Some recent posts on the coming US recession....
Here is the insightful Nouriel Roubini taking stock of the dire state of the US economy, and the path it is on to recession.
Here is James Hamilton explaining why the oil price is so high. It's a simple case of supply and demand. We've got lots of the latter, and not quite enough of the former.
In the past, any major rise in oil prices has lead to a recession- no questions asked. Hamilton continues here with why the economy need not be as sensitive to the price of oil as it was in the past, which may be cause for a little optimism.
And his fellow Blogger, Menzie Chinn, continues here with a roundup of recessionary causes, and the historical inability of growing trade to keep the US economy out of recession.
Wednesday, October 31, 2007
The Collateral Damage of Trade....
Yesterday I posted on the link between trade and disease. Trade results in other risks as well... like creating racial offense from poor translations!
Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!
As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.
Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!
As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.
Monday, October 29, 2007
Trading Diseases.....
Economic integration, in the form of the flow of goods, people, and capital is generally perceived to be unambiguous good to economists. Non-economists are sometimes more skeptical, pointing to increased carbon dioxide output due to shipping goods across the globe, and loss of cultural uniqueness as the world becomes increasingly homogenous.
The first of these could be easily rectified with an appropriately implemented carbon tax, while the second is very hard to quantify, or rectify. And since economic integration is a natural phenomena that occurs when individuals are able to freely trade with each other, it's impossible to argue that preventing such integration is not itself costly to society.
But there are other unintended effects of integration as well. Remember SARS? It started in southern China and spread into Hong Kong, one of the most globally integrated regions anywhere. From there it spread far and wide, with over 8,000 patients falling ill in 25 countries in short order.
An even more serious case of integration leading to the spread of disease can be found in Africa. According to a recent study from Emily Oster (thanks to Marginal Revolution for the link), "a doubling of exports leads to as much as a quadrupling in new HIV infections" in Africa. Increasing trade flows result in increased movements of transient workers, who themselves are high risk, and take their diseases with them.
I wouldn't interpret this as evidence that trade is bad per se- it's just one more component to weigh up when deciding how to steer an economy. And remember that HIV infections are just one component of economic welfare. Trade also allows many members of society to improve their living standards, and in poor parts of Africa, this is likely to have a large positive effect on overall health and welfare.
The first of these could be easily rectified with an appropriately implemented carbon tax, while the second is very hard to quantify, or rectify. And since economic integration is a natural phenomena that occurs when individuals are able to freely trade with each other, it's impossible to argue that preventing such integration is not itself costly to society.
But there are other unintended effects of integration as well. Remember SARS? It started in southern China and spread into Hong Kong, one of the most globally integrated regions anywhere. From there it spread far and wide, with over 8,000 patients falling ill in 25 countries in short order.
An even more serious case of integration leading to the spread of disease can be found in Africa. According to a recent study from Emily Oster (thanks to Marginal Revolution for the link), "a doubling of exports leads to as much as a quadrupling in new HIV infections" in Africa. Increasing trade flows result in increased movements of transient workers, who themselves are high risk, and take their diseases with them.
I wouldn't interpret this as evidence that trade is bad per se- it's just one more component to weigh up when deciding how to steer an economy. And remember that HIV infections are just one component of economic welfare. Trade also allows many members of society to improve their living standards, and in poor parts of Africa, this is likely to have a large positive effect on overall health and welfare.
Froth and Bubbles....
"What should China do to try to reduce excess liquidity and inflation" - Qin
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China's Growing Reserves....
"China has accumulated huge USD reserves. How might these affect the US in future?" -Arun
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
Understanding Hyperinflation
Zimbabwe has the highest inflation rate in the world today, and provides an illustration of the effects of inflation. Consider this news article on CNN on inflation in Zimbabwe, which has picked back up to 7982% in the year ended September.
Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.
To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!
Relatedly, the Government recently devalued the official exchange rate from 250 Zimbabwe Dollars per USD to 30,000. At the time, commentators mentioned that this was not enough, as the underlying black market rate was closer to 250,000 ZimD per USD. Well now, just one month later, the black market rate has deteriorated to close to 1million ZimD per USD. And that was on October 18.
