Where is the Bottom?

So mainland shares have started falling- finally- in the wake of the tripling of stamp duties. Just how far will they fall, and does this represent the end of the bubble market?

These questions are impossible to answer definitively. First, day-to-day market performance depends crucially on sentiment and expectations. I will not even pretend to be equiped to make a prediction on how these will play out in the coming days. However, I am encouraged that for a second consecuative day a number of major equities have fallen by the maximum allowable 10% daily decline. (Update: they've bounced back....)

Second, just as it's impossible to be certain that the market represented a bubble (rather than the rational expectations of investors) in the first place, so it is impossible to be sure that the market has in fact returned to fundamental levels.

But in the case of China, there are some indicators that we can look at. First, A-shares listed in Shanghai were trading at an average premium of about 200% over H-shares of the same companies listed in Hong Kong. Even though capital controls effectively segment the market (mainland Chinese cannot invest in Hong Kong equities), this difference is far higher than can be justified by fundamentals. Even without a bubble, some difference in price will remain: the fundamental price of equities depends on the opportunity cost of not investing in the next best alternative instrument. Hong Kong's openness and capital mobility provide a vast array of possible investment products, potentially decreasing the value investors place on holding shares in mainland companies relative to their mainland counterparts. Without being very precise about it, I'd guess that this could account for about a 20% - 50% premium... far less than the original 200%.

And second, we need to stop seeing stories like these ones

"About 10 percent of maids in Shanghai resigned because they made more money trading shares......"

"Investors on May 28 opened 455,111 accounts, a daily record. "

My best guess: we need a few more days of the major shares declining their maximum 10% before we can say with any confidence that the bubble has been deflated. Ideally this will also leave investors with a more informed view of the risks they take when they hold equities, driving out unrealistic expectations of market gains at the same time.

Pop Goes the Bubble (2) ????

So the mainland authorities have followed (1) from my earlier post.... they've trebled transaction fees, and the equities market have declined in response. It remains to be seen if they've done enough to prick the bubble, or even to stop it rising further. In that case, there are still (2), (3), and (4) to go....

Pop Goes the Bubble...

What do bubbles look like when they burst? That all depends on the characteristics of the market with the bubble. Sometimes it may burst quickly, like a balloon, and other times it may takes months or even years to correct.

The reason for this is that bubbles develop when market expectations of future prices de-couple from market fundamentals. Bubbles burst when those expectations change. Changes in expectations depend on the flow of information, and this varies with the market.

Take, for example, the housing market in the US. This bubble is bursting as I write.... but slowly. The latest figures show that home prices declined 1.4% in the 12 months ending March 31. How could such a small price decline represent a bursting bubble?

One key feature of housing (especially outside of Hong Kong high rises) is that houses are unique. As a result, they are highly illiquid- a sale depends on a match between a prospective buyer and seller, and few buyers will simply buy the first house they see. Matching takes time, so the market is sluggish. That sluggishness translates into information flowing slowly through the housing market, and sluggish expectations.

Uniqueness also makes determining the price more difficult. Any two houses are likely to differ along many dimensions, so even if you think that equilibrium prices may have fallen, any fall is small relative to the overall price variation between houses. Yes, average prices may have fallen by 1.4%, but the most desirable houses in a neighbourhood still sell for a price that is a multiple of the least desirable. Paying attention to the differences between houses is far more important to the individual buyer or seller than paying attention to movement in the average price.

Additional sluggishness stems from uncertainty. At times like this, many potential buyers may simply stay away from the market because they do not know which direction the price is going, reducing the number of sales that take place. Fewer sales imply less information and slower learning.

Where these information asymmetries are partially alleviated, the collapse of the bubble may be faster. For example, the price of new homes in the US dropped 11% over the past year, and some home builders expect the market to take until 2011 to recover. What's the difference between the new home sector and the second hand market? The former is dominated by larger players, selling many homes, with similar characteristics, while the latter is mostly individuals selling a single unit. The former therefore have a much better idea of the overall direction of the market. They were faster to cut prices as they recognised the change in trend. I expect that second hand homes will follow new homes down in price, perhaps by a similar magnitude, although it is not yet clear that even the new home market has bottomed out.

Equities are a stark contrast from homes. They're liquid, generic, and price is public knowledge. Up until the latest house price data was released, various analysts were speculating on what the price of housing was in the previous month! In comparison, no one has any doubt as to what the price of shares was just a few minutes ago. So when the market does change, expectations adapt quickly. Participants rapidly adjust their positions, and the market adjustment continues. This process is further exsacerbated by "stop-loss" orders, where investors can agree to sell their holdings automatically if the price falls below some pre-set limit. Clearly it's impossible to have a stop-loss order on your house!

For more on the US housing market, Calculated Risk has some excellent analysis on all the latest numbers. See also Nouriel Roubini's blog

A quick recent history of the Hong Kong Economy...

....thanks to William Mellor at Bloomberg.

Evidence of Competence

How much Faith should you put in the Government? Xavier Sala-i-Martin, an economist at Columbia, says not much, and points to this as the reason why.

I'm not sure that we can blame all those examples on the Government, which doesn't have a monopoly on incompetence. But they're funny anyway!

Property Rights....

Well established and enforced property rights offer enormous benefits for economic growth, the environment, social well-being, and just about everything else! See this link on Niger, on the benefits from property rights on trees.

Ignorance is NOT bliss....

From Saturday's SCMP, the Mainland National Social Security Fund chairman Xiang Huaicheng was reported as saying

"the holders of the 100 million stock investment accounts include retirees, teachers, civil servants and even monks, most of whom do not understand the stock market."

And this is supposed to be re-assuring? See my earlier comments here.

