Real Share Prices

A few months ago, we heard in the news media that many share price indices around the world were at record levels. But were they? A share price index is measured in domestic currency, and is simply a nominal variable. If the index has increased over time, that simply means that the average investor selling their shares today will receive more money than they paid for then. Whether their real wealth has increased is not clear.

Michael Mandel (thanks to Newmark's Door for the pointer) corrects that with a real S&P 500 index, deflating it by the CPI, and shows that the S&P 500 is significantly lower today than it was in 1999.

How about Hong Kong? The HSI has grown from 8,800 during SARS in 2003 to highs of over 20,000 recently. It is 12% higher than its previous peak in 1999.

How about the real value of the HSI? That is also at an all-time peak, and is almost 17% higher than its previous peak, due to the persistent deflation (falls in the CPI) between 1999 and 2004.

The more important question is whether shares in Hong Kong are now too expensive. That's a more difficult question, since the fundamental underlying value of the HSI is the discounted expected future profits of the underlying companies. Hong Kong company profits are, in turn, heavily dependent on the growth rate of Mainland China, and it's anybody's guess as to how fast and for how long China will continue it's remarkable growth path. Hong Kong shares might still be a bargain.... we cannot know for sure.

Annoying beeps

One annoying feature of the MTR trains in Hong Kong is the beeps before the doors close. Unfortunately they're going to get worse, supposedly for a good reason. From today's SCMP:

How do you stop impatient passengers charging onto trains as the doors are closing and getting themselves or their belongings trapped? Simply increase the number of beeps.

When the number of beeps is increased from 9 to 20, travellers who are timing their run for the doors now arrive before the doors close. The newspaper article reports that since this new policy was introduced, "the number of cases of people or objects caught in the doors dropped by 10 per cent on the Kwun Tong Line in the two months after the change" and 1 to 2 percent on the Hong Kong Island Line.

I am highly sceptical. First, there's no mention of whether these reductions in objects getting caught in doors is statistically significant (1-2%? Give me a break!), and second, basic economics would predict that any benefits will be only temporary. Let's outline this second argument in more detail.

Economics views humans as rational agents, who choose their behaviour to maximise their happiness. Now we can quibble about whether this is truly what humans do, but as an empirical model of observed behaviour, it's not a bad starting point. Their behaviour will depend on the environment around them. Change that environment, and they change their behaviour- at least once they have learned about the new environment. Passengers who run for the train once they hear the beeps do so because they think they have 9 beeps to get on the train, and they value being on that train.... not the next one, even if the wait is only 3 minutes.

Now increase the number of beeps. In the short run, passengers rush for the train, and arrive in time to hear another 11 beeps before the doors close. The first time, they may be surprised by this. But eventually, if the MTR continue with their policy, they'll start to notice a pattern. They're rational, utility-maximising consumers, after all! With time, hurried passengers will start charging for the train later in the cycle of beeps, and eventually, when everyone has adjusted to the new regime, I predict that there will be just as many blocked doors as before.

Of course the MTR, in their great wisdom, could take the experiment one step further. If increasing the beeps from 9 to 20 increased for a while, why not increase it from 20 to 30? And after that wears off, from 30 to 40, and so on? If consumers are rational, even increasing the number of beeps in a predictable pattern shouldn't work eventually- as people will notice the pattern of beep increases, and start to predict this when determining their behaviour. The MTR could move up a derivative: why not increase the rate of growth of the number of beeps? Even then, rational people will eventually notice the pattern.

I plan to buy some earplugs....

Analysing the business cycle

Central banks pay very careful attention to the business cycle. If they believe that the economy is going to slow, then they can reduce interest rates to stimulate aggregate demand.

Yesterday, Ben Bernanke, the Federal Reserve Chairman, made some comments on the current state of the US economy that shed light on the difficulties in figuring out exactly what is going on in the US economy. Here, with some excellent commentary from James Hamilton is a synopsis of what he said....

http://www.econbrowser.com/archives/2007/03/about_that_down.html

Measuring Potential Output

Measuring potential GDP is inherently difficult. As we have demonstrated in class, in the short run, the outcomes we observe in the economy are based on short-run supply and aggregate demand, and these variables may move in ways that are counter to the long run ability of the economy to generate output (i.e. potential GDP). But all is not lost. There are a number of variables that are helpful in working out what is happening to potential output:

- the labour market. If the gap between the unemployment rate and the natural rate is falling, then the actual level of output will be moving closer to potential output. This is not entirely informative, since the natural rate of unemployment is unknown, and varies through time (see previous post).
- investment. If firms are increasing their level of investment, then potential GDP should be increasing, as workers have more capital to work with.
- productivity. If the level of output per worker is increasing, the rate of increase in productivity times the rate of growth in the labour force should give us a good estimate of changes in potential output.
- capacity utilisation. There are various ways of trying to measure the extent to which firms are operating at their maximum capacity.

