Why can't Hong Kong set it's own monetary policy?
The answer is very simple...
The essence of monetary policy is interest rates. If a government or central bank effectively set the interest rates for an economy, it can set its own monetary policy.
Hong Kong does not have this luxury. Suppose interest rates in Hong Kong were higher than that in the US. Investors will transfer wealth from the US to Hong Kong (buying HKD with their USD) in order to profit from the price difference. The result of increased demand for Hong Kong currency will increase the supply of money in Hong Kong. An increased supply of money lowers the Hong Kong interest rate, as the financial system soaks up the excess liquidity. This process continues until the interest rate difference is too small for investors to profit from moving currency between the two economies.
Any remaining differences in interest rates should be explainable by one of two things:
1) Transaction costs. The steps outlined above are not cost-free; thus arbitrage will not fully remove interest rate differentials
2) Fixed exchange rate credibility. If investors believe that the fixed exchange rate regime may be changed, then the equilibrium interest rate differential will reflect expected exchange rate gains or losses and also the risk to investors of being exposed to exchange rate volatility.
Friday, May 18, 2007
Thursday, May 17, 2007
The Mainland Chinese Bubble
Further to my earlier post here, Li Ka-shing says that Mainland Chinese equities represent a bubble right now. As Asia's richest resident, the 9th richest in the world, and a long history of success in business, his views should carry soem weight.
Equities are up 85% so far this year, and almost 300% over the past 12 months. The average P/E ratio in the CSI 300 is 43- suggesting an expected fundamental return (that is, ignoring capital appreciation) of 2.3% (in contrast, the average P/E in the HSI in Hong Kong is 16, implying fundamental returns of 6.25%). New brokerage accounts are being set up at a rate of 300,000 per day. This market is due for a crash... it's just a matter of time. See this story for more.
Equities are up 85% so far this year, and almost 300% over the past 12 months. The average P/E ratio in the CSI 300 is 43- suggesting an expected fundamental return (that is, ignoring capital appreciation) of 2.3% (in contrast, the average P/E in the HSI in Hong Kong is 16, implying fundamental returns of 6.25%). New brokerage accounts are being set up at a rate of 300,000 per day. This market is due for a crash... it's just a matter of time. See this story for more.
Universities... Iraq Style
War has many consequences, few of them good. Here is a news story about universities in Iraq as a result of the US invasion. Apparently being a university professor is a dangerous occupation, and worthy of being specifically targeted by the insurgents.
But this is not just a story about university professors. Stepping back, universities play a vital role in developing human capital. The long term economic costs of the invasion of Iraq, even IF it ends peacefully, depends most strongly on how much human capital has dissipated in the interim.
The loss of human capital may be far worse than death and injury statistics suggest. Where professionals are forced to stay "... at home almost 24 hours a day, seven days a week," in order to increase their likelihood of survival, their human capital is slowly deteriorating, through disuse. It's an example of hysteresis.
But this is not just a story about university professors. Stepping back, universities play a vital role in developing human capital. The long term economic costs of the invasion of Iraq, even IF it ends peacefully, depends most strongly on how much human capital has dissipated in the interim.
The loss of human capital may be far worse than death and injury statistics suggest. Where professionals are forced to stay "... at home almost 24 hours a day, seven days a week," in order to increase their likelihood of survival, their human capital is slowly deteriorating, through disuse. It's an example of hysteresis.
Tuesday, May 15, 2007
The North Korean Model....
The Hermit Kingdom is an excellent teaching tool, and makes my job easy. Just look at the economic decisions made by deranged despots, and argue for the opposite. Google a few recent news articles on whatever is making headlines in those countries, and you even have some relevent, interesting, real-world illustrations to keep your students awake during lectures.
Consider two recent news stories carried by Bloomberg. Here we learn that North Korea's : "Arirang mass games," ostensibly put on to showcase the worker's paradise to the world, involves twice as many performers as spectators. That's a great example of a profitable business model.... NOT!
Here's another, discussing the lavish palace built to hold all the gifts given to the "President for Eternity" and his son, North Korea's current leader. At the same time as wealth is being allocated to such high priority tasks,
A high percentage of [soldiers] are five feet tall or shorter. In the 1990s, North Korea reduced the minimum height for military service to 148 centimeters (4 foot 9 inches) from 150 centimeters and the minimum weight to 43 kilograms (95 pounds) from 48 kilograms....
in order to be able to recruit soldiers, despite a shrinking population. And why were people shrikning? As a direct result of their "Great Leader's" misguided policies leading to severe malnutrition. Surely you know you've done something wrong when your people are getting shorter from one generation to the next!