How to Pop a Stock Market Bubble...

Continuing with my recent theme, today I will suggest ways for the Mainland authorities to pop the equities bubble. Fundamentally, too high a share price implies too much demand or too little supply of shares. Ultimately any meaningful solution must address at least one side of the market. So what can be done?

1) increase transaction fees. Many recent participants are flipping shares with high frequency. Tax them for their troubles, and some participants will cool their activities. Note that transaction fees would have little effect on long-term investors, but only those "frequent flippers."

2) Tax capital gains to reduce the benefits from short-term speculation.

3) encourarge foreign firms to list in Mainland China. Yesterday I mentioned that A-shares in Shanghai trade at approximately 3 times the price of the equivalent H-shares in Hong Kong, even though they are effectively the same shares. This is as a direct result of capital controls preventing investors from arbitraging between the different markets. Capital controls segment the market, limiting the potential investments that Mainland savers can access. as a result, asset prices in the Mainland trade at a premium over equivalent assets elsewhere.

If capital controls cannot be dismantled in the near term, then why not try to encourage foreign firms to list in Mainland China? Given the huge savings rates and high price-earnings ratios, this must be an appealing prospect to some firms, as it implies that it would be a relatively cheap way to raise capital. In addition, there may be a political pay-off for such firms in the future as China continues to develop.

If foreign firms list in the Mainland, the total supply of available shares increases, effectively putting downward pressure on share prices.

4) Reduce Government share holdings. In general, only a small portion of the total number of available shares are actually traded; the rest are held by the Government. If the Government reduced its holdings, the supply of shares would increase, reducing prices.

5) Do nothing. In the short term, this is the path of least resistance. But the longer the Government follows this route, the larger the bubble may get. Then one day, when the taxi drivers / university students / pensioners wake up and all realise collectively that their life savings / tuition fees / retirement savings are all built on a house of cards, they'll try to sell their investments. But selling shares requires a buyer, and they're likely to be in short supply! So prices will come crashing down.

Even if the mainland market is not a bubble, some of these steps are desirable in their own right- e.g. 3) and 4).

What other solutions have I missed?

Bubbles Continued....

Further to yesterday's post, I just learned today that there are no instruments available to investors in Mainland China to short equities, in contrast to most other major markets.

The lack of instruments for shorting equities increases the likelihood of a bubble, for the following reason. If I believe that the market will rise, I can easily place my "bet" by buying equities. In contrast, if I believe that the market will fall, I can also also place my bet, by shorting equities. If there are equally efficient means for placing bets on either side of the market, then the share price should reflect the overall beliefs of the market, and, as long as markets are reasonably rational, equity bubbles should be rare.

My complaint in yesterday's post was that there are more efficient instruments available for investors to bet on increasing equity prices than falling ones. As a result, prices tend to reflect more the beliefs of the optimists, and less the beliefs of the pessimists. It's even worse than that: knowing that the market will continue to disproportionately reflect the beliefs of the optimists means that even rational pessimists will be more likely to invest in equities, despite their pessimism, because the possible gains from market growth exceed the possible gains from market contraction. So equity price bubbles last longer, and have larger real effects when they eventually burst, all because of a lack of efficient instruments to short the market.

Now I learn that in Mainland China, the problems are even worse. There are simply no tools available to short the market. Thus the most that pessimists can do to reflect their pessimism is close their investments and remove their money from the market. As long as there are enough optimists remaining, the market will continue to grow. It's only when the optimists become pessimistic that the market can meaningfully correct.

Combine that with a market consisting of millions of novice investors, who have not experienced any major market falls. In the West, we know that share prices fell about 90% in the Great Depression. On October 19th 1987, the Dow dropped 22.6% in a single day. These events are part of our consciousness; we understand the risks of investing, knowing that while returns are there to be made, they are not guaranteed.

Is the same consciousness present in the Mainland Chinese investors? Investors who are willing to pay on average 3 times the price for A-shares than investors in Hong Kong pay for the equivalent H-shares? I fear not.

The possible consequences- economic, social, and political- of a substantial correction in Mainland share prices are staggering. Just to bring the A-share prices in line with H-share prices would require a 60% fall in Mainland share prices. But the high A-share prices likely increase the perceived value of the H-shares, so any major correction could be even larger than that.

For a optimistic outlook, check this Economist article (thanks to Mike for the pointer). If you want more pessimism, check this bloomberg article by William Pesek.

Growing Consensus on China....

Alan Greenspan joins the chorus.... Mainland China is in the middle of an equities bubble.

How long can bubbles last? In principle, for a long time. The reason is that it is very difficult to make money from knowing that the market represents a bubble, even if you turn out to be correct.

At the risk of displaying my ignorance of the nuances of financial markets, I'll develop this argument further. First a couple of disclaimers: I'm a macroeconomist, NOT a financial advisor. What follows is intended to stimulate discussion, NOT as investment advice. OK- on with the argument.....

Suppose Greenspan, Li Ka-shing, and Yetman :-) are all correct. To profit from this, one could short mainland equities, and generate income from their inevitable decline. But shorting equities is costly. If you're correct, you make a large profit; if you're wrong, and equity prices continue to rise, you loose 100% of the capital you spent shorting them. In the meantime, you've also lost out on the continuing share price appreciation by being absent from the market. So even though you will eventually be correct, you might have lost so much potential gain that you would have been better off staying in the market!

The result of this is that investors who believe that the market is a bubble might be better off keeping their positions while buying partial insurance against a market correction by shorting the equities, rather than pulling their investments out entirely. Thus investors are biased towards making bigger bets on continued market growth than might be optimal. So the bubble continues for longer than it should, and when it crashes, it falls further.