In general, we have a better idea of potential output after the fact. Partly this is because some economic data (for example investment and productivity) is only released with a lag, so it is impossible to know how these are varying in real time. But there is an additional reason: with time we simply have more data that might be informative for determining potential output today, for the following reason.

We normally think of potential output as changing relatively smoothly over time (at least more smoothly than actual output), and moving towards potential output, as firms and workers adjust wages/prices/expectations in response to shocks. If workers and firms are rational (in that they set prices and wages based on all available information), then the difference between actual output and potential output is due to shocks that could not be anticipated by workers and firms. Then the level of actual output should be equal to the level of potential output on average. So if we put a smooth line through actual output, we can argue that we have an estimate of potential output. There's no exact science to doing this, but the most common method involves the HP filter (http://economics.about.com/library/glossary/bldef-hodrick-prescott-filter.htm).

If we want to construct a smooth line over some data to work out the level of potential output today, we only have the data up to today to use. As time passes, we will have more data points, and so the level of that smooth line today will be estimated more precisely.

No matter how we construct potential output, it will always be an imperfect measure of the ability of the economy to produce output.

Full Employment

On March 25, the SCMP had an article titled "Jobs for all in reach for first time since handover." This was written in response to the latest unemployment statistics for Hong Kong, which showed a decline in the unemployment rate to just 4.3%. Based on an estimate of the natural rate of unemployment of 3.9%, the article argues that HK is close to "full employment." (See an earlier discussion of the unemployment data here: http://hongkongmacro.blogspot.com/2007/03/latest-employment-numbers.html)

As the following graph makes clear, the unemployment rate is still far above low historical levels. In 1989, the unemployment rate was as low as 1%!


So what has changed between 1989 and 2007? First, the structure of the economy has changed. In the late 80's, the backbone of the economy was manufacturing. To put numbers on this, in 1989 there were 52,475 manufacturing establishments employing 829,000 workers. There was high demand for low skill jobs, and almost anyone could find work. By 2005, there were only 14,050 manufacturing establishments employing a mere 164,000 workers.

The decline of the manufacturing sector has been matched by massive growth of the services sector. Over the same period, "Wholesale, retail and import and export trades, restaurants and hotels" has grown from 119,000 establishments to 184,000 and from 770,000 employees to 1,050,000 employees; the story is similar in "Financing, insurance, real estate and business services" (see http://www.censtatd.gov.hk/showtableexcel2.jsp?tableID=017&charsetID=1 for details).

The difference between manufacturing and services employment is that employee-specific characteristics are more likely to be crucial in the services sector. The provision of services usually requires the employee to interact with the consumer. In contrast, in manufacturing there are typically several layers (wholesalers, retailers) separating the producers of the goods from the consumer. As a result, hiring someone with the right interpersonal skills is typically more important for a services sector job than a manufacturing job. The result of this is to drive up the level of frictional unemployment in a services based economy, as employers screen hires more carefully.

There is another adjustment going on in Hong Kong that may drive up the natural rate of unemployment as well. As a result of the decline of manufacturing, there remain a large number of relatively unskilled workers in Hong Kong who may be too old to consider undergoing retraining to prepare themselves for a job in the services sector. These individuals are likely to face longer and more frequent unemployment spells, driving up the level of structural unemployment until these individual retire.

The overall effect of these factors would increase the natural rate of unemployment. However, the Government estimate of 3.9% is just an estimate (or " good guess") of this level. If the mainland economy continues its rapid growth, which is the main engine of HK's growth, then I would expect the unemployment rate to continue falling in Hong Kong, maybe below 3.9%.

How do I do Research?

"How can I learn to do research?"

I would suggest that the only way to to develop research skills is by doing research, and reading the research of others.

I think of research as comprising the following steps...

1) What question do you want to answer? The more clearly the question is defined, the better.

2) Has the question already been answered? In the internet age, answering this question is much easier than before! Google and (for academic economics research) Econlit are the best ways to find out. You can access Econlit through the university library online.