To understand what 7982% inflation means, that implies a daily compounding inflation rate of 1.21%. (That is, (1+0.0121)^365=(1+79.82)) That's about Hong Kong's annual inflation rate every day, compounding! Put another way, prices double every 57 days ((1+0.0121)^57=2), or about every 2 months. Every 4 months, they quadruple, etc. Based on this back-of-the-envelope calculation, in the unlikely event that you hold some ZimD, sell them fast- the value of the ZimD will be falling approximately proportionally with the inverse of the price level. Since the news story I linked to above was published 11 days ago, the black market rate has likely fallen to about 1.14 million ZimD per USD already!
Thursday, October 25, 2007
Measuring The Contribution of Labour and Capital to Growth
"When we analyse the source of economic growth, we include the capital stock (K) and the labour supply (N), and total factor productivity (A). Sometimes adjustments are made to K and N, reflecting changes in quality or prices. Should such adjustments be made?" - Candy
You're referring to growth accounting- using a simple production function to figure out how much of economic growth is due to growth in the labour supply, how much is due to growth in the capital stock, and how much cannot be explained by growth in these most basic factors of production. This final left over part may be thought of as a measure of how efficient the economy is, and it is variations in this variable (A) that explain the huge variation in economic wealth between poor and rich countries.
Often we do adjust measures of the capital stock and measures of the labour supply. Whether this is a good idea or not depends on the source of the adjustment, and what exactly we're trying to measure. Sometimes the adjustments are due to measurement problems, and should rightly be made. For example, when we measure the capital stock, ideally we want a measure of the total physical quantity of capital that is used in production. We can't easily measure this; instead we measure the market value of the capital stock. But the market value can change because of a change in the quantity of capital, or a change in the price of capital. Clearly correcting our measures of capital for changes in the price of capital is a good idea.
Similar adjustments in the labour supply may also be warranted. For example, as the demographic structure of the economy changes, measuring the total number of workers or the total number of hours worked may be a poor measure of the total contribution of the labour force to production. If more experienced workers are replacing less experienced ones, then ignoring this fact will exaggerate the rate growth rate of A, the part of economic growth that is not due to labour or capital.
But some adjustments might not be a good idea, because the quality of labour or capital is itself an endogenous variable that responds to the growth of the economy. For example, as the economy's growth rate increases, workers are induced to increase their level of education and learn new skills to take advantage of new job opportunities. Is this an increase in the level of the labour supply (N) or an increase in productivity (A)? In truth, it is both. A similar argument can be made for capital. There are greater incentives to buy better quality capital the more developed the economy is, and the greater are the possible returns to using high quality capital.
So I end up sitting on the fence. If you want to know how much of the growth of the economy cannot be explained by labour and capital, maybe you should adjust away to your heart's content. If instead you want to know how much of the growth of the economy is "endogenous" - i.e. not directly due to changes in the quantity of the factors of production, you should limit adjustments to correcting more meaurement errors, and not quality changes.
You're referring to growth accounting- using a simple production function to figure out how much of economic growth is due to growth in the labour supply, how much is due to growth in the capital stock, and how much cannot be explained by growth in these most basic factors of production. This final left over part may be thought of as a measure of how efficient the economy is, and it is variations in this variable (A) that explain the huge variation in economic wealth between poor and rich countries.
Often we do adjust measures of the capital stock and measures of the labour supply. Whether this is a good idea or not depends on the source of the adjustment, and what exactly we're trying to measure. Sometimes the adjustments are due to measurement problems, and should rightly be made. For example, when we measure the capital stock, ideally we want a measure of the total physical quantity of capital that is used in production. We can't easily measure this; instead we measure the market value of the capital stock. But the market value can change because of a change in the quantity of capital, or a change in the price of capital. Clearly correcting our measures of capital for changes in the price of capital is a good idea.
Similar adjustments in the labour supply may also be warranted. For example, as the demographic structure of the economy changes, measuring the total number of workers or the total number of hours worked may be a poor measure of the total contribution of the labour force to production. If more experienced workers are replacing less experienced ones, then ignoring this fact will exaggerate the rate growth rate of A, the part of economic growth that is not due to labour or capital.