If I'm right, bubbles are more persistent and more economically damaging because of an underlying asymmetry in share price instruments: it's easier to make money from an expanding market than a contracting one. All we need is access to instruments that allow investors to benefit from a declining market more efficiently, reducing their incentives to bet against a market fall.

Consider, for example, "inverse shares" whose value moved in opposition to the market. If the share price increased by 2%, the "inverse share" would loose 2% of it's value. They'd provide an efficient way for the median investor to effectively purchase an entire portfolio of short positions that are currently only available to large, institutional investors.

I'm sure there are a million reasons this wouldn't work, and I'm looking forward to reading why in the comments!

(See also my earlier posts on bubbles here and here).

Will China be the leading nation in the 21st century?

In this 2005 blog post, which is still as relevant today as it was then, Gary Becker, 1992 Nobel Prize winner, suggests a cautious "probably not."

Rapid growth over the short term from a low starting point does not necessarily translate into continued rapid growth in the longer term. In essence, it's easier to generate rapid growth when you're poor. China will struggle to maintain this as it gets wealthier.

Becker also points out that there have been many other cases of countries growing rapidly that have led to misplaced views on their eventual economic domination (Germany, Japan, Russia).

Read more here.

Monetary Policy and Dragon Slaying

The objectives of monetary policy are very different in different economies. For example, Singapore seeks to stabilise the exchange rate against a basket of other currencies. Many central banks seek to maintain the inflation rate on consumer goods in the low single-digits (referred to as "inflation targeting"). The Federal Reserve in the United States seeks to "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," although in recent years its behaviour has looked much like an inflation targeter.

Stepping back, each of these objectives is chosen based on an over-arching concern that monetary policy should increase stability in the economy. Because economies have different structures, different objectives may be appropriate for different economies, and at different times.

To understand why "inflation targeting" is so popular today, a little history is helpful. The 1970's were a disastrous period of monetary policy. Inflation rates increased into the high teen's in many developed economies, reducing economic stability. Inflation targeting was an appropriate and timely foil to this problem. It was pioneered by one of the worst performing central banks in the developed world over this period, the Reserve Bank of New Zealand, but was quickly adopted by other countries as a transparent way to maintain stable inflation at minimal cost to the real economy.

So the inflation dragon has been slayed; does that mean that central banks can relax, knowing that they are achieving their objectives? Unfortunately, the answer is "no." While price stability is important, it is just one element in achieving a stable economy. Further, there is increasing evidence that slaying the inflation dragon has allowed another, potentially more ominous dragon, to grow in its absence.

What I am talking about here is asset price bubbles. Low and stable inflation over a decade or more has ensured that consumers and investors at large have come to expect low inflation in the future. They know that if the inflation rate jumps, the central bank will quickly respond by increasing interest rates, stabilising inflation. Thus, not worried about surprise inflation, they are content with moderate wage increases, sustaining low inflation as an equilibrium.

With little inflationary pressure, central banks have been able to increase the money supply (or equivalently lower real interest rates) below historical levels. The resulting cheap credit and excess liquidity has led to increased demand for assets, pushing up equities and real estate prices in many countries. To some extent, this is an appropriate outcome: lower real interest rates imply that the opportunity cost of owning equities or real estate is lowered, encouraging higher real prices. My concern is that this process has gone too far, and the prices of many assets now exceed fundamental levels. And when asset price bubbles develop, they must eventually burst.

Examples of possible asset price bubbles vary by country. In the US, UK, Australia, New Zealand, Spain, etc, I would point to real estate as a probable bubble, and one that is starting to burst in the US at least (see my earlier posts here, here, and here). For China, the bubble appears to be equities (see my earlier posts here and here).

Suppose that the arguments I'm making here are correct. Because boom-bust cycles are disruptive for the real economy, monetary policy is not achieving its ultimate objective of economic stability, regardless of its effectiveness at stabilising prices or exchange rates.

What should we do about it? That's the million dollar question! In principle, existing monetary policy tools could be used to try to prevent asset price bubbles developed, but that may require extreme changes in interest rates, which themselves would be destabilising. I'd also be very skeptical of the ability of any central bank to correctly detect bubbles in the long run. That is because it is not always clear whether a rapid increase in asset prices represents a bubble.

But there are some simple first steps that a central bank could take. For example, if inflation is benign but asset prices are roaring ahead, the central bank should be hesitant at cutting rates, and maybe should raise rates at the margin.

These are just my preliminary thoughts on this important topic. I think that this is one of the potential big new areas where central bank behaviour is likely to change in the coming decade, although I have no idea at this point what form such changes are likely to take. I'll blog more on this topic in the near future.....

The "Forever Stamp"

Changes in the price level are costly. As a result of inflation, firms need to adjust prices; employers and employees need to renegotiate employment contracts; governments need to adjust tax schedules; and the lack of co-ordination between firms, employers, and governments affects relative prices, distorting resource allocation and reducing the efficiency of the economy.

But some of the costs of inflation may be avoided. Take, for example, this story. It is now possible to buy stamps in the United States that have no price on them, but are valid for sending a letter at any time in the future. To the extent that consumers buy these stamps, they protect themselves from future stamp price increases, and they save the US Postal Service future menu costs when stamp prices go up, as they will no longer need to update the "Forever Stamp".

Given the chance, should you buy such stamps? Yes, they provide the opportunity to protect yourself against changes in the cost of stamps. But they also require that you hold stamps, sacrificing possible investment returns from holding your wealth in some other form.

Given that the real (that is, inflation adjusted) return on most investments is positive, there is little incentive to buy these stamps unless you expect the price of stamps to increase at a much faster rate than overall inflation.

