income earned in that same informal sector.
Thanks to Lolita for the pointer.
Mis-measuring GDP....
"The different approaches to measuring GDP (income approach, product approach, etc) are supposed to all give the same answer. But some activities are hard to measure- for example drug dealing- and are likely to be excluded from the product approach for lack of data. Might this explain why the different approaches give different answers?" - Chen
This shouldn't be too much of a problem, as we likely miss-measure both the income approach and the product approach by a similar amount. We don't measure the consumer's purchases of illegal drugs, but we don't measure the income earned by the drug dealer either! Since the amounts are identical, ignoring parts of the economy should not systematically bias one measure of GDP relative to another.
This shouldn't be too much of a problem, as we likely miss-measure both the income approach and the product approach by a similar amount. We don't measure the consumer's purchases of illegal drugs, but we don't measure the income earned by the drug dealer either! Since the amounts are identical, ignoring parts of the economy should not systematically bias one measure of GDP relative to another.
Saturday, October 13, 2007
Housing wealth shock... US version
When the property bubble in Hong Kong burst, average Hong Kong apartment prices fell about 66% according to the official index between the peak (October 1997) and trough (July 2003) (for a graph, click here). The result of this was a long-term recession, deflation, and general economic malaise.
The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.
Thanks to Calculated Risk for the link.
The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.
Thanks to Calculated Risk for the link.
Friday, October 12, 2007
Hong Kong Tax Cut Harmony....
Continuing yesterday's post, William Pesak of Bloomberg agrees that Hong Kong's tax cut is a bad idea- although he adds some additional reasons to my argument about macroeconomic instability: (1) instead of cutting taxes, the government could have used it's largese to try to reduce inequality, and (2) the government should focus less on competing with Singapore (Hong Kong's closest competitor in the low-tax stakes in Asia), and more on forward planning- figuring out what Hong Kong needs for future growth.
(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.
But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.
Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.
For more of Pesek's column, see here.
(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.
But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.
Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.
For more of Pesek's column, see here.
Thursday, October 11, 2007
Hong Kong's fiscal policy is cyclical?
Further to my previous post, the Hong Kong government has responded to the healthy fiscal situation by announcing a tax cut. But is that a good idea? To answer that, we need to think about the role of Government policy.
In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.
For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.
Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.
But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.
For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.
It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.
The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).
In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.
Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.
My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.
But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!
In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.
For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.
Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.
But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.
For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.
It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.
The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).
In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.
Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.
My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.
But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!
The CE announces tax cuts.... big deal
Just yesterday, the Chief Executive announced that tax rates in Hong Kong are coming down.
From the news story today in the SCMP:
"Donald Tsang Yam-kuen announced that the standard tax rates for salaries and profits tax would be cut by 1 percentage point respectively to 15 per cent and 16.5 per cent from the 2008-09 financial year, which would cost the Treasury about HK$5 billion a year."
The standard tax rate discussed here has little effect on the taxes that most of us pay, since it is effectively the maximum average tax rate that a person may have to pay. Given the mildly progressive nature of HK's tax system (2% on the first 35,000 after exemptions, 7% on the next 35,000, 12% on the next 35,000, and 17% on the remainder) and the basic $100,000 exemption, the standard tax rate directly affects only those people earning more than $2,750,000 per year. The calculation is as follows:
Taxes paid under the progressive system on an income of Y are:
T(progressive) = 0.02x35,000 + 0.07x35,000 + 0.12x35,000 + 0.17x(Y-105,000-100,000)
Taxes paid under the standard rate are:
T(standard) = 0.16xY
Actual taxes paid are the minimum of these two equations; the former is lower for all incomes below 2.75 million. With only about 5,000 people in Hong Kong earning more than this threshhold, this tax cut alone will have no effect on most tax payers. So the announced cuts themselves are no big deal.
But the expectation is that there will be additional tax cuts- not yet announced- that will apply to the progressive tax system that affects a far larger number of residents. This can occur in one of two ways: reductions in the tax rates and/or increases in the threshholds at which the tax rates apply.