Remember the concave production possibility frontier used to teach opportunity cost and diminishing returns? "Guns" lie on one axis (representing military spending) and "Butter" on the other (representing food). Korea demonstrates what happens when you choose a corner solution, and it's the wrong one! (DPRK even looks dark at night from space).
Even if North Korea miraculously find a way to improve, there are other deranged leaders willing and able to fill it's large shoes. Zimbabwe is an excellent example of how NOT to generate economic growth, run monetary policy, support property rights, and so on. I don't expect to run out of teaching material anytime soon....
Consider two recent news stories carried by Bloomberg. Here we learn that North Korea's : "Arirang mass games," ostensibly put on to showcase the worker's paradise to the world, involves twice as many performers as spectators. That's a great example of a profitable business model.... NOT!
Here's another, discussing the lavish palace built to hold all the gifts given to the "President for Eternity" and his son, North Korea's current leader. At the same time as wealth is being allocated to such high priority tasks,
A high percentage of [soldiers] are five feet tall or shorter. In the 1990s, North Korea reduced the minimum height for military service to 148 centimeters (4 foot 9 inches) from 150 centimeters and the minimum weight to 43 kilograms (95 pounds) from 48 kilograms....
in order to be able to recruit soldiers, despite a shrinking population. And why were people shrikning? As a direct result of their "Great Leader's" misguided policies leading to severe malnutrition. Surely you know you've done something wrong when your people are getting shorter from one generation to the next!
Remember the concave production possibility frontier used to teach opportunity cost and diminishing returns? "Guns" lie on one axis (representing military spending) and "Butter" on the other (representing food). Korea demonstrates what happens when you choose a corner solution, and it's the wrong one! (DPRK even looks dark at night from space).
Even if North Korea miraculously find a way to improve, there are other deranged leaders willing and able to fill it's large shoes. Zimbabwe is an excellent example of how NOT to generate economic growth, run monetary policy, support property rights, and so on. I don't expect to run out of teaching material anytime soon....
Money vs. Legal Tender
A recent news story (here or here [SCMP, gated]) discusses the right to spend pennies in the United States:
A group of people this month protested in front of a Chinese takeaway restaurant in the Bronx after a customer said the cashier refused to accept 10 pennies as part of the payment for a US$2.75 dish. [....]
"This is America. If you want to do business in America, you have to accept all American currency," said Ruben Diaz, the Democratic senator who attended the protest.
The Senator is correct. In the United States, all US currency is "legal tender." That means that it must be accepted by law in exchange for a debt. Senator Diaz wants to enforce this law, with a threat of a $500 fine for any retailer who refuses to be paid in pennies!
This is absurd. Imagine buying a new car, and insisting on paying with pennies. Just counting, storing, securing, and exchanging the pennies into more useful currency would probably cost the car dealer more than the $500 fine. But that's the law... in the US at least.
In most countries, a more reasonable approach is taken. Money and Legal Tender are not identical. Take, for example, this quote from the Bank of Canada website:
The method of payment can be whatever is mutually acceptable to both parties — cash, credit card, cheque, etc. Thus, a merchant may refuse to accept bank notes in payment for goods or services, without contravening the law.
Other countries define in law what is reasonable for a retailer to accept, and enforce those standards. For example, in the United Kingdom,
... only coins valued 1 pound Sterling and 2 pounds Sterling are legal tender in unlimited amounts throughout the territory of the United Kingdom. [...]
Currently, 20 pence pieces and 50 pence pieces are legal tender in amounts up to 10 pounds; 5 pence pieces and 10 pence pieces are legal tender in amounts up to 5 pounds; and 1 penny pieces and 2 pence pieces are legal tender in amounts up to 20 pence.
This Wikipedia site contains the rules for many other countries.
What about Hong Kong? A quick search on the web didn't show up any results, although some stores openly advertise that they do not accept $1000HKD notes, and taxi drivers are not obliged to accept $500HKD notes as well.
As the SCMP article suggests, if you have to pay a fine in the US, insist on paying it in pennies. You would be fully within your rights to do so! In any other country, just be reasonable....
A group of people this month protested in front of a Chinese takeaway restaurant in the Bronx after a customer said the cashier refused to accept 10 pennies as part of the payment for a US$2.75 dish. [....]