This constitutes a compelling argument AGAINST buying the stamps. As the Slate story argues, stamp prices in the US cannot increase at a faster rate than the overall inflation rate by law. So keep your money in the bank, and deal with future price increases as they arise.

That brings me back to the original point. Yes, inflation may be costly. But protecting yourself against inflation may be even more costly.

Chinese Monetary Policy... Divisible by 9....

Why are interest rates in Mainland China always divisible by 9? Here's Greg Mankiw, thanks to Marginal Revolution for the pointer.

Hong Kong's Monetary Policy... continued

In my last post, I argued that HK doesn't have independent monetary policy because of the fixed exchange rate. Here I respond to the question

"Why doesn't the same argument apply to the US?"

The key difference is the exchange rate. Between HK and US, there is very little exchange rate risk. Therefore any difference in interest rates can be arbitraged by investors, at little risk to investors.

In comparison, between most currencies, exchange rate risk is high. For example, interest rates in the US are about 4% higher than Japan. That means borrowing yen to invest in the US yields approximately 0.015% in expected return per trading day. But this is trivial compared to the exchange rate risk.... according to Bloomberg, today the Yen has depreciated by 0.11% so far today already- that's an order of magnitude larger! Today the depreciation of the Yen would increase the profits of someone engaged in arbitrage. More generally, it might increase profits or wipe them out, replacing them with large losses.

The important point is that the exchange rate change is typically far larger than the interest rate differential. Investors are risk averse, so exchange rate uncertainty leads them to avoid fully arbitraging interest rate differentials.

That doesn't mean that investors aren't engaged in borrowing low interest rate currencies like the Yen to invest in higher interest rate currencies like the USD. It's called the Carry Trade- see my earlier posts here and here.

Hong Kong's Monetary Policy

Why can't Hong Kong set it's own monetary policy?

The answer is very simple...

The essence of monetary policy is interest rates. If a government or central bank effectively set the interest rates for an economy, it can set its own monetary policy.

Hong Kong does not have this luxury. Suppose interest rates in Hong Kong were higher than that in the US. Investors will transfer wealth from the US to Hong Kong (buying HKD with their USD) in order to profit from the price difference. The result of increased demand for Hong Kong currency will increase the supply of money in Hong Kong. An increased supply of money lowers the Hong Kong interest rate, as the financial system soaks up the excess liquidity. This process continues until the interest rate difference is too small for investors to profit from moving currency between the two economies.

Any remaining differences in interest rates should be explainable by one of two things:
1) Transaction costs. The steps outlined above are not cost-free; thus arbitrage will not fully remove interest rate differentials
2) Fixed exchange rate credibility. If investors believe that the fixed exchange rate regime may be changed, then the equilibrium interest rate differential will reflect expected exchange rate gains or losses and also the risk to investors of being exposed to exchange rate volatility.

Zimbabwe Inflation.... 3731%

The title says it all. See here for more.

The Mainland Chinese Bubble

Further to my earlier post here, Li Ka-shing says that Mainland Chinese equities represent a bubble right now. As Asia's richest resident, the 9th richest in the world, and a long history of success in business, his views should carry soem weight.

Equities are up 85% so far this year, and almost 300% over the past 12 months. The average P/E ratio in the CSI 300 is 43- suggesting an expected fundamental return (that is, ignoring capital appreciation) of 2.3% (in contrast, the average P/E in the HSI in Hong Kong is 16, implying fundamental returns of 6.25%). New brokerage accounts are being set up at a rate of 300,000 per day. This market is due for a crash... it's just a matter of time. See this story for more.

Universities... Iraq Style

War has many consequences, few of them good. Here is a news story about universities in Iraq as a result of the US invasion. Apparently being a university professor is a dangerous occupation, and worthy of being specifically targeted by the insurgents.

But this is not just a story about university professors. Stepping back, universities play a vital role in developing human capital. The long term economic costs of the invasion of Iraq, even IF it ends peacefully, depends most strongly on how much human capital has dissipated in the interim.

The loss of human capital may be far worse than death and injury statistics suggest. Where professionals are forced to stay "... at home almost 24 hours a day, seven days a week," in order to increase their likelihood of survival, their human capital is slowly deteriorating, through disuse. It's an example of hysteresis.

The North Korean Model....

The Hermit Kingdom is an excellent teaching tool, and makes my job easy. Just look at the economic decisions made by deranged despots, and argue for the opposite. Google a few recent news articles on whatever is making headlines in those countries, and you even have some relevent, interesting, real-world illustrations to keep your students awake during lectures.

Consider two recent news stories carried by Bloomberg. Here we learn that North Korea's : "Arirang mass games," ostensibly put on to showcase the worker's paradise to the world, involves twice as many performers as spectators. That's a great example of a profitable business model.... NOT!

Here's another, discussing the lavish palace built to hold all the gifts given to the "President for Eternity" and his son, North Korea's current leader. At the same time as wealth is being allocated to such high priority tasks,

A high percentage of [soldiers] are five feet tall or shorter. In the 1990s, North Korea reduced the minimum height for military service to 148 centimeters (4 foot 9 inches) from 150 centimeters and the minimum weight to 43 kilograms (95 pounds) from 48 kilograms....

in order to be able to recruit soldiers, despite a shrinking population. And why were people shrikning? As a direct result of their "Great Leader's" misguided policies leading to severe malnutrition. Surely you know you've done something wrong when your people are getting shorter from one generation to the next!

Remember the concave production possibility frontier used to teach opportunity cost and diminishing returns? "Guns" lie on one axis (representing military spending) and "Butter" on the other (representing food). Korea demonstrates what happens when you choose a corner solution, and it's the wrong one! (DPRK even looks dark at night from space).