But some adjustments might not be a good idea, because the quality of labour or capital is itself an endogenous variable that responds to the growth of the economy. For example, as the economy's growth rate increases, workers are induced to increase their level of education and learn new skills to take advantage of new job opportunities. Is this an increase in the level of the labour supply (N) or an increase in productivity (A)? In truth, it is both. A similar argument can be made for capital. There are greater incentives to buy better quality capital the more developed the economy is, and the greater are the possible returns to using high quality capital.
So I end up sitting on the fence. If you want to know how much of the growth of the economy cannot be explained by labour and capital, maybe you should adjust away to your heart's content. If instead you want to know how much of the growth of the economy is "endogenous" - i.e. not directly due to changes in the quantity of the factors of production, you should limit adjustments to correcting more meaurement errors, and not quality changes.
Tuesday, October 23, 2007
You're not as old as you think....
As many of my students know, one of my pet concerns is the demographic transition that is affecting most of the developed world, and some of the developing world (China) as well. For the first time, we're facing a rapidly aging population, and in the fullness of time a shrinking population as well. This may have profound implications for asset markets (see, for example, this paper on the effects of demographics on real estate prices), aggregate savings, and therefore interest rates. Higher interest rates in turn may reduce investment, lowering the capital stock, and future economic growth. You can't get much more of a profound chain of events in economics than that.
The big unknown in all my doomsdaying is how our aging population will respond to their predicament. If people start working longer, and remain economically productive later in life, in principle this could offset a large part (or all) of the negative effects. And indeed, as marginal revolution and the Economist point out, this paper by John Shoven at Stanford suggests that there is room for some optimism on these fronts.
See the links for more....
The big unknown in all my doomsdaying is how our aging population will respond to their predicament. If people start working longer, and remain economically productive later in life, in principle this could offset a large part (or all) of the negative effects. And indeed, as marginal revolution and the Economist point out, this paper by John Shoven at Stanford suggests that there is room for some optimism on these fronts.
See the links for more....
Monday, October 22, 2007
How will the USD depreciation affect the US economy?
"What is the benefit of a depreciating USD? In particular, will it reduce interest in investing in US assets, as they will offer a lower return? And does it make the US better off?" - Catherine
I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.
On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.
More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.
This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.
Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.
I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.
On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.
More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.
This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.
Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.
Thursday, October 18, 2007
Oct. 19 1987: Could it happen again?
Oct. 19 1987 remains the largest one-day correction in world equity markets. The DJIA lost 22.6%, and the S&P 500 20.4%. Closer to home, the drop in the HSI lagged that in New York due to the time difference. But drop it did, from 3362.40 at close on Oct. 19 to 2241.70 at close on Oct. 26- a staggering 33.3% drop. (For the data, see here. This NYT story explains the lack of data for the intervening days: the market had already dropped 11.1% on Oct. 19, ahead of the US melt-down, and was closed for the following four trading days as a result).
Could such a melt-down happen again? Nouriel Roubini of NYU and Roubini Global Economics draws the parallels between 1987 and 2007 here.
My take: yes, there are some strong parallels, and a major melt-down is certainly possible. But timing any such melt-down is extremely difficult. It could happen tomorrow, next week, next month, next year, or even next decade.
Could such a melt-down happen again? Nouriel Roubini of NYU and Roubini Global Economics draws the parallels between 1987 and 2007 here.
My take: yes, there are some strong parallels, and a major melt-down is certainly possible. But timing any such melt-down is extremely difficult. It could happen tomorrow, next week, next month, next year, or even next decade.
Wednesday, October 17, 2007
The current account and the exchange rate...
"What is the effect of the current account balance on the exchange rate?" - Vincent
To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.
Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.
Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?
The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.
To put this another way, the current account balance may be defined as
CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)
The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.
We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.
To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.
Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.
Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?
The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.
To put this another way, the current account balance may be defined as
CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)
The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.
We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.
