Multipliers...

When there is a shock to the economy, it is generally thought to have a multiplied effect on the economy. Some households enjoy higher income, they spend it, increasing the income for other households, who in turn spend it, and so on. The size of the multiplier is finite because there are leakages: some of the increase in income may be saved, used to pay taxes, or used to buy imports, and is therefore not available as income to others.

How big are these multipliers? Menzie Chinn provides some estimates at Econbrowser.

Causality vs correlation....

When we look at economic outcomes, we observe correlations: event "x" happened along with event "y". There are several possible interpretations of this. First, "x" may have caused "y". Alternatively, "y" may have caused "x". Finally, some other variable "z" may have caused both "x" and "y". Without knowing the causality involved, we cannot answer most relevant policy questions available data.

One specific example from my own research: we observe that members of currency unions trade a lot more than other countries. That's the correlation. If being a member of a currency union induces people to trade more, this might make a compelling case for countries to form currency unions. But if countries trading more tend to form currency unions, then the correlation is reversed, and countries may not see an increase in trade from forming a currency union.

Economists spend a lot of time trying to find "natural experiments," where we can be sure of the direction of any possible causality. Often this is based on an unexpected change in "x" which was clearly exogenous- i.e. was not caused by "y".

One interesting application is to the effects of female leadership rather than male leadership. Read this slate article for more. (Thanks to Marginal Revolution for the link).

University Rankings....

Earlier this month, the Times Higher Education Supplment came out with its latest university ranking. And if you live in Hong Kong, you would have had to turn off all news media to have failed to learn that my employer, HKU, ranked 18th worldwide! That's an impressive performance by any means, and the University is rightly trumpeting its performance.

But university rankings are inherently problematic. In this case, the THES takes a series of relevant indicators (peer review, employer review, international staff, international students, staff/student ratio, and citations), combines them with a formula, and comes out with a number that can be compared between universities.

In general, these indicators are proxies for latent variables that cannot be accurately measured, and may be poor proxies at that. For example, I suspect the "international" variables are trying to capture the extent to which the university encourages its students to think outside the box, and take into account other viewpoints and perspectives. But just having international students and international staff is neither necessary nor sufficient for this to occur.

There are likely to be significant measurement issues as well. Who exactly are the peers and employers who are asked about their views of different universities? Is the sample biased towards one country, or one demographic? How do we count international students, and international staff? Are mainland students in HK domestic or international? Are exchange students, who come to HKU for one semester or one year, treated identically to international students who come for their complete degree program? Is "international" determined by passport, or birthplace? In the staff count for the staff-student ratio, who is included? Only permanent, tenured staff? Gardeners and cleaners? I could go on....

There are two reasonable responses to these problems. One would be to dismiss these rankings as noisy indicators of very little. The other is to treat the noise in the ranking as sampling error, and try to increase the sampling size, by considering more university rankings.

Unfortunately there's only one other well-known global university ranking, by Shanghai Jiao Tong University. And where does HKU rank here? Somewhere between 203rd and 304th.

Oops.... I guess we need a lot more rankings than two to get any accurate idea of where HKU really stands!

The Zimbabwe CPI is now Undefined....

According to this article, the Zimbabwe state statistical agency is no longer calculating the CPI, as there are too many empty shelves, and not enough goods left to include in the calculation.

Following from my earlier discussions of Zimbabwe's inflation (the latest being here), I think this new development highlights a potential bias in the CPI that I haven't seen discussed elsewhere. What is the price of a good that is no longer available at any price? The only answer to this question is that it is undefined, or infinite. If even one component of the CPI is no longer available at any price, then regardless of how trivial that component is within the CPI, Zimbabwe inflation now equals infinity!

(This is part of the reason why price controls are such a bad idea: they lower the prices for some consumers but inevitably create shortages, and therefore infinite prices, for others).

But life is not actually quite as bad as infinite inflation would imply. Recall that we often use the CPI as a measure of the "cost of living." To an economist, the cost of living is the lowest cost of attaining a given standard of living, or utility. The CPI is an imperfect measure of this because it ignores substitution effects (consumers substitute away from relatively expensive goods towards cheaper ones), new goods (the weights are only updated occasionally, so ignores the rapid price declines usually associated with new goods), and improvements in quality over time. These three biases tend to result in the CPI overstating rises in the true cost of living.