Even if North Korea miraculously find a way to improve, there are other deranged leaders willing and able to fill it's large shoes. Zimbabwe is an excellent example of how NOT to generate economic growth, run monetary policy, support property rights, and so on. I don't expect to run out of teaching material anytime soon....

Money vs. Legal Tender

A recent news story (here or here [SCMP, gated]) discusses the right to spend pennies in the United States:

A group of people this month protested in front of a Chinese takeaway restaurant in the Bronx after a customer said the cashier refused to accept 10 pennies as part of the payment for a US$2.75 dish. [....]

"This is America. If you want to do business in America, you have to accept all American currency," said Ruben Diaz, the Democratic senator who attended the protest.

The Senator is correct. In the United States, all US currency is "legal tender." That means that it must be accepted by law in exchange for a debt. Senator Diaz wants to enforce this law, with a threat of a $500 fine for any retailer who refuses to be paid in pennies!

This is absurd. Imagine buying a new car, and insisting on paying with pennies. Just counting, storing, securing, and exchanging the pennies into more useful currency would probably cost the car dealer more than the $500 fine. But that's the law... in the US at least.

In most countries, a more reasonable approach is taken. Money and Legal Tender are not identical. Take, for example, this quote from the Bank of Canada website:

The method of payment can be whatever is mutually acceptable to both parties — cash, credit card, cheque, etc. Thus, a merchant may refuse to accept bank notes in payment for goods or services, without contravening the law.

Other countries define in law what is reasonable for a retailer to accept, and enforce those standards. For example, in the United Kingdom,

... only coins valued 1 pound Sterling and 2 pounds Sterling are legal tender in unlimited amounts throughout the territory of the United Kingdom. [...]
Currently, 20 pence pieces and 50 pence pieces are legal tender in amounts up to 10 pounds; 5 pence pieces and 10 pence pieces are legal tender in amounts up to 5 pounds; and 1 penny pieces and 2 pence pieces are legal tender in amounts up to 20 pence.

This Wikipedia site contains the rules for many other countries.

What about Hong Kong? A quick search on the web didn't show up any results, although some stores openly advertise that they do not accept $1000HKD notes, and taxi drivers are not obliged to accept $500HKD notes as well.

As the SCMP article suggests, if you have to pay a fine in the US, insist on paying it in pennies. You would be fully within your rights to do so! In any other country, just be reasonable....

Sticky Prices...

In my teaching and research, I focus on models of business cycles based on the assumption of sticky prices. That is, prices take time to adjust to shocks. As a result, prices may deviate from those that are optimal, at least for a while. And if prices deviate from optimal levels, consumption will also deviate, since consumers' behaviour depends on prices. In simple terms, if prices are too low, consumption and output will rise, and if prices are too high, consumption and ouput will fall.

Such models lie at the heart of most undergraduate testbooks of macroeconomics, and also provide the basis for using monetary policy to try to stabilise the economy. Suppose instead that prices were completely flexible. Then monetary policy would be impotent, since prices could fully adjust in response to shocks, ensuring that the economy always operates efficiently.

Whether prices are sticky is ultimately an empirical question. Tim Harford discusses one case of sticky prices that is truly remarkable: Coca Cola sold for 5 cents in the US continuously from 1886 until 1959, despite huge changes in the world economy over that period. (See here for more, or here for the original paper).

Numbers....

Did you know that approximately 30% of all street numbers begin with the digit '1', while only 4.6% begin with the digit '9'? And that the same percentages apply to all manner of phenomena? It can even be used to check for electoral fraud, or for corruption of datasets! See Marginal Revolution for more discussion of Benford's Law.

Mainland Chinese Inflation

Mainland China is in an enviable position. Rapid economic growth, huge current account surpluses, and the world's largest foreign reserves all suggest a rosy future for the world's most populous country. But maybe not all is as well as it seems.

China's foreign reserves are reportedly growing by 1.5 billion USD per day. Such accumulation is generally the result of an undervalued exchange rate, where the currency trades at below its equilibrium value, supported by central bank intervention (although given China's currency controls, it is not clear where the equilibrium value of the RMB really lies).

If the currency were overvalued, there is a risk that the central bank would be forced to devalue the currency- for example, if it ran out of foreign reserves. This can have devastating consequences for the economy, as Thailand illustrated during the Asian Financial Crisis.

In contrast, the risks of an undervalued exchange rate seem mild. Supporting an undervalued exchange rate requires the central bank to demand foreign currency (bolstering foreign reserves) and supply local currency in return (increasing the domestic money supply). In principle, there are no limits to how long the central bank can continue doing this.

But it is not without negative consequences. As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomena." Unfortunately for China, the relationship holds in both directions. If you print too much money, you will generate inflation.

When I read headlines such as this one on increasing mainland inflation, it makes me nervous. Friedman also argued that an increase in the money supply increases inflation, but with "long and variable lags," a statement that is accepted as fact by most monetary economists. I'm concerned that the disproportionate increase in the money supply resulting from foreign exchange accumulation may yet result in a large increase in inflation in the coming months.

Aside from the massive build-up of foreign reserves, there is additional evidence of a highly expansionary monetary policy in Mainland China. With consumers earning less than the inflation rate when they deposit money at the bank, real interest rates are effectively negative. That is hardly going to constrain the growth rate of a runaway economy like China!

China needs higher nominal interest rates, and soon. That might also help to burst that other problem of the equity price bubble, before it gets worse.

China Bubble...