3) Next, assuming the question has not already been answered adequately, you need to try to answer it yourself. Depending on the nature of the question, that may involve mathematical modelling (especially if you were doing a PhD or MPhil or other academic research), or statistical modelling. For the latter, you would need to find the appropriate data. There are many different sources of data; often experience is required to know where to look. As a starting point, see where related studies obtained their data. (Academic research should always clearly outline datasources; more popular research may not). There are some references on the Econ1002 course homepage of some sources of data- although they are just the tip of the iceberg.

This third step requires you to have or learn the appropriate tools in order to answer your question. For an undergraduate student, most questions you would be able to answer will be statistical in nature. A good understanding of statistics and econometrics is essential; you should be selecting your courses appropriately. If you have the ability and desire to go on to postgraduate studies, you should also be taking some difficult math courses, since these would give you an excellent foundation for later research work based on mathematical models.

4) Market your results. For academics, this is perhaps the most important step! More generally, if your research results are interesting and add to the stock of knowledge of how the world works, then you will want to pass on your results are widely as possible.

Here's a link on how to do research, although it's geared at postgrad Econ students....
http://www.infra.kth.se/se/nec/Doing%20Research%20in%20Economics.ppt#33

How dependent is Hong Kong on China?

A common perception is that the Hong Kong economy is heavily dependent on Mainland China. Most trade through the Hong Kong port, the worlds' busiest by container volume, is re-exports to/from China; many Hong Kong residents have significant capital investments in China; and China is the main source of tourists to Hong Kong (13.6 million out of a total of 25.3 million in 2006). Just how dependent really is Hong Kong?

One way to examine the degree of links between two economies is to look for similarities in the business cycles. If one economy is heavily dependent on another, then we would expect to find that their business cycles move closely together. Petra Gerlach-Kristen wrote a paper for the Hong Kong Institute of Economics and Business Strategy that showed Hong Kong's business cycle becoming more synchronised with China over time (see http://www.hiebs.hku.hk/working_paper_updates/pdf/wp1115.pdf).

The figure below, from her paper, shows a measure of the output gap for Hong Kong (labelled y(HK) ) and mainland China (y). In recent years, the two are highly synchronised. The one exception is the Asian Financial Crisis in 1997/98. This is not suprising, since we would expect the relationship between Hong Kong and China to be uni-directional: mainland China influences Hong Kong, but Hong Kong is too small to have much effect on mainland China. In the case of 97/98, in addition to suffering from the Asian Crisis, Hong Kong was battered as the real estate bubble burst. Since this shock was confined to Hong Kong, we would not expect it to have any effect in mainland China. This is consistent with the common perception.

Creative Destruction

Creative destruction, as applied to Economics, is the idea that the demise of some firms / industries may be beneficial for the economy since it frees up resources to be used more efficiently by other firms. A quote from the film "Other People's Money" carried on Newmark's Door illustrates this perfectly:

You know, at one time there must have been dozens of companies making buggy whips. And I'll bet the last company around was the one that made the best [....] buggy whip you ever saw.
Now, how would you have liked to have been a stockholder in that company?

For more, see http://newmarksdoor.typepad.com/mainblog/2007/03/devitos_speech_.html

US Recession

It has been my view for some time that the US is about to enter a recession. A major cause of this is house prices, which are now falling. As house prices fall, house owners feel poorer, and so reduce their consumption. But that is only part of the story. In addition, some home owners will no longer be able to pay their mortgages, and will potentially loose their homes. This is likely to spill over to the economy more broadly: anyone who "owns" mortgages (financial institutions, hedge funds, etc) will be poorer as a result.

Here in Hong Kong, we are no strangers to falling home prices. Between 1997 and 2004, the price of residental real estate fell about 70%. But things could have been much worse. The maximum a bank will loan, based on the value of a property, is 70%. This ensures that owners have a significant cushion of wealth if prices should start to fall. Without this cushion, prices would have fallen further and faster, and major financial institutions in Hong Kong would have been likely to fail as owners defaulted on their loans.