From the news story today in the SCMP:
"Donald Tsang Yam-kuen announced that the standard tax rates for salaries and profits tax would be cut by 1 percentage point respectively to 15 per cent and 16.5 per cent from the 2008-09 financial year, which would cost the Treasury about HK$5 billion a year."
The standard tax rate discussed here has little effect on the taxes that most of us pay, since it is effectively the maximum average tax rate that a person may have to pay. Given the mildly progressive nature of HK's tax system (2% on the first 35,000 after exemptions, 7% on the next 35,000, 12% on the next 35,000, and 17% on the remainder) and the basic $100,000 exemption, the standard tax rate directly affects only those people earning more than $2,750,000 per year. The calculation is as follows:
Taxes paid under the progressive system on an income of Y are:
T(progressive) = 0.02x35,000 + 0.07x35,000 + 0.12x35,000 + 0.17x(Y-105,000-100,000)
Taxes paid under the standard rate are:
T(standard) = 0.16xY
Actual taxes paid are the minimum of these two equations; the former is lower for all incomes below 2.75 million. With only about 5,000 people in Hong Kong earning more than this threshhold, this tax cut alone will have no effect on most tax payers. So the announced cuts themselves are no big deal.
But the expectation is that there will be additional tax cuts- not yet announced- that will apply to the progressive tax system that affects a far larger number of residents. This can occur in one of two ways: reductions in the tax rates and/or increases in the threshholds at which the tax rates apply.
Wednesday, October 10, 2007
The HKMA is On Top of Things....
The Hong Kong Monetary Authority, Hong Kong's de facto Central Bank, is on top of things... literally! In fact, being housed in the top 11 floors of IFC2, the world's 7th tallest building (and Hong Kong's tallest.... at least until the new ICC building going up across the harbour adds a few more floors).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Tuesday, October 9, 2007
Paying for Inactivity, Indonesian Style
The Indonesian government have a cunning plan for making money. They'd like the rest of the world to pay them not to destroy the rest of their forests- $5-20 per hectare, to be precise. This might have almost made sense.... the forests in Indonesia are of benefit to the whole world, so the whole world can pay for their maintenance. It's the classic case of externality.
We could apply this same principle in many other areas. Let's pay fishermen not to fish (after all, they deplete the sea, to the detriment of all), farmers not to farm (that'd reduce chemical run-off that is harming world water supplies), and drivers to leave their cars at home (reducing congestion and pollution for everyone else).
But would this really work? I'm very skepical for several reasons. First Indonesia is a very corrupt country. According to Transparency International, Indonesia is ranked 130th out of 163 countries for corruption, on par with Zimbabwe and Ethiopia (in contrast, Hong Kong is ranked 15th, and China manages 70th). Does anyone really believe that this money will get past the government officials charged with administering it to actually help preserve the forests in Indonesia? If so, I have some snake oil I'd like to sell them.....
Second, this sets an alarming precedent. Paying people for not destroying their own environment would encourage more countries to follow suit. How much would the rich world be willing to pay Kenya if threatened with the eradication of elephants and lions? What's the difference between this and blackmailing the rest of the world with the destruction of your own future?
Third, there has to be a better way. How about using property rights, rather than paternalistic handouts, to encourage the indonesians to protect their own forests? It works in Niger, a country that is both poorer (on a PPP basis as well) and more corrupt than Indonesia, so couldn't it work in Indonesia too?
We could apply this same principle in many other areas. Let's pay fishermen not to fish (after all, they deplete the sea, to the detriment of all), farmers not to farm (that'd reduce chemical run-off that is harming world water supplies), and drivers to leave their cars at home (reducing congestion and pollution for everyone else).
But would this really work? I'm very skepical for several reasons. First Indonesia is a very corrupt country. According to Transparency International, Indonesia is ranked 130th out of 163 countries for corruption, on par with Zimbabwe and Ethiopia (in contrast, Hong Kong is ranked 15th, and China manages 70th). Does anyone really believe that this money will get past the government officials charged with administering it to actually help preserve the forests in Indonesia? If so, I have some snake oil I'd like to sell them.....