The Mainland Chinese stock market is booming, and this makes me nervous. I've spoken to colleagues who cannot visit China without being asked by everyone from taxi drivers up which stocks they should invest in. Stories abound of students investing their university fees in equities in the hope of making a quick profit. Retired people investing all their retirement savings. As a rule of thumb, when everyone else to too eager to invest and doesn't seem to understand the risks involved, the market is suffering from a bubble.... and it's time to sell before the coming correction.

But maybe there is still hope. Even a bubble may ultimately be good for China's economic development. Daniel Gross argues that past bubbles have been good for the US (see here). I hope the same can be argued for China.... but I'm still very skeptical.

Zimbabwe.... at the UN

International policy organisations can be very entertaining... even when they try not to be.

The UN is set to elect a head of their "Commission on Sustainable Development." The likely winner? The Zimbabwe Environment Minister, Francis Nheme (see here for more).

As anyone who has listened to my lectures knows, Zimbabwe is a great example of everything that a government should NOT DO. They've destroyed property rights and generated hyperinflation. Millions of citizens have left the country for South Africa or Botswana. Unemployment is above 80%. Zimbabwe is the FASTEST SHRINKING ECONOMY OUTSIDE OF A WAR ZONE, as a direct result of the government's incompetence and corruption.

The only justification I can think of for appointing Zimbabwe to head this commission is that a rapidly shrinking economy may be sustainable. Just increase the corruption levels in each successive year, and shrink the economy a little further!

This reminds me of another incompetent world body appointment. By convention, the United States appoints the head of the World Bank, the world's largest anti-poverty organisation. George W. Bush appointed Paul Wolfowitz, someone with the dubious distinction of being an architect of the Iraq war. He was unqualified for the job, but was supposed to reduce levels of corruption in the dealings of the World Bank with third world officials. One of his first actions? A major pay raise and promotion of his girlfriend, in contravention of World Bank policy. Maybe it takes a corrupt official to recognise corruption!

Fortunately Wolfowitz will probably be forced to resign his position. I don't expect we will be as lucky regarding the UN appointment... Zimbabwe will probably chair the Sustainable Development commission for the full term regardless of their demonstrated incompetence.

Hyperinflation.... Yugoslavian Edition

"Between October 1, 1993 and January 24, 1995 prices increased by 5 quadrillion percent. That’s a 5 with 15 zeroes after it."

See more here (thanks to Newmark's Door for the pointer). Maybe Robert Mugabe of Zimbabwe should try harder... at only four digit's, he's no where near making the record books!

Another curious hyperinflation fact:

"At the inflationary peak reached by Chiang Kai-shek's regime, one US dollar was worth Yuan 41 276 595 744 681 - still a world record!"

See this story for more international comparisons.

The Economics of Charitable Giving....

Suppose that you wish to help someone who is not as well off as yourself. That should be easy, right? Just give them money. Wrong! As Tim Hartford argues (thanks to Marginal Revolution for the pointer), if we really want to make a difference, we need to think carefully about the incentives that our giving may create.

As a simple example of perverse incentives, suppose we give money to the first beggar that we see. By so doing, we increase the incentives to beg, which is an unproductive activity. In the margin, our giving may induce more people to forgo a productive job and instead take up begging. Society as a whole looses.

There are other less obvious costs as well. Pedestrians tend to follow similar paths, and beggars will concentrate in areas where pedestrian density is greatest. In Hong Kong's case, that would imply increased congestion around exits to the MTR, an externality borne by all of society.

To some degree, perverse incentives are an unavoidable cost of charity, but there are ways to minimize these negative effects. The first step is to try to ensure that any money we give is used to meet a short-term human need like food, rather than as an alternative source of income to a job. This requires some effort. Instead of giving money, give food. Or even better, give money to a charity that provides food to the very poor- hopefully in a more cost-effective and efficient manner than you can as an individual. Since the marginal utility of food consumption falls rapidly with increased consumption and beggars cannot easily on-sell donations of food, this ensures that hungry beggars have their most basic need met, while at the same time ensuring that they face little incentive to make a career out of begging.

Next, we should view charity as making an investment in the future welfare of the planet, and try to get the maximum long-run return on our investment. As the old proverb says, "Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime." Giving food to beggars may be good, but giving him life skills is even better.

As an individual, there is little most of us can do to help the very poor to improve their ability to earn an income. But, as with food, there are many well-run charities that we can support that provide these services economically.

Charity may create perverse incentives, but by creatively targeting our charity, we may minimise these incentives and so maximise the benefits of our giving on society.

Predicting Exchange Rates... using Politics

Does an unpopular politician cause the exchange rate to drop? Maybe. (Take note of the important caveats and limitations in the discussion).

A Common Currency for Asia?

From time to time, the idea of a common currency for Asia, similar to the Euro, is mentioned in the press (see, for example, here). It has been actively encouraged by Robert Mundell, winner of the 1999 Nobel Prize. Here I will briefly answer two questions: Is a common currency for Asia possible? And is it a good idea?

Starting with the second question first, a common currency should increase economic efficiency, for two reasons. In all international transactions, there are costs involved in exchanging wealth from one currency to another. The presence of these costs may reduce the willingness of firms to trade. But more importantly, there are risks involved in transacting between currencies. If I invest in assets denominated in another currency, that currency may appreciate or depreciate, potentially making the difference between turning a profit or a loss on my investment.

To understand the extent of this, in May 2000, one Euro bought 89 cents US. Today it buys $1.36 US. If an American invested in Euro denominated assets in 2000, the currency appreciation alone has earned them a 6.2% windfall gain PER YEAR, compounding, over and above any returns on their assets. In contrast, a European investing in the United States has been loosing the same amount.