"This is America. If you want to do business in America, you have to accept all American currency," said Ruben Diaz, the Democratic senator who attended the protest.
The Senator is correct. In the United States, all US currency is "legal tender." That means that it must be accepted by law in exchange for a debt. Senator Diaz wants to enforce this law, with a threat of a $500 fine for any retailer who refuses to be paid in pennies!
This is absurd. Imagine buying a new car, and insisting on paying with pennies. Just counting, storing, securing, and exchanging the pennies into more useful currency would probably cost the car dealer more than the $500 fine. But that's the law... in the US at least.
In most countries, a more reasonable approach is taken. Money and Legal Tender are not identical. Take, for example, this quote from the Bank of Canada website:
The method of payment can be whatever is mutually acceptable to both parties — cash, credit card, cheque, etc. Thus, a merchant may refuse to accept bank notes in payment for goods or services, without contravening the law.
Other countries define in law what is reasonable for a retailer to accept, and enforce those standards. For example, in the United Kingdom,
... only coins valued 1 pound Sterling and 2 pounds Sterling are legal tender in unlimited amounts throughout the territory of the United Kingdom. [...]
Currently, 20 pence pieces and 50 pence pieces are legal tender in amounts up to 10 pounds; 5 pence pieces and 10 pence pieces are legal tender in amounts up to 5 pounds; and 1 penny pieces and 2 pence pieces are legal tender in amounts up to 20 pence.
This Wikipedia site contains the rules for many other countries.
What about Hong Kong? A quick search on the web didn't show up any results, although some stores openly advertise that they do not accept $1000HKD notes, and taxi drivers are not obliged to accept $500HKD notes as well.
As the SCMP article suggests, if you have to pay a fine in the US, insist on paying it in pennies. You would be fully within your rights to do so! In any other country, just be reasonable....
Monday, May 14, 2007
Sticky Prices...
In my teaching and research, I focus on models of business cycles based on the assumption of sticky prices. That is, prices take time to adjust to shocks. As a result, prices may deviate from those that are optimal, at least for a while. And if prices deviate from optimal levels, consumption will also deviate, since consumers' behaviour depends on prices. In simple terms, if prices are too low, consumption and output will rise, and if prices are too high, consumption and ouput will fall.
Such models lie at the heart of most undergraduate testbooks of macroeconomics, and also provide the basis for using monetary policy to try to stabilise the economy. Suppose instead that prices were completely flexible. Then monetary policy would be impotent, since prices could fully adjust in response to shocks, ensuring that the economy always operates efficiently.
Whether prices are sticky is ultimately an empirical question. Tim Harford discusses one case of sticky prices that is truly remarkable: Coca Cola sold for 5 cents in the US continuously from 1886 until 1959, despite huge changes in the world economy over that period. (See here for more, or here for the original paper).
Such models lie at the heart of most undergraduate testbooks of macroeconomics, and also provide the basis for using monetary policy to try to stabilise the economy. Suppose instead that prices were completely flexible. Then monetary policy would be impotent, since prices could fully adjust in response to shocks, ensuring that the economy always operates efficiently.
Whether prices are sticky is ultimately an empirical question. Tim Harford discusses one case of sticky prices that is truly remarkable: Coca Cola sold for 5 cents in the US continuously from 1886 until 1959, despite huge changes in the world economy over that period. (See here for more, or here for the original paper).
Numbers....
Did you know that approximately 30% of all street numbers begin with the digit '1', while only 4.6% begin with the digit '9'? And that the same percentages apply to all manner of phenomena? It can even be used to check for electoral fraud, or for corruption of datasets! See Marginal Revolution for more discussion of Benford's Law.
Friday, May 11, 2007
Mainland Chinese Inflation
Mainland China is in an enviable position. Rapid economic growth, huge current account surpluses, and the world's largest foreign reserves all suggest a rosy future for the world's most populous country. But maybe not all is as well as it seems.
China's foreign reserves are reportedly growing by 1.5 billion USD per day. Such accumulation is generally the result of an undervalued exchange rate, where the currency trades at below its equilibrium value, supported by central bank intervention (although given China's currency controls, it is not clear where the equilibrium value of the RMB really lies).
If the currency were overvalued, there is a risk that the central bank would be forced to devalue the currency- for example, if it ran out of foreign reserves. This can have devastating consequences for the economy, as Thailand illustrated during the Asian Financial Crisis.