Second, this sets an alarming precedent. Paying people for not destroying their own environment would encourage more countries to follow suit. How much would the rich world be willing to pay Kenya if threatened with the eradication of elephants and lions? What's the difference between this and blackmailing the rest of the world with the destruction of your own future?
Third, there has to be a better way. How about using property rights, rather than paternalistic handouts, to encourage the indonesians to protect their own forests? It works in Niger, a country that is both poorer (on a PPP basis as well) and more corrupt than Indonesia, so couldn't it work in Indonesia too?
Sunday, October 7, 2007
Sports, sentiment, and cycles....
I can't sit here, as a native-born Kiwi (New Zealander) and not make a comment on the shocking result in the Rugby World Cup in the early hours of the morning, HK time. Completely against expectations, the world's top rugby team, and the most successful in the history of the sport, lost to France in the quarter-finals. There are many things I'd like discuss (like the refereeing), but I'll leave that to the experts. The fact is, based on current form, the All Blacks (as the NZ team are called) should have won by a large margin.
Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.
Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).
Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.
Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.
Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.
The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.
But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.
So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?
Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.
This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.
Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....
Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.
Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).
Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.
Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.
Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.
The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.
But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.
So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?
Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.
This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.
Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....
Friday, October 5, 2007
China is a "Bubble of Bubbles".... and Ben is to Blame....
Thursday, October 4, 2007
Do bubbles slow economic growth?
"Will the presence of bubbles not slow economic growth in real economy? In China at the moment, investing in real assets may appear relatively unattractive compared with investing in equities, based on recent returns. Also, some SOE have been prosecuted for using funds earmarked for real investments to speculate in the markets instead. In the long run, is this bad for economic growth?"- Mattias
You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.
Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.
In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.
Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.
You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.
Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.
In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.
Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.
Dilbert the Economist...
Some time ago, I commented that Scott Adams, the creater of Dilbert, understands marginal utility.
The plot thickens.... it turns out that Scott Adams trained as an economist, and thinks that economics confers mild super-powers! No wonder I enjoy reading Dilbert so much!
See the links here for more.
Thanks to Newmark's Door for the link.
The plot thickens.... it turns out that Scott Adams trained as an economist, and thinks that economics confers mild super-powers! No wonder I enjoy reading Dilbert so much!
See the links here for more.
Thanks to Newmark's Door for the link.
Wednesday, October 3, 2007
Will India Catch up... continued
India and China are growing at a high, approximately constant rate. But will their growth continue at the current rate? Hong Kong, as a more mature economy, provides a good example as to what may be expected to happen as China and India continue to grow. As Hong Kong developed, it's progression was approximately linear until about 1988- and it's been slowing down since then. That's not really a surpise: high growth rates are easier to maintain the lower is your GDP, as you can grow simply by adopting the technology of others. But at some point, that process will run out of steam.
And the point where growth starts to slow is likely to be a function of the level of "social infrastructure" (Hall and Jones, QJE, 1999) in society. Short of a major change in institutional quality in China and India, resulting in substantial reductions in corruption, expect GDP growth to slow at much lower per capita levels in these countries than it did in Hong Kong, which enjoys an excellent, corruption-free administration, at least by comparison.
Even this may be optimistic. Hong Kong has endured no major crises over that period shown on the grapth. Sure, 1989 and the Asian Financial Crisis shook up markets, but there have been no major events that have significantly threatened the functioning of the economy or the political structure of Hong Kong since our data begins in 1961. Will the same hold true for China and India over the coming decades? We can only hope so.
And the point where growth starts to slow is likely to be a function of the level of "social infrastructure" (Hall and Jones, QJE, 1999) in society. Short of a major change in institutional quality in China and India, resulting in substantial reductions in corruption, expect GDP growth to slow at much lower per capita levels in these countries than it did in Hong Kong, which enjoys an excellent, corruption-free administration, at least by comparison.