Tuesday, October 16, 2007
Nobel Prize Winners in Economics
Hurwicz, Maskin and Myerson won the nobel prize in economics for "Mechanism Design." What on earth is that, I hear you ask? Alex Tabarrok of Marginal Revolution provides some excellent examples here.
Monday, October 15, 2007
Why have a currency board?
"Notwithstanding the fact that the currency peg is very political, are there any compelling reasons why the HKD should not be "unpegged" from the USD, particularly in view of expected further depreciation of the greenback?"
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
Sunday, October 14, 2007
Mis-measuring Trade
While we're on the subject of mis-measurement, what do Mongolia, Papua New Guinea, Angola, and Libya all have in common? According to the World Trade Organisation they all trade a greater value of goods and services than they produce- see this link, for example.
This is news to me. The only way a country is likely to trade in excess of production is if it is a major re-exporter, like Hong Kong or Singapore. Yes it is possible for other countries to enjoy a trade:GDP ratio exceeding 100%- if you export every good and service you produce, and import every good and service you consume, the ratio could theoretically hit 200% without any re-exports- but I hardly think that is likely for the countries listed here.
If the ratio is incorrect, it is most likely due to mis-measurement of GDP, with the countries concerned exporting goods produced in the informal sector that slip under the radar of the statistics agency beancounters, and paying for imports with income earned in that same informal sector.
Thanks to Lolita for the pointer.
This is news to me. The only way a country is likely to trade in excess of production is if it is a major re-exporter, like Hong Kong or Singapore. Yes it is possible for other countries to enjoy a trade:GDP ratio exceeding 100%- if you export every good and service you produce, and import every good and service you consume, the ratio could theoretically hit 200% without any re-exports- but I hardly think that is likely for the countries listed here.
If the ratio is incorrect, it is most likely due to mis-measurement of GDP, with the countries concerned exporting goods produced in the informal sector that slip under the radar of the statistics agency beancounters, and paying for imports with income earned in that same informal sector.
Thanks to Lolita for the pointer.
Mis-measuring GDP....
"The different approaches to measuring GDP (income approach, product approach, etc) are supposed to all give the same answer. But some activities are hard to measure- for example drug dealing- and are likely to be excluded from the product approach for lack of data. Might this explain why the different approaches give different answers?" - Chen
This shouldn't be too much of a problem, as we likely miss-measure both the income approach and the product approach by a similar amount. We don't measure the consumer's purchases of illegal drugs, but we don't measure the income earned by the drug dealer either! Since the amounts are identical, ignoring parts of the economy should not systematically bias one measure of GDP relative to another.
This shouldn't be too much of a problem, as we likely miss-measure both the income approach and the product approach by a similar amount. We don't measure the consumer's purchases of illegal drugs, but we don't measure the income earned by the drug dealer either! Since the amounts are identical, ignoring parts of the economy should not systematically bias one measure of GDP relative to another.
Saturday, October 13, 2007
Housing wealth shock... US version
When the property bubble in Hong Kong burst, average Hong Kong apartment prices fell about 66% according to the official index between the peak (October 1997) and trough (July 2003) (for a graph, click here). The result of this was a long-term recession, deflation, and general economic malaise.
The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.
Thanks to Calculated Risk for the link.
The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.
Thanks to Calculated Risk for the link.
Friday, October 12, 2007
Hong Kong Tax Cut Harmony....
Continuing yesterday's post, William Pesak of Bloomberg agrees that Hong Kong's tax cut is a bad idea- although he adds some additional reasons to my argument about macroeconomic instability: (1) instead of cutting taxes, the government could have used it's largese to try to reduce inequality, and (2) the government should focus less on competing with Singapore (Hong Kong's closest competitor in the low-tax stakes in Asia), and more on forward planning- figuring out what Hong Kong needs for future growth.
(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.
But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.
Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.
For more of Pesek's column, see here.
(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.
But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.
Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.
For more of Pesek's column, see here.
Thursday, October 11, 2007
Hong Kong's fiscal policy is cyclical?
Further to my previous post, the Hong Kong government has responded to the healthy fiscal situation by announcing a tax cut. But is that a good idea? To answer that, we need to think about the role of Government policy.
In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.
For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.
Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.
But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.
For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.
It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.