If we ignore goods that are no longer available at any price due to a collapsing, corrupt, crime-ridden economy, then that introduces a bias that works the other way. It will not in fact result in infinite inflation (since a rational consumer would substitute away from the unavailable goods to those that are still available), but in the case of Zimbabwe is likely to result in measured inflation significantly understating the true rise in the cost of living. True infinite inflation can only arise when there is nothing left available for sale at any price.

So the poor people of Zimbabwe who have been arguing that the prices they pay are rising faster than official CPI figures indicate have a point.

And what is the source of this hyper-inflation? The money supply is growing at 18000% per year! as Friedman said, "Inflation is always and everywhere a monetary phenomena."

The dire outlook for the US economy....

Back to my recurring theme of arguing that the US economy is heading for recession (last installment here), both Roubini and a Financial Times columnist argue that things are worse, and the economy is heading for a generalised systematic financial meltdown.

At some point, perma-bears like Roubini may overstate their case... and if Roubini doesn't, someone else will. Pessimism is like a commodity: there's a market for pessimistic economic projections. And the markets almost always overshoot. In this case, I'll be surprised if Roubini is not still calling for a worsening recession even once the economy starts to recover.

But, for the record, I think that point is still a long way off....

Too expensive at half the price.... Mainland equities.

I've talked repeatedly here about China's equities bubble (for my last installment, see here). But here's another piece of the puzzle. Bloomberg reported on November 5 that on its first day of trading in Shanghai, Petro China tripled in value, and became the most valuable company in the world by market cap- much larger than any other oil company, even though several of these have significantly higher revenues, oil reserves, and other assets.

Or consider this table published in mid-October. Of the 25 most valuable companies in the world by market cap, 8 were Chinese, while only one Japanese company, Toyota, makes the list- even though Japan is the world's second largest national economy, and many Japanese companies are global brands, with a strong global presence.

Focusing on financial institutions on the same list, there are 4 Chinese companies on the list, and only three from the rest of the world.

Yes, China represents a great opportunity for future growth and therefore future profits. But this great?

How Rich is China?

A recent article in the Financial Times (thanks to Marginal Revolution for the pointer) suggests that some soon-to-be released numbers will show that living standards in China are 40% lower than had previously been believed.

Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).

But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.

But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.

One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.

How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.

And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.

I'll be following this story with interest....

Do you buy or sell an appreciating asset?

This must be "undercover economist" day at HongKongMacro. Here's another facinating post by Tim Harford.

The crux of the post: should you buy an asset that has appreciated in price, or not? Clearly if you failed to buy it when it was cheaper before, and you were rational about your decision then, you should be less likely to buy the asset now. But many financial analysts seem to have different ideas. The fact the price has gone up must mean that it's an asset worth holding.... or something like that.

I shouldn't complain. Markets would be far less interesting if we all invested like economists. There would be no bubbles, and we'd have a lot less to talk about! Just look at the Hang Seng Index, which has dropped almost 15% since October 30.

Benford's Law... and Testing Economics Data

I earlier posted a link on Benford's law, the idea that most data series are likely to have many more observations starting with the digit "1" than "2", and more starting with "2" than "3", etc. The idea was that to get from "1" to "2" requires a 100% increase in magnitude, while getting from "2" to "3" requires only a 50% increase in magnitude.... and so on.

Well, the undercover economist has more... the same principle can be used to assess whether economic statistics are accurate.

Suspician of the accuracy of statistics has a long history. Benjamin Disraeli famously commented that there are three kinds of lies.... "lies, damned lies, and statistics." But maybe this is not fair. At a minimum, most statistics should satisfy Benford's law.

I can think of an excellent application. Many people are suspicious of the macroeconomic numbers generated by Mainland China, especially at the state level. A simple test of whether they're made-up or not would be to see whether the series satisfy Benford's Law.

Of course this would not be a fall-proof test. What if the numbers really were made up, but by statisticians who knew about Benford's law?

Free Lunch....

"There's no such thing as a free lunch" is an idiom, the title of a book by Milton Friedman, and the substance of a wiki page. It's also the idea behind a paper I wrote a few years ago on monetary policy published in the Journal of Macroeconomics.

More recently, we have more proof that very little is in fact free... as the UndercoverEconomist reports here.

Housing Prices and Recession...

I keep harping on about the fall in house prices in the US leading to a recession- my last installment was here.

CalculatedRisk have a careful assessment of the argument here, and essentially agree. If you don't have time to read the whole article, this graph illustrates it nicely. Housing values were recently at an all-time high as a percentage of GDP, and so mortgages still are. As house prices start to fall, those mortgages are going to stay at their stratospheric levels, implying that net wealth of households is falling far more dramatically (in percentage terms) than the fall in house prices alone would suggest. And we know the influence of the wealth affect on consumption, and therefore GDP......