Even this may be optimistic. Hong Kong has endured no major crises over that period shown on the grapth. Sure, 1989 and the Asian Financial Crisis shook up markets, but there have been no major events that have significantly threatened the functioning of the economy or the political structure of Hong Kong since our data begins in 1961. Will the same hold true for China and India over the coming decades? We can only hope so.
India is Catching Up? China too? Don't count on it...
Regularly we see articles in the media stating that China will be the largest economy in the world by 2050, or that India will soon overtake Britain (see this story- thanks to Olly for the pointer). "Within 15 years Indians should, on average, be four times richer than today," the article states. Frankly, I'm skeptical. Yes, it may happen, but there are many reasons why that day may not arrive nearly as soon as the article argues.
Lets consider an analogy. Woman sprinters are getting faster every year. So are men. But woman are getting faster at a faster rate. Ergo one day woman sprinters will be faster than men- by 2156 according to this story. The academic study behind this story was even published in Nature, one of the top science journals, so it might be correct, right? Not so fast.....
So what's wrong with it? Well, everything, really. Let's take the recent past, project it forward linearly, and see where we end up in the distant future. Do we live in a linear world? No. Do we expect to live in a linear world in the future? No. Would any rational person expect growth rates to continue at current rates? No. Do these long-term linear projections do anything more than create headlines to help journalists sell newspapers? No.
Consider the following graph of real GDP for India. I've taken logs, so constant growth would result in a linear relationship. And in recent years, growth has been approximately linear. Chinese data results in a similar graph.
Lets consider an analogy. Woman sprinters are getting faster every year. So are men. But woman are getting faster at a faster rate. Ergo one day woman sprinters will be faster than men- by 2156 according to this story. The academic study behind this story was even published in Nature, one of the top science journals, so it might be correct, right? Not so fast.....
So what's wrong with it? Well, everything, really. Let's take the recent past, project it forward linearly, and see where we end up in the distant future. Do we live in a linear world? No. Do we expect to live in a linear world in the future? No. Would any rational person expect growth rates to continue at current rates? No. Do these long-term linear projections do anything more than create headlines to help journalists sell newspapers? No.
Consider the following graph of real GDP for India. I've taken logs, so constant growth would result in a linear relationship. And in recent years, growth has been approximately linear. Chinese data results in a similar graph.
But will growth continue to be linear? See the next post for more....
Tuesday, October 2, 2007
Mysterious Markets....
So the markets have decided that the credit crunch is over, and equity valuations have jumped. The DJIA is at all time highs, and closer to home, the HSI is growing in leaps and bounds. What is going on here?
To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.
The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.
The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.
If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....
To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.
The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.
The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.
If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....
Saturday, September 29, 2007
Sky High Oil....
So the oil price is at all time high levels- as the following graph shows (although this data series stops in March 2007: the price is now over $80/Barrel).
But is it really? First, here's the real price of oil- still significantly below the level attained in 1980, shortly after the Iranian Revolution.
But there's another reason to downplay the massive growth in the price of oil. It just happens to be reported in US dollars, which have been losing value against almost all other currencies in recent months.
Here is the real price of oil faced by consumers in the United Kingdom, by comparison. Yes, the price of oil is up, but hardly by the spectacular levels we'd imagine when we read the headline figures- especially for countries with exchange rates that have appreciated against the USD. in fact, because oil happens to be priced in USD, a fall in the value of the greenback will naturally increase the price of oil irrespective of the supply and demand for "black gold."
But is it really? First, here's the real price of oil- still significantly below the level attained in 1980, shortly after the Iranian Revolution.
But there's another reason to downplay the massive growth in the price of oil. It just happens to be reported in US dollars, which have been losing value against almost all other currencies in recent months.
Here is the real price of oil faced by consumers in the United Kingdom, by comparison. Yes, the price of oil is up, but hardly by the spectacular levels we'd imagine when we read the headline figures- especially for countries with exchange rates that have appreciated against the USD. in fact, because oil happens to be priced in USD, a fall in the value of the greenback will naturally increase the price of oil irrespective of the supply and demand for "black gold."