The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).
In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.
Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.
My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.
But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!
In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.
For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.
Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.
But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.
For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.
It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.
The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).
In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.
Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.
My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.
But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!
The CE announces tax cuts.... big deal
Just yesterday, the Chief Executive announced that tax rates in Hong Kong are coming down.
From the news story today in the SCMP:
"Donald Tsang Yam-kuen announced that the standard tax rates for salaries and profits tax would be cut by 1 percentage point respectively to 15 per cent and 16.5 per cent from the 2008-09 financial year, which would cost the Treasury about HK$5 billion a year."
The standard tax rate discussed here has little effect on the taxes that most of us pay, since it is effectively the maximum average tax rate that a person may have to pay. Given the mildly progressive nature of HK's tax system (2% on the first 35,000 after exemptions, 7% on the next 35,000, 12% on the next 35,000, and 17% on the remainder) and the basic $100,000 exemption, the standard tax rate directly affects only those people earning more than $2,750,000 per year. The calculation is as follows:
Taxes paid under the progressive system on an income of Y are:
T(progressive) = 0.02x35,000 + 0.07x35,000 + 0.12x35,000 + 0.17x(Y-105,000-100,000)
Taxes paid under the standard rate are:
T(standard) = 0.16xY
Actual taxes paid are the minimum of these two equations; the former is lower for all incomes below 2.75 million. With only about 5,000 people in Hong Kong earning more than this threshhold, this tax cut alone will have no effect on most tax payers. So the announced cuts themselves are no big deal.
But the expectation is that there will be additional tax cuts- not yet announced- that will apply to the progressive tax system that affects a far larger number of residents. This can occur in one of two ways: reductions in the tax rates and/or increases in the threshholds at which the tax rates apply.
From the news story today in the SCMP:
"Donald Tsang Yam-kuen announced that the standard tax rates for salaries and profits tax would be cut by 1 percentage point respectively to 15 per cent and 16.5 per cent from the 2008-09 financial year, which would cost the Treasury about HK$5 billion a year."
The standard tax rate discussed here has little effect on the taxes that most of us pay, since it is effectively the maximum average tax rate that a person may have to pay. Given the mildly progressive nature of HK's tax system (2% on the first 35,000 after exemptions, 7% on the next 35,000, 12% on the next 35,000, and 17% on the remainder) and the basic $100,000 exemption, the standard tax rate directly affects only those people earning more than $2,750,000 per year. The calculation is as follows:
Taxes paid under the progressive system on an income of Y are:
T(progressive) = 0.02x35,000 + 0.07x35,000 + 0.12x35,000 + 0.17x(Y-105,000-100,000)
Taxes paid under the standard rate are:
T(standard) = 0.16xY
Actual taxes paid are the minimum of these two equations; the former is lower for all incomes below 2.75 million. With only about 5,000 people in Hong Kong earning more than this threshhold, this tax cut alone will have no effect on most tax payers. So the announced cuts themselves are no big deal.
But the expectation is that there will be additional tax cuts- not yet announced- that will apply to the progressive tax system that affects a far larger number of residents. This can occur in one of two ways: reductions in the tax rates and/or increases in the threshholds at which the tax rates apply.
Wednesday, October 10, 2007
The HKMA is On Top of Things....
The Hong Kong Monetary Authority, Hong Kong's de facto Central Bank, is on top of things... literally! In fact, being housed in the top 11 floors of IFC2, the world's 7th tallest building (and Hong Kong's tallest.... at least until the new ICC building going up across the harbour adds a few more floors).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Tuesday, October 9, 2007
Paying for Inactivity, Indonesian Style
The Indonesian government have a cunning plan for making money. They'd like the rest of the world to pay them not to destroy the rest of their forests- $5-20 per hectare, to be precise. This might have almost made sense.... the forests in Indonesia are of benefit to the whole world, so the whole world can pay for their maintenance. It's the classic case of externality.
We could apply this same principle in many other areas. Let's pay fishermen not to fish (after all, they deplete the sea, to the detriment of all), farmers not to farm (that'd reduce chemical run-off that is harming world water supplies), and drivers to leave their cars at home (reducing congestion and pollution for everyone else).