In the US, financial instutitions have applied a much more lax standard. Home owners were able (at least until recently) to borrow up to 100% of the value of a property, and in some cases make monthly payments that were less than the interest on the mortgage, implying that the size of the loan outstanding actually grows over time, rather than shrinking! (See, for example, this story on Bloomberg http://www.bloomberg.com/apps/news?pid=20601087&sid=a8ilcv.eOxMc&refer=home). This practice is foolish at best, and suggests that prices may come down a long way before they stabilise. If it is very easy to buy a home due to lax credit requirements, the demand for homes will be relatively higher, pushing up prices in the first place. Then, when the correction comes and home prices start to fall, the number of people who loose their homes will be much larger, and so the supply of homes will increase much more than it otherwise would have, driving down prices further. In short, very easy credit implies very volatile prices. I won't be surprised if house prices in the US fall by 20-30% in the coming 2-3 years.

Zimbabwe in freefall

There's an excellent post on Zimbabwe in the latest Time magazine.... http://www.time.com/time/world/article/0,8599,1601081,00.html?xid=site-cnn-partner. Zimbabwe is an excellent example of the importance of good government and law and order to maintain economic growth.... and the perils of bad government.

GDP vs. GNP

"In China, a large part of GDP takes place in foreign-owned factories. If we want to mesaure the standard of living in China, wouldn't it be better to use GNP than GDP to allow for this?"

In prinicple you are right. Any profits earned by foreign firms in China ultimately benefit the owners of the foreign firm, rather than people in China. These profits are included in China's GDP, but not in China's GNP. GNP would therefore make a better measure of Mainland China's standard of living.

Ultimately, however, this is an empirical matter, and the difference between GDP and GNP is typically small. For example, in 2005, Mainland Chinese GDP was larger than GNP by 1.5%. The reason for this is that just as the rest of the world owns lots of assets in Mainland China, Mainland China owns lots of assets in the rest of the world. In fact, Mainland China owns more foreign assets ($1218 Billion USD in 2005) than the rest of the world owns Chinese assets ($931 Billion USD) according to the IMF's International Financial Statistics. Many of the Chinese assets earn only small returns (for example, US Government issued Treasury Bills), hence the income flow favours the rest of the world.

Hong Kong is a more extreme case: in 2005, Hong Kong entities owned the equivalent of 8.5 times Hong Kong's GDP in foreign assets, while the rest of the world owned 6.0 times Hong Kong's GDP in Hong Kong assets. Both these numbers are huge by comparison with most other countries, but the difference (Hong Kong's net asset position with the rest of the world) is a whopping 2.5 times Hong Kong's GDP! Yet in 2005, the difference between Hong Kong's GDP and GNP was a miserly 0.2% of GDP. That was low compared with most other years, but as the following graph shows, the differences are usually small, even for Hong Kong.

Latest Employment Numbers

THe Hong Kong Census and Statistics Department just released the latest employment data, covering the Dec 2006 - Feb 2007 period. They report that the unemployment rate has declined to its lowest level since 1998 (4.3%).



However, at the same time, total employment and the labour force also declined slightly, by 8000 and 11000 respectively.


While one month's economic news may be due to one-off factors and may not constitute a trend, this is mixed news for the economy. The economy is not creating new jobs, and the only reason for the fall in the unemployment rate was that people were leaving the labour force faster than jobs were disappearing!

The most popular labour market statistic is the unemployment rate, but just focusing on that can be misleading. A strong labour market is one where the labour force participation rate is growing (a larger portion of the working age population wants to work), the employment ratio is growing (a larger portion of the working age population is working) AND the unemployment rate is falling.

The size of the population is required to calculate the first two of these statistics, and this is not available on a monthly basis. So the only way the participation and employment ratios are rising is if the working age population fell by 0.3% or more. While this is possible, it is highly unlikely: the working age population in Hong Kong (defined as persons aged 15 and over) is growing at about 1.3% per year, as the population ages. Any sudden change to this is likely to be due to a spike in emigration, which would be a concern for other reasons.

Household Production and Measured GDP

"The value of the household production is hard to measure. But can I draw the conclusion that the value of real GDP plus household production is lower in the recession than in the expansion because the standard of living is lower?"

That's not clear. If I produce something in my home to consume (such as a home cooked meal), it clearly increases my standard of living, yet the value added by cooking my own meal is excluded from GDP. In a recession, if consumers are more inclined to consume household produced goods, then measured GDP will systematically exaggerate the negative effects of recession. This is plausible, especially if you think about the effect of recessions on the service sector (restaurants and entertainment in particular).

The Other Side of the Carry Trade Coin

Yesterday, I looked at the relationship between volatility and the value of the Japanese Yen. I argued that "carry trade" provides the link between the two. When volatility increases, speculators holding short positions on Japanese Yen and long positions on other currencies get nervous and reduce their positions. This reduction in carry trade causes the Yen to appreciate.