Tuesday, September 25, 2007
Hong Kong's Money...
Want to know how monetary policy is really set in Hong Kong, and the intricacies of the Currency Board system? Look no further than "Hong Kong's Money," a new book written by Tony Latter and Published by Hong Kong University Press. Mr Latter is a former Deputy Chief Execuative of the Hong Kong Monetary Authority, and his association with monetary policy stretches back to the formation of the currency board in 1983. But his understanding of Hong Kong's monetary history stretches back a long way before then....
Monday, September 24, 2007
How Does a Central Bank Create Money?
James Hamilton of UC San Diego and prolific blogger at Econbrowser provides an excellent explanation of the process by which the Federal Reserve creates money here. While the labels and details vary, any economy with an independent central bank follows a similar process.
The Maestro
Alan Greenspan is the former Chairman of the Federal Reserve Board, the US Central Bank. He was widely hailed as an excellent Chairman throughout his tenure, but some cracks are starting to appear in his reputation.
For one, he continued with an expansionary monetary policy even when most analysts expected interest rates to rise. At the time, this appeared to be a masterstroke- the economy continued growing at a fast rate without the resulting inflation that economists feared.
But now there is an alternative interpretation given to this expansionary policy, and one that implies that he was less than the maestro many had thought. Maybe Greenspan's expansionary policy fueled increased inflation afterall- just not in the prices of consumer goods and services that we track so carefully.
I'm talking about asset prices, of course. Low interest rates encouraged US households to over-invest in real estate, driving up property prices, and creating a property market bubble that is now in the process of deflating. The bubble, and the consequent bust, would most likely have been less severe without the active help of the Greenspan Fed.
We could go further. Indeed, one insightful journalist - Caroline Baum at Bloomberg- has listed a range of excellent questions that she'd like to pose to Greenspan, that together read like an attempt to bring the Maestro from his pedistall back down to earth. Read her article here.
For one, he continued with an expansionary monetary policy even when most analysts expected interest rates to rise. At the time, this appeared to be a masterstroke- the economy continued growing at a fast rate without the resulting inflation that economists feared.
But now there is an alternative interpretation given to this expansionary policy, and one that implies that he was less than the maestro many had thought. Maybe Greenspan's expansionary policy fueled increased inflation afterall- just not in the prices of consumer goods and services that we track so carefully.
I'm talking about asset prices, of course. Low interest rates encouraged US households to over-invest in real estate, driving up property prices, and creating a property market bubble that is now in the process of deflating. The bubble, and the consequent bust, would most likely have been less severe without the active help of the Greenspan Fed.
We could go further. Indeed, one insightful journalist - Caroline Baum at Bloomberg- has listed a range of excellent questions that she'd like to pose to Greenspan, that together read like an attempt to bring the Maestro from his pedistall back down to earth. Read her article here.
Friday, September 21, 2007
The Canadian Dollar
Further to my earlier post, the Canadian dollar was worth more than the US dollar last night for the first time in 31 years. As I write, $1CDN will buy $1.0014USD!
As this Bloomberg story notes, the Canadian dollar has appreciated by more than 62% since 2002. This has also largely been a real (as opposed to nominal) exchange rate change, as the inflation experiences of the US and Canada have been similar over this period.
There's a warning implicit in the there for all international transactions: exchange rate fluctuations are huge, and can easily dwarf all other risks faced by businesses.
As this Bloomberg story notes, the Canadian dollar has appreciated by more than 62% since 2002. This has also largely been a real (as opposed to nominal) exchange rate change, as the inflation experiences of the US and Canada have been similar over this period.
There's a warning implicit in the there for all international transactions: exchange rate fluctuations are huge, and can easily dwarf all other risks faced by businesses.
Arbitraging the HKD
"What is the role of arbitrage in HK's exchange rate arrangement?" - Vincent
Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!
Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.
When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.
The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.
Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!
Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.
When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.
The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.
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