But would this really work? I'm very skepical for several reasons. First Indonesia is a very corrupt country. According to Transparency International, Indonesia is ranked 130th out of 163 countries for corruption, on par with Zimbabwe and Ethiopia (in contrast, Hong Kong is ranked 15th, and China manages 70th). Does anyone really believe that this money will get past the government officials charged with administering it to actually help preserve the forests in Indonesia? If so, I have some snake oil I'd like to sell them.....
Second, this sets an alarming precedent. Paying people for not destroying their own environment would encourage more countries to follow suit. How much would the rich world be willing to pay Kenya if threatened with the eradication of elephants and lions? What's the difference between this and blackmailing the rest of the world with the destruction of your own future?
Third, there has to be a better way. How about using property rights, rather than paternalistic handouts, to encourage the indonesians to protect their own forests? It works in Niger, a country that is both poorer (on a PPP basis as well) and more corrupt than Indonesia, so couldn't it work in Indonesia too?
We could apply this same principle in many other areas. Let's pay fishermen not to fish (after all, they deplete the sea, to the detriment of all), farmers not to farm (that'd reduce chemical run-off that is harming world water supplies), and drivers to leave their cars at home (reducing congestion and pollution for everyone else).
But would this really work? I'm very skepical for several reasons. First Indonesia is a very corrupt country. According to Transparency International, Indonesia is ranked 130th out of 163 countries for corruption, on par with Zimbabwe and Ethiopia (in contrast, Hong Kong is ranked 15th, and China manages 70th). Does anyone really believe that this money will get past the government officials charged with administering it to actually help preserve the forests in Indonesia? If so, I have some snake oil I'd like to sell them.....
Second, this sets an alarming precedent. Paying people for not destroying their own environment would encourage more countries to follow suit. How much would the rich world be willing to pay Kenya if threatened with the eradication of elephants and lions? What's the difference between this and blackmailing the rest of the world with the destruction of your own future?
Third, there has to be a better way. How about using property rights, rather than paternalistic handouts, to encourage the indonesians to protect their own forests? It works in Niger, a country that is both poorer (on a PPP basis as well) and more corrupt than Indonesia, so couldn't it work in Indonesia too?
Sunday, October 7, 2007
Sports, sentiment, and cycles....
I can't sit here, as a native-born Kiwi (New Zealander) and not make a comment on the shocking result in the Rugby World Cup in the early hours of the morning, HK time. Completely against expectations, the world's top rugby team, and the most successful in the history of the sport, lost to France in the quarter-finals. There are many things I'd like discuss (like the refereeing), but I'll leave that to the experts. The fact is, based on current form, the All Blacks (as the NZ team are called) should have won by a large margin.
Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.
Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).
Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.
Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.
Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.
The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.
But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.
So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?
Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.
This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.
Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....
Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.
Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).
Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.
Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.
Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.
The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.
But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.
So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?
Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.
This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.
Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....
Friday, October 5, 2007
China is a "Bubble of Bubbles".... and Ben is to Blame....
Thursday, October 4, 2007
Do bubbles slow economic growth?
"Will the presence of bubbles not slow economic growth in real economy? In China at the moment, investing in real assets may appear relatively unattractive compared with investing in equities, based on recent returns. Also, some SOE have been prosecuted for using funds earmarked for real investments to speculate in the markets instead. In the long run, is this bad for economic growth?"- Mattias
You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.
Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.
In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.
Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.
You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.
Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.
In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.
Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.
Dilbert the Economist...
Some time ago, I commented that Scott Adams, the creater of Dilbert, understands marginal utility.
The plot thickens.... it turns out that Scott Adams trained as an economist, and thinks that economics confers mild super-powers! No wonder I enjoy reading Dilbert so much!
See the links here for more.
Thanks to Newmark's Door for the link.
The plot thickens.... it turns out that Scott Adams trained as an economist, and thinks that economics confers mild super-powers! No wonder I enjoy reading Dilbert so much!
See the links here for more.
Thanks to Newmark's Door for the link.