Mainland Futures...

There's a new feature that may be introduced shortly that may have a profound effect on mainland equities. I've argued before that Mainland Chinese equities represent a bubble, and that one day it must burst. One reason why it's lasted so long is that there are no instruments available for investors in the mainland to short equities. Thus people who think that the market is overvalued remove their money from the market, but can do little more. Investors who remain are by definition optimists, who believe that the market will continue to rise- otherwise they wouldn't invest in the first place!

In an economy where the number of new investors is growing at incredible rates (remember those reports about hundreds of thousands of new equity accounts being opened every day?), there's no stortage of optimism.

But now that pie cart may be about to be overturned. From today's South China Morning Post:

"The imminent launch of index futures in the mainland is increasingly spooking investors who fear it could herald a sharp correction in a market that has almost doubled this year."

The response?

"The mainland's stock benchmarks slipped for a fourth day yesterday as investors braced for the introduction of a system that will allow big funds to bet on a market decline. The losses contrasted with a rebound in the Hong Kong market."

So mainland investors may be able to short mainland equities soon, and that's enough for the market to drop? Chalk that up to additional evidence of a bubble...

Oil, Gold, Exchange Rates, and Inflation....

Does the rapid appreciation of the price of oil and gold signify increased inflation? Here's a careful analysis by James Hamilton on Econbrowser.

Japan's Phillip's Curve....

.... looks like Japan. That's from my former PhD Supervisor and co-author, Professor Gregor Smith of Queen's University. The same is apparently true of the Marshal Islands, the Netherlands, and the Czech Republic (see the links on Smith's homepage). It's not true for HK.... I checked.

What will happen to the USD?

The value of the USD has been falling dramatically against all major currencies. What is the likely future direction? Well, that's the billion dollar question.... literally. If I knew, I would not be writing it here, but would use my information to speculate on the currency! But alas, I'm not sure which way the dollar will move. (As I've argued earlier, part of the reason why we can't predict exchange rates well is the ease with which we can speculate on them). So instead, I'll write a blog entry about it!

I'm not alone. Menzie Chinn provides a very careful survey of academic thinking on the behaviour of exchange rates here, and ends up being about as non-committal as me.

For the record, I think we can predict the exchange rate with a little success. First, high interest rate bearing currencies tend to appreciate relative to low interest rate ones- the motivation for the "carry trade" (see my earlier posts here and here).

Second exchange rates tend to over-correct in the short run, like most other assets- thanks perhaps to "momentum traders" who tend to buy assets that are appreciating simply because they're appreciating, rather than due to underlying fundamental value. So ultimately someone will make a lot of money by buying USD at the bottom of the market. (That person will probably not be me, as we have no way of knowing when we're at the bottom until after the fact!)

And third in the long run, purchasing power parity is an important driver of exchange rates. Based on this, I still consider my earlier position to be reasonable: the USD will have appreciated a long wayt from its current value (and even its value as of 6 months ago) within 5 years.

The Economics of Remittances....

Every year, domestic helpers in Hong Kong send money home to support their families. In this post, I want to briefly examine the economics of these remittances. (This post is motivated by this story about the remittances of polish truck drivers from the UK).

First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.

So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.

So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.

But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.

Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.

If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.

If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!

Has the Fed lost the plot?

"I am afraid that the Fed Reserve, which regards its loose monetary policy can overcome potential recession, has missed the point. The underlying problem with US' economy is the unbelievable deficit! With high deficit and high oil price, I am reminded of the stagflation of 1970s. What do you think?" - Wallace

The Federal Reserve is in a tight spot. Their objective is to try to ensure that the US economy grows as fast as possible without generating excessive inflation. If the economy starts to slow, they cut interest rates, while if the economy grows too fast, they raise rates.

That's the theory, in the simplest possible terms. But the reality is much more complicated. We can think of the economy as consisting of many different key indicators, that all suggest different monetary policy responses. For example, if we were to focus on the latest employment numbers, GDP release, or inflation data, they were relatively strong, suggesting that a reduction in interest rates is definitely not required at the current point in time, and runs the risk of fueling further increases in the inflation rate. In sharp contrast, if we focus on one key aspect of the economy, the stock of wealth tied up in housing, this is dropping in value very quickly, and will most likely lead to a significant drop in consumption and a recession in the coming months. (I know I've been making this argument for some time now, but I still believe it to be true!).