In contrast, the risks of an undervalued exchange rate seem mild. Supporting an undervalued exchange rate requires the central bank to demand foreign currency (bolstering foreign reserves) and supply local currency in return (increasing the domestic money supply). In principle, there are no limits to how long the central bank can continue doing this.
But it is not without negative consequences. As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomena." Unfortunately for China, the relationship holds in both directions. If you print too much money, you will generate inflation.
When I read headlines such as this one on increasing mainland inflation, it makes me nervous. Friedman also argued that an increase in the money supply increases inflation, but with "long and variable lags," a statement that is accepted as fact by most monetary economists. I'm concerned that the disproportionate increase in the money supply resulting from foreign exchange accumulation may yet result in a large increase in inflation in the coming months.
Aside from the massive build-up of foreign reserves, there is additional evidence of a highly expansionary monetary policy in Mainland China. With consumers earning less than the inflation rate when they deposit money at the bank, real interest rates are effectively negative. That is hardly going to constrain the growth rate of a runaway economy like China!
China needs higher nominal interest rates, and soon. That might also help to burst that other problem of the equity price bubble, before it gets worse.
China's foreign reserves are reportedly growing by 1.5 billion USD per day. Such accumulation is generally the result of an undervalued exchange rate, where the currency trades at below its equilibrium value, supported by central bank intervention (although given China's currency controls, it is not clear where the equilibrium value of the RMB really lies).
If the currency were overvalued, there is a risk that the central bank would be forced to devalue the currency- for example, if it ran out of foreign reserves. This can have devastating consequences for the economy, as Thailand illustrated during the Asian Financial Crisis.
In contrast, the risks of an undervalued exchange rate seem mild. Supporting an undervalued exchange rate requires the central bank to demand foreign currency (bolstering foreign reserves) and supply local currency in return (increasing the domestic money supply). In principle, there are no limits to how long the central bank can continue doing this.
But it is not without negative consequences. As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomena." Unfortunately for China, the relationship holds in both directions. If you print too much money, you will generate inflation.
When I read headlines such as this one on increasing mainland inflation, it makes me nervous. Friedman also argued that an increase in the money supply increases inflation, but with "long and variable lags," a statement that is accepted as fact by most monetary economists. I'm concerned that the disproportionate increase in the money supply resulting from foreign exchange accumulation may yet result in a large increase in inflation in the coming months.
Aside from the massive build-up of foreign reserves, there is additional evidence of a highly expansionary monetary policy in Mainland China. With consumers earning less than the inflation rate when they deposit money at the bank, real interest rates are effectively negative. That is hardly going to constrain the growth rate of a runaway economy like China!
China needs higher nominal interest rates, and soon. That might also help to burst that other problem of the equity price bubble, before it gets worse.
China Bubble...
The Mainland Chinese stock market is booming, and this makes me nervous. I've spoken to colleagues who cannot visit China without being asked by everyone from taxi drivers up which stocks they should invest in. Stories abound of students investing their university fees in equities in the hope of making a quick profit. Retired people investing all their retirement savings. As a rule of thumb, when everyone else to too eager to invest and doesn't seem to understand the risks involved, the market is suffering from a bubble.... and it's time to sell before the coming correction.
But maybe there is still hope. Even a bubble may ultimately be good for China's economic development. Daniel Gross argues that past bubbles have been good for the US (see here). I hope the same can be argued for China.... but I'm still very skeptical.
But maybe there is still hope. Even a bubble may ultimately be good for China's economic development. Daniel Gross argues that past bubbles have been good for the US (see here). I hope the same can be argued for China.... but I'm still very skeptical.
Zimbabwe.... at the UN
International policy organisations can be very entertaining... even when they try not to be.
The UN is set to elect a head of their "Commission on Sustainable Development." The likely winner? The Zimbabwe Environment Minister, Francis Nheme (see here for more).
As anyone who has listened to my lectures knows, Zimbabwe is a great example of everything that a government should NOT DO. They've destroyed property rights and generated hyperinflation. Millions of citizens have left the country for South Africa or Botswana. Unemployment is above 80%. Zimbabwe is the FASTEST SHRINKING ECONOMY OUTSIDE OF A WAR ZONE, as a direct result of the government's incompetence and corruption.