But what about the other side of the transaction? Carry trade entails borrowing Yen at low interest rates in order to invest in other currencies offering higher interest rates. If carry trade is driving the Yen exchange rate, then surely it is also driving the exchange rate of the "other" currency (or currencies) that these speculators are investing in.

One key currency that might offer evidence of this is the New Zealand Dollar. While the Yen has the lowest interest rates among developed economies (the trend-setting central bank rate is 0.5%), New Zealand has the highest (just increased last week from 7.25% to 7.5%). Also, while the New Zealand economy may be small (according to http://www.photius.com/rankings/economy/gdp_official_exchange_rate_2007_0.html, it ranks 49th in the world by GDP- between Chile and the Philippines), it has no capital controls and a clean floating exchange rate- with no Government intervention in exchange rates for many years, making it an attractive target for speculators who want to be able to move their money around freely. According to http://www.ezinearticles.com/?Which-Are-The-Top-Forex-Currencies?&id=473454, it is one of the 8 most traded currencies in the world!

The figure below shows that the New Zealand Dollar moves in inverse to the Japanese Yen, especially since late-February (note that one of the exchange rate series is already inverted). Added to yesterday's arguments, this is consistent with carry trade being the main driver of both the Yen and NZD exchange rates at the moment.


Of course there are many other variables that also determine exchange rates: expectations of future economic growth, trade flows, foreign direct investment, etc. But at the moment, in a period where volatility is volatile (!), the importance of these variables pales in comparison to Carry Trade. I expect the world economy to remain volatile for some time, with increasing evidence each week that the US economy is soon to enter recession. If I am correct, Carry Trade will remain the main determinant of many currency values. Once stability to the world economy returns, then I expect to see increasing evidence that other variables matter as well.

Exchange Rates and Share Prices

Consider the following graphs:

The Japanese exchange rate and the value of the Nikkei 225 (the main share index in Japan) have been moving very closely together, especially this year.

There's also a very strong link between the exchange rate and the VIX index. I'm going to argue that these two are linked.

One of the main drivers of the exchange rate in Japan is what is called "carry trade". Interest rates are lower in Japan than in any other major economy. Therefore speculators can borrow in Yen and invest in higher yielding currencies overseas. When they do this, exchanging Yen into other currencies increases the supply of Yen, and so causes the value of the Yen to fall. And provided exchange rates don't change very much, the speculators can earn large profits from their investments, especially as they can be highly leveraged- using futures contracts on currencies, speculators can effectively borrow and lend many times the amount of money they have to invest.

It's difficult to estimate exactly how large the carry trade is, but it is potentially a very large portion of total currency flows with Japan, and therefore an important determinant of the exchange rate. Note, however, that carry traders can make large losses if the Japanese Yen appreciates significantly: they end up needing to repay their Yen debts at a higher price. Speculators wish to avoid this possibility by closing out their positions (that is, effectively repaying their Yen loans) whenever they believe that there is a high probability that the Yen will appreciate. But this is self-fulfilling: if enough speculators close out their positions at the same time, the Yen will appreciate as a result.

Any evidence of increased future volatility tends to make speculators nervous, and so they close out their positions. One excellent measure of expected future volatility is the Chicago Board of Exchange Volatility Index (VIX), which measures the amount of volatility predicted by futures contracts on the S&P 500. On February 26, this jumped by over 50%, causing speculators to close out their carry trade positions, and the Yen to appreciate by almost 2%. Since then, the two have moved in lock-step: when volatility in the VIX increases, speculators close out their positions, and the Yen appreciates. When volatility decreases, carry trade increases, and so the Yen depreciates. This pattern is likely to continue in the near future.

The link with share prices in Japan is because the real cost of investing in Japanese companies for outsiders moves in lock-step with the exchange rate. If the value of the Yen falls, Japanese companies are relatively cheap, so capital flows into Japan to purchase shares in Japanese companies. The effect of these inflows reduces the size of the depreciation caused by the carry traders, but is not enough to fully reverse it.

Another way to represent the data is in the following way: March 16 2006- March 16 2007, the correlation between the VIX and the Yen/USD exchange rate was 0.53, while the correlation between the Yen/USD and the Nikkei 225 was 0.52. Since February 1 this year, those correlations have jumped to 0.88 and 0.70 respectively. Based on the graphs above, this story can explain most of the behaviour in Japanese macro data in recent weeks.