Investors are risk averse, and respond to risk by reducing their exposure- in this case, by limiting trade across currencies. They may also spend real resources in trying to protect themselves from currency fluctuations, by "hedging" away currency risk, again reducing economic efficiency. These costs would be avoided by adopting a common currency.

But there are also costs to adopting a common currency. Most importantly, monetary policy will be identical across all economies using the common currency, even though individual countries will be subject to different economic shocks and business cycles. The cost of this loss of monetary policy depends on how flexible prices and wages are, i.e. the degree to which the economy can rapidly adjust in response to macroeconomic shocks.

So to answer the question of whether a common currency is a good idea, we would need to weigh the relative benefits of increased efficiency against the relative costs of losing monetary policy as an effective tool to steer the economy.

Moving on to the second question, whether a common currency for Asia is possible, the simple answer is "not for a long time." To understand why, we can look to the experience in Europe.

The development of the Euro in Europe was the result of a drawn-out political process start started with the European Common Market in the late 1950's (see here for a history). It took almost 50 years from the start of the political process to the common currency we have today, and each of the countries involved has sacrificed independent monetary policy to be set by a joint central bank, housed in Frankfurt, Germany.

Consider the situation in Asia. Suppose that the major economies of Asia agreed to a joint central bank. Where would such a central bank be situated? The largest economies are Japan and China, so they are the obvious candidates. However, at the current time it is inconceivable that either country would be willing to allow the central bank to be housed in the other country! And that is just a trivial matter next to the more important agreements that would have to be reached on how monetary policy would be set, and what objectives the central bank should seek to achieve! Developing a common currency requires a high degree of political co-operation and integration, neither of which is evident in Asia!

To be clear, I do not expect to see a common currency in Asia within my lifetime.... and I expect to live a long time!

So You Want to Go to Harvard?

A recent article in the New York Times on students interviewing for Harvard here (thanks to Newmarks Door for the pointer) is food for thought for students wanting to study in top universities. I have had the priviledge of discussing future education plans with many students since coming to HKU 6 years ago; here I'll outline a few thoughts that might help you in your plans.

1) EVERYONE wants to go to Harvard- and nearly everyone who applies fails to get in. So be realistic.... apply by all means, but have a plan B, because you'll probably need it. And just to be safe, have a plan C, D, and E as well. When I talk to students, nothing worries me more than those who have not thought seriously about what they'll do if their plans don't work out. Life is too valuable to waste, waiting and hoping that you might get in if you apply again next year.

2) I DIDN'T go to Harvard. (If you're curious, you can trace my progression through universities here or here). There are many other excellent universities in the world, and going to any good university will open many excellent career opportunities to you. Sure, going to Harvard would give you an advantage, but there are other ways of achieving your career objectives.

Aside from those general principles, a few more that are specific to students contemplating postgraduate studies in Economics:

3) If you are not desperate to do research, than a PhD is not for you. Some top undergraduate students choose to stay on at university simply because it is what they know. Like most things in life that are worth doing, a PhD is difficult and requires persistence. If you start a PhD without complete commitment, you'll probably drop out without finishing, wasting a few years of your life in the process. By the end of your second year of undergrad, you should have some good ideas on where you WANT to be in future. Actively work towards that end.... don't just drift into further studies.

4) As an application of 3), if you can be persuaded NOT to do a PhD, you probably should not do one. (If you come to me for advice, I will first try to persuade you that you should do something else).

5) You MUST take lots of Maths courses. You can bluff your way through most undergrad courses with very limited maths. But economics gets increasingly mathematical the further you study; writing descriptive essays, no matter how polished, will probably not get you a PhD, let alone a job.

6) And finally, a PhD from a bottom-ranked university may give you very few career choices. Don't loose sight of the role of your studies- they're ultimately a means to obtaining the career you want, not an end in themselves.

Unrest in Macau... lessons for China

Macau has been in the world headlines recently, for both good and bad reasons. A few weeks ago, I discussed Macau's rapid growth (real GDP grew 16.6% last year: see my earlier post here). Now they're back in the headlines, for protests that turned violent and police firing warning shots into the air (a YouTube clip of the action is here).

So what are Macau residents protesting about? In economics, we often focus on average or aggregate wages, without paying enough attention to the full distribution of those wages. I was guilty of that in my earlier post, in which I argued that average real wages have grown spectacularly in recent years. It turns out that while many people in Macau are benefitting from growth, a significant minority feel that they're being left behind, and are seeing no benefits from the increased construction, gambling, and associated service industry growth.

What lies beneath this dissatisfaction? It's not as if the people who were protesting are worse off than they were before the rapid growth! Well, it turns out that people appear to derive utility not just from the level of their income, but also from their relative status in the economy. That is, I'm happier being poor if you are also poor. But if I observe you becoming better off while I am not, that imposes a negative externality on me. I feel worse off, even if I enjoy the same level of consumption as before. It's called the "relative income hypothesis" (RIH).

I would expect that the power of the RIH to affect utility is non-linear. If changes in status occur only slowly (for example, over generations), consumers slowly adjust to their new-found status or lack thereof, without any major loss of utility. However, the more rapid is the change in status, the more difficult is the adjustment process, and the greater is the loss of utility.

Coming back to Macau, rapid economic growth results in rapid changes in relative status. The Macau SAR government should be very careful to try to redistribute wealth from the newly wealthly to those who have not benefitted from growth to ensure political stability. The simplist way to achieve this would be to levy a progressive tax on income, and offer more generous social welfare payments to the poorest of Macau society. Given that there are currently no income taxes in Macau, this may be a very difficult policy change to make. Maybe that's why I'm an economist and not a politician!