Add to the mixture the fact the monetary policy acts on the real economy (e.g. GDP) with a lag of 6-12 months, and on the nominal economy (i.e. inflation) with a lag of 12-18 months, and you end up with a central bank that has to worry about what is going to happen in the future, rather than the present.

And just to make things even more confusing, the current subprime mortgage meltdown has effectively tightened monetary policy, as banks require higher interest rates to offset their increased risk aversion as a large part of their portfolio has gone up in smoke. To some extent, the cuts in interest rates have simply offset this recent phenomena. To illustrate this, consider the following graph, containing the prime rate, the effective federal funds rate, and the yield on BBA-rated bonds (all data taken from FRED). While the first two series have seen falls in interest rates since May of 50 basis points, the BBA yields are actually higher!



So coming back to the question, I think there is a risk of stagflation (when the economy's growth rate slows and inflation increases) if the central bank cuts rates too much, but there's also a risk of a serious recession (if house prices continue to fall dramatically, and consumers cut back on their consumption). On balance, we could argue about whether the central bank has done too little or too much, but we will never know for sure until after the fact, and by then it is too late to do anything about it!

On the real issue being the budget deficit, this is indeed a problem going forward for the United States, but not directly related to the monetary policy dilemma that the Federal Reserve faces. (In the margin, an expansionary fiscal policy requires a relatively contractionary monetary policy to offset its inflationary effects). And of course, moving to a contractionary fiscal policy would only make matters worse if the US economy does enter a recession.

Pressure on the HKD peg...

The HKMA has been intervening regularly lately to maintain the HKD peg. The currency is nominally fixed at 7.80 HKD per USD, but allowed to fluctuate between 7.75 and 7.85. When it hits the weak side of the band (7.85), the HKMA is obliged to buy HKD in exchange for USD. And when it hits the strong side, the HKMA sells HKD in exchange for USD.

Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).

However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.

But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.

Good or bad news about the economy?

Just a few days back, the latest employment data for the US was released, and the data was surprisingly good, as this Bloomberg story reports. But how exactly should we interpret a single piece of evidence? The data is volatile, and as a result, there are lots of conflicting pieces of evidence, as Nouriel Roubini discusses here. The rational thing to do is to take moving averages through the data, to drop out some of the volatility (and if we have 12 month moving averages, drop out any distortions caused by seasonal factors or- more likely- poor adjustment for seasonality), and then interpret the smoothed data, as James Hamilton proposes here. The conclusion? The news is not good.

The US dollar de-internationalisation....

The US dollar is the most internationalised of all currencies at the current point in time. But it is loosing ground, especially to the Euro. Psychology plays a role here, and the large depreciation of the USD relative to most other currencies over the last 18 months has not exactly helped the dollar's case. According to this Bloomberg article, the USD is becoming less acceptable in some economies.

Studying the Dismal Science....

Economics is often referred to as the "Dismal Science," a label which is not exactly supposed to reflect positively on economists. But is it a fair label? Are economists really dismal people? Does studying economics increase your dismal-rating, or do dismal people self-select into the discipline?

How about the converse? Maybe economists are a happy lot, deriving pleasure from using economic analysis to understand the world around us, and as a result of our outlook on life, gaining insights that are a mystery to most of the world's population.

Marginal Revolution, one of the most popular economics blogs, recently put this question to their many readers. Does studying economics make you happier? Read more and offer your comments here.

My conclusion: Maybe we're not such a dismal lot afterall!

Price Controls make a Comeback...

Price controls are making a comeback, in Argentina, Russia, and China. as I've argued before this is a bad idea. Let me recount my two main objections briefly.

First, price controls do not generally work. If they succeed in preventing prices from rising, then shortages will inevitably result. I'd rather pay "too much" for a good or service than fail to be able to buy it at all because the supplier has run out! (If a supplier runs out of a product, the effective price is infinity- which can hardly be thought of as successful if your objective was to prevent prices from rising! Normally, however, the black market ensures that one can still purchase price controlled goods- perhaps at an inflated price- even when shortages result).

Second, even if they did "work" by prevening prices from rising, they do so from distorting the price signals that are essential for efficient resource allocation.

In the end, too high inflation results from one and only one cause: too lax monetary policy. As Milton Friedman famously said "Inflation is always and everywhere a monetary phenomenom." Indeed, for high inflation countries there is approximately a 1-for-1 relationship between money supply growth and inflation, although the link is less than proportional for lower inflation economies.

See my earlier post for more.