Residential Investment

"Why is buying residential flats in Hong Kong a form of investment?"

When we calculate total spending in the economy in order to measure GDP, it is divided into consumption (all spending by households EXCEPT residential investment), investment (spending on capital goods, INCLUDING household purchases of new homes, plus inventories), Government spending on final goods and services, and net exports (see http://www.censtatd.gov.hk/hong_kong_statistics/statistics_by_subject/concept/national_income/index.jsp for a discussion of the components of GDP in the Hong Kong context). Residential investment receives different treatment from all other household spending. Why?

Residential investment shares some characteristics with durables (furniture, cars, electical appliances, etc), which are included in consumption: both are purchased to be used over time rather than consumed at a given point in time. However, in other respects residential investment is much more like a capital good that a firm purchases. First, it is purchased to provide a stream of services (a place to live) in future periods. Second it does not get used up in providing those services. And third it is a very large investment that is often financed with borrowing.

So the view from the statistical office is that households invest in housing in order to enjoy a stream of future services. They then consume the services from the house, rather than the house itself.

For flats that are purchased in order to rent out as a source of income, this is clearly the appropriate treatment: the landlord uses the flat as a capital good in order to earn future revenue. In the case of owner-occupied housing, we treat the owner as both the landlord and the tenant! The owner buys the flat (an investment good) and receives rent from the tenant (himself) in return for owning it.

This treatment of housing is applied to other statistics as well. For example, when the Consumer Price Index is computed (see http://www.censtatd.gov.hk/statistical_literacy/educational_materials/introduction_to_the_consumer_price_index/index.jsp), the price of new houses is excluded. Instead the Census and Statistics department imputes a rent to home owners, and it is the value of this rent that enters the CPI.

This may seem like a strange way to treat housing, but as long as it is applied consistently, the data are not misleading. There are many different "correct" ways that statistics can be computed.

Hong Kong Life Expectancy

Why do people in Hong Kong live so long? From the latest news (http://www.gulf-times.com/site/topics/article.asp?cu_no=2&item_no=137602&version=1&template_id=45&parent_id=25), people in Hong Kong- both men and women- have longer life expectancy than anywhere else. This is a puzzle: Hong Kong has relatively high levels of stress and pollution, and people live in cramped flats.

One possibility I've heard is that maybe stress is good for you- especially in old age. Consider a quiet retirement in a Western country: it is easy to not be stimulated, day after day. This lack of stimulation may speed the onset of death. In contrast, in Hong Kong all you have to do is look out the window or stand on the street corner, and there is stimulation all day (and in some areas all night as well!) as the world passes by.

What are you views? Why do people in Hong Kong live longer on average than anywhere else? (Here's a related link... http://www.biorap.org/rg/rgagelifestyle.html)

Why is Growth important?

"Why is 'growth' in GDP important? If GDP can be kept constant every year (that means zero growth rate), what's the problem to the country or even to the world?"

That's a great question that gets at the very core of economics. Generally we accept in Economics that increases in wealth, income, and consumption levels are desirable. That's because we view consumers as being utility maximisers, who derive increased utility from increased consumption. In such a model of the world, increased GDP implies increased utility. If the role of Government is to maximise the welfare (utility) of consumers, it should institute policies that are therefore consistent with maximum growth rates.

So given our model of the world, consumers have higher utility the higher is their consumption level. But utility is unobservable, so we cannot directly test this hypothesis. Most reasonable people would agree that at low levels of income, an increase in income clearly makes people better off. They are able to eat better food, live in a more comfortable physical environment, enjoy better health, and generally suffer less throughout their life. This is the stage of development for many parts of rural mainland China to this day.

But once we have all our basic human needs met, are we still better off with economic growth (i.e. increased incomes and consumption levels)? That may be disputed by some, although I can assure you, that at the margain, I think I would be happier with a better car, a nicer flat, or more holidays.

But maybe this is delusional. I also observe people who seem to be fully content with their current modest standard of living, and appear to be making no effort to improve upon it. My interpretation of this is that learning to be content with your standard of living is itself an important contributer to enjoying a high level of utility.

Following this argument, if contentment matters more than growth for welfare once basic human needs have been met, then Governments of developed economies maybe should focus less on growth and more on other matters that play an important role in welfare, like the environment.