Need I point out that Mainland China, with growth of approximately 10% for many years now, has the potential to replicate the tensions in Macau, but on a much larger scale. Only time will tell whether the government in Beijing is doing enough to ensure social stability, by ensuring that the poor are not completely left behind by China's rapid development.

Blogging Economists

Some very well known economists wrote blogs, as this story discusses. I can identify with many of the reasons they give, but mostly this is an experiment. In economics, "learning by doing" is an important way to develop expertise. What better way to think about writing for a diverse audience about economics than actually doing it! Like Drezner, I plan to do this for about a year. Maybe also like Drezner, I'll still be doing it in five years! Is that a violation of "rational expectations?"

China's Golden Week

Mainland China introduced its "Golden Week" holidays in 1999, giving workers 7 days off in order to stimulate domestic travel and consumption. It currently has 3 such golden weeks; the "Spring Festival" (Chinese New Year) in January or February, "Labour Day Golden Week" (starting May 1) and "National Day Golden Week" (starting October 1). What is the effect of these on the economy? Should they be extended, or shortened?

The common perception is that the "Golden Week" holidays have had mixed success in stimulating domestic consumption. I would be more harsh, and argue that they've been a failure. The main driver of economic growth in Mainland China has been export growth, especially with the United States. China has opened up to the rest of the world economy and, as a result of cheap labour and economies of scale, has transformed itself from an impoverished state into a less impoverished factory for the world's consumers.

But missing almost entirely from this transformation is consumer demand. Estimates of domestic savings suggest that households save approximately 50% of incomes (compared with negative savings in the United States, for example). Consumption demand remains tiny relative to income levels, with or without forced vacations for workers.

A more important question is why households choose to save so much instead of consuming it. Households should use their savings to seek to smooth their consumption levels over their lifetimes. In an economy with high growth rates (and therefore projected higher income levels in the future), this would suggest low savings rates now, to be made up by higher savings rates later- which is the opposite of what we see!

So why do households save so much today? I believe this has more to do with the state of the health sector in Mainland China, combined with risk averse consumers. It is now widely recognised that good health care is practically unavailable to consumers without money, and even for the wealthy, consumer rights are limited. In response to such uncertainty, risk averse consumers will tend to save too much, to avoid the possibility of dying prematurely for want of wealth to pay for care.

Education is likely to play a role in China's excessive savings as well. As China continues to develop, an increasing share of the population will attend university. In the absence of readily available student loans, parents pay for their children's education, requiring a very high savings rate from the parents. In contrast, if the student pays for their own education by taking out a loan, repayment of that loan will require a much lower effective savings rate from the student. This is because the student, armed with a university degree, will earn a much higher income than their parents.

So to increase domestic demand, I suggest the following policy changes.

1) Reform health care. Central to this will be enforcing patient rights.
2) Ensure the provision of efficient health care insurance that is financially accessible at all levels of society. I'm sure that there are many world-leading insurance companies who would love to have a share of the health insurance market in Mainland China. Insurance companies may also play an important role in enforcing efficient care for their clients as well.
3) Ensure student loans are readily available to academically qualified students, so that individuals can pay for their education based on their own future earnings, rather than requiring high savings of parents.

I believe that these measures would have a far greater effect on consumption than any number or mix of national holidays!

Greenspan Speaks on US Housing Equity Withdrawal....

The United States has enjoyed high growth rates compared with most other developed countries in recent years. In part, this has been due to rapidly increasing property prices fuelling increased consumption. Household consumption has grown based on home owners withdrawing equity from their homes (by taking out larger mortgages, for example), and spending part of this withdrawn equity on consumption.

In the long run, this behaviour may generate risks for the economy, as the ability of households to continue to withdraw equity depends on continued increases in the price of houses.

In a recent paper by the former Chairman of the US Federal Reserve, Alan Greenspan (and co-author James Kennedy) carefully calculate how large a share of consumption in recent years was due to home owners extracting equity from their homes. I find the results somewhat alarming.

Consider the following figure from their paper. US households have been spending approximately 1% more than they earn for the past two years (fat solid line). But if we subtract consumption and repayment of non-mortgage debt that is financed by equity withdrawal from their spending, they are in fact living within their means, with a savings rate of just over 1% (thin solid line). The difference between these lines may be interpreted as the extent to which the housing market has fuelled consumption demand.

To try to see how this has affected Real GDP growth in the US, I've reproduced the offical GDP numbers for the US, adjusted by the difference between the two lines. The first figure below is in terms of levels, while the second is in terms of growth rates. (The correction for 2006 is based on the average for the first three quarters only, the latest figures contained in the paper).

Taken at face value, the effects don't look too alarming. Even thought most economists would agree that the growing difference between these lines is unsustainable, it is small, at about 2.3% of GDP in levels in 2006. Under normal circumstances, we might expect that households would slowly reduce their equity withdrawals over time, which would slow GDP growth a little, but probably not by enough to cause a recession.

The problem comes if the correction is forced to occur more quickly. Now that house prices are actually falling in the United States, the ability of households to extract equity has effectively evaporated in most areas. If consumption were to fully drop by the amount of the equity withdrawals, then it is likely that the resulting 2.3% drop in real GDP would more than offset any increases in other sectors of the economy, and so cause a recession.

The problem may also be further compounded:

1) If house prices were to continue to fall, we could see equity withdrawal go into reverse: households reduce consumption by more than 2.3% to try to increase savings to offset their loss of wealth.

2) Other components of the economy are dependent on housing and consumption. It is likely that investment spending would also decline significantly in response to a major fall in consumption.

Only time will tell if this is correct, but I remain pessimistic.

For my earlier views on the US economy and the role of housing see here and here.