Wednesday, October 3, 2007
Will India Catch up... continued
India and China are growing at a high, approximately constant rate. But will their growth continue at the current rate? Hong Kong, as a more mature economy, provides a good example as to what may be expected to happen as China and India continue to grow. As Hong Kong developed, it's progression was approximately linear until about 1988- and it's been slowing down since then. That's not really a surpise: high growth rates are easier to maintain the lower is your GDP, as you can grow simply by adopting the technology of others. But at some point, that process will run out of steam.
And the point where growth starts to slow is likely to be a function of the level of "social infrastructure" (Hall and Jones, QJE, 1999) in society. Short of a major change in institutional quality in China and India, resulting in substantial reductions in corruption, expect GDP growth to slow at much lower per capita levels in these countries than it did in Hong Kong, which enjoys an excellent, corruption-free administration, at least by comparison.
Even this may be optimistic. Hong Kong has endured no major crises over that period shown on the grapth. Sure, 1989 and the Asian Financial Crisis shook up markets, but there have been no major events that have significantly threatened the functioning of the economy or the political structure of Hong Kong since our data begins in 1961. Will the same hold true for China and India over the coming decades? We can only hope so.
And the point where growth starts to slow is likely to be a function of the level of "social infrastructure" (Hall and Jones, QJE, 1999) in society. Short of a major change in institutional quality in China and India, resulting in substantial reductions in corruption, expect GDP growth to slow at much lower per capita levels in these countries than it did in Hong Kong, which enjoys an excellent, corruption-free administration, at least by comparison.
Even this may be optimistic. Hong Kong has endured no major crises over that period shown on the grapth. Sure, 1989 and the Asian Financial Crisis shook up markets, but there have been no major events that have significantly threatened the functioning of the economy or the political structure of Hong Kong since our data begins in 1961. Will the same hold true for China and India over the coming decades? We can only hope so.
India is Catching Up? China too? Don't count on it...
Regularly we see articles in the media stating that China will be the largest economy in the world by 2050, or that India will soon overtake Britain (see this story- thanks to Olly for the pointer). "Within 15 years Indians should, on average, be four times richer than today," the article states. Frankly, I'm skeptical. Yes, it may happen, but there are many reasons why that day may not arrive nearly as soon as the article argues.
Lets consider an analogy. Woman sprinters are getting faster every year. So are men. But woman are getting faster at a faster rate. Ergo one day woman sprinters will be faster than men- by 2156 according to this story. The academic study behind this story was even published in Nature, one of the top science journals, so it might be correct, right? Not so fast.....
So what's wrong with it? Well, everything, really. Let's take the recent past, project it forward linearly, and see where we end up in the distant future. Do we live in a linear world? No. Do we expect to live in a linear world in the future? No. Would any rational person expect growth rates to continue at current rates? No. Do these long-term linear projections do anything more than create headlines to help journalists sell newspapers? No.
Consider the following graph of real GDP for India. I've taken logs, so constant growth would result in a linear relationship. And in recent years, growth has been approximately linear. Chinese data results in a similar graph.
Lets consider an analogy. Woman sprinters are getting faster every year. So are men. But woman are getting faster at a faster rate. Ergo one day woman sprinters will be faster than men- by 2156 according to this story. The academic study behind this story was even published in Nature, one of the top science journals, so it might be correct, right? Not so fast.....
So what's wrong with it? Well, everything, really. Let's take the recent past, project it forward linearly, and see where we end up in the distant future. Do we live in a linear world? No. Do we expect to live in a linear world in the future? No. Would any rational person expect growth rates to continue at current rates? No. Do these long-term linear projections do anything more than create headlines to help journalists sell newspapers? No.
Consider the following graph of real GDP for India. I've taken logs, so constant growth would result in a linear relationship. And in recent years, growth has been approximately linear. Chinese data results in a similar graph.
But will growth continue to be linear? See the next post for more....
Tuesday, October 2, 2007
Mysterious Markets....
So the markets have decided that the credit crunch is over, and equity valuations have jumped. The DJIA is at all time highs, and closer to home, the HSI is growing in leaps and bounds. What is going on here?
To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.
The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.
The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.
If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....
To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.
The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.
The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.
If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....
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