I'm weary of that conclusion, however: many of the steps that I would advocate a Government to take in order to encourage economic growth (efficient Government, good health care and education, property rights, democracy) are good in their own right, and make people better off independent of their effect on economic growth. The fact that they happen to encourage economic growth is an added bonus.

Inventories and Growth

"Does a decline in unplanned inventories always imply higher economic growth in the future?"

That all depends. Recently, 2006Q4 GDP growth in the US was revised downwards from 3.5% to 2.2%; almost half of that revision was due to a decline in inventories. In principle, if firms experience a substantial decline in unplanned inventories, we would expect those firms to seek to replenish their inventories by increasing production in future, which would increase GDP.

However, suppose the decline in inventories was largely made up of imported goods to begin with. Then the resulting increase in GDP will not be in US, but instead overseas. Such a reduction in inventories would tell us little about future US economic growth.

In some circumstances, a decline in inventories may actually suggest less growth in the US, rather than more. Suppose the decline in inventories is confined to oil and related products. The US is the largest user of oil, and demand for oil is relatively inelastic (that is, the demand curve is steep so quantities demanded do not change very much when prices change). If US inventories of oil fall, the resulting increase in world demand for oil to replenish inventories will raise the world oil price. Consumers will be spending a greater portion of their incomes on oil-related expenditures, leaving less to spend on US-made goods and services. Thus a decline in oil inventories would suggest less future economic growth in the US, not more.

Which of these is currently the case is an emprical question; I haven't tried to figure it out. This news story ( http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a5phQR9mbIuQ ) suggests the decline in inventories was planned (and therefore should imply little for future growth rates in the US) while this one ( http://www.bloomberg.com/apps/news?pid=newsarchive&sid=asXGkcI1fLsg ) says oil inventories plunged last week. If the decline in oil inventories is a large part of the overall decline in inventories, this would be consistent with lower future US growth rates.

Exchange Rate Fluctuations

From last week....

"In today's lecture, we talked about the huge decline in the stockmarket. In today's newspaper, one article said that JPY increased to 119 againstthe USD yesterday because of the US stock market. Since the stock prices reflectthe expetation of the company's future revenue, does it imply that the macroeconomy will experience a recession so that the US dollar will be weaker? Is the stock price one of the factor that influence the exchange rate? And what does the currency reflect in terms of an economy? When I read the newspaper, I always see that stock prices and exchange rates fluctuate a lot. In the daily chart or the weekly chart, it is very difficult to estimate the trend, but in the yearly one, we can see thetrend more clearly. What kind of information, index or policy will have the greatest impact in the long run?"

In the short run currencies can move significantly due to all sorts of different reasons. For example, interest rates in Japan are the lowest of any major currency. Therefore people tend to borrow Yen in order to invest in other countries where interest rates are higher. The amounts of money involved are huge, and any change in these flows can cause a large movement in the exchange rate in the short run. In the long run, things like expectations of the future macroeconomic performance of the economy should have a relatively larger effect on exchange rates. If the US does experience a recession, I would expect the USD to depreciate relative to other major currencies..... assuming that other major economies do not also have a recession at the same time.

Why slow down Mainland China?

"The latest news reported that mainland China plans to slow its economy and reduce the GDP growth rate to 8% this year from last year's double-digit expension. I wonder why it's necessary to reduce GDP growth rate? Isn't it the higher the better? Could you explain this for me?"

There is a lot of talk of "overheating" in the mainland economy. The basic idea is that very high growth rates may not be sustainable. If the mainland economy is growing at 10%+ per year, every year, maybe firms and property developers will start to make careless investment decisions- overinvesting in real estate and fixed capital. In the short run, the effect of overinvesting increases the growth rate of the economy. But eventually they would be forced to cut back on their investment severely, leading to a large drop in the growth rate, or even a recession. Think of the mainland government preferring stable growth of 8% instead of higher growth that may be unstable in the future.

Introducing HongKongMacro!

I've decided to start a blog! The purpose of this blog is primarily to meet the needs of my Econ1002C/D students. Often I receive questions from my students that are related to the current news or the course material in Intro Macro. I enjoy responding to those questions, but I suspect that for every student who bothers asking me a question, there may be many who would be interested in seeing the answer. From now on, I plan to respond to the more interesting questions here. So please go ahead and ask your questions by email. Of course if I get too many questions, I'll need to filter them (time is a valuable resource), but we'll see how we go.... Any announcements related to the course itself will remain on the course homepage.