The only justification I can think of for appointing Zimbabwe to head this commission is that a rapidly shrinking economy may be sustainable. Just increase the corruption levels in each successive year, and shrink the economy a little further!
This reminds me of another incompetent world body appointment. By convention, the United States appoints the head of the World Bank, the world's largest anti-poverty organisation. George W. Bush appointed Paul Wolfowitz, someone with the dubious distinction of being an architect of the Iraq war. He was unqualified for the job, but was supposed to reduce levels of corruption in the dealings of the World Bank with third world officials. One of his first actions? A major pay raise and promotion of his girlfriend, in contravention of World Bank policy. Maybe it takes a corrupt official to recognise corruption!
Fortunately Wolfowitz will probably be forced to resign his position. I don't expect we will be as lucky regarding the UN appointment... Zimbabwe will probably chair the Sustainable Development commission for the full term regardless of their demonstrated incompetence.
The UN is set to elect a head of their "Commission on Sustainable Development." The likely winner? The Zimbabwe Environment Minister, Francis Nheme (see here for more).
As anyone who has listened to my lectures knows, Zimbabwe is a great example of everything that a government should NOT DO. They've destroyed property rights and generated hyperinflation. Millions of citizens have left the country for South Africa or Botswana. Unemployment is above 80%. Zimbabwe is the FASTEST SHRINKING ECONOMY OUTSIDE OF A WAR ZONE, as a direct result of the government's incompetence and corruption.
The only justification I can think of for appointing Zimbabwe to head this commission is that a rapidly shrinking economy may be sustainable. Just increase the corruption levels in each successive year, and shrink the economy a little further!
This reminds me of another incompetent world body appointment. By convention, the United States appoints the head of the World Bank, the world's largest anti-poverty organisation. George W. Bush appointed Paul Wolfowitz, someone with the dubious distinction of being an architect of the Iraq war. He was unqualified for the job, but was supposed to reduce levels of corruption in the dealings of the World Bank with third world officials. One of his first actions? A major pay raise and promotion of his girlfriend, in contravention of World Bank policy. Maybe it takes a corrupt official to recognise corruption!
Fortunately Wolfowitz will probably be forced to resign his position. I don't expect we will be as lucky regarding the UN appointment... Zimbabwe will probably chair the Sustainable Development commission for the full term regardless of their demonstrated incompetence.
Thursday, May 10, 2007
Hyperinflation.... Yugoslavian Edition
"Between October 1, 1993 and January 24, 1995 prices increased by 5 quadrillion percent. That’s a 5 with 15 zeroes after it."
See more here (thanks to Newmark's Door for the pointer). Maybe Robert Mugabe of Zimbabwe should try harder... at only four digit's, he's no where near making the record books!
Another curious hyperinflation fact:
"At the inflationary peak reached by Chiang Kai-shek's regime, one US dollar was worth Yuan 41 276 595 744 681 - still a world record!"
See this story for more international comparisons.
Wednesday, May 9, 2007
The Economics of Charitable Giving....
Suppose that you wish to help someone who is not as well off as yourself. That should be easy, right? Just give them money. Wrong! As Tim Hartford argues (thanks to Marginal Revolution for the pointer), if we really want to make a difference, we need to think carefully about the incentives that our giving may create.
As a simple example of perverse incentives, suppose we give money to the first beggar that we see. By so doing, we increase the incentives to beg, which is an unproductive activity. In the margin, our giving may induce more people to forgo a productive job and instead take up begging. Society as a whole looses.
There are other less obvious costs as well. Pedestrians tend to follow similar paths, and beggars will concentrate in areas where pedestrian density is greatest. In Hong Kong's case, that would imply increased congestion around exits to the MTR, an externality borne by all of society.
To some degree, perverse incentives are an unavoidable cost of charity, but there are ways to minimize these negative effects. The first step is to try to ensure that any money we give is used to meet a short-term human need like food, rather than as an alternative source of income to a job. This requires some effort. Instead of giving money, give food. Or even better, give money to a charity that provides food to the very poor- hopefully in a more cost-effective and efficient manner than you can as an individual. Since the marginal utility of food consumption falls rapidly with increased consumption and beggars cannot easily on-sell donations of food, this ensures that hungry beggars have their most basic need met, while at the same time ensuring that they face little incentive to make a career out of begging.
Next, we should view charity as making an investment in the future welfare of the planet, and try to get the maximum long-run return on our investment. As the old proverb says, "Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime." Giving food to beggars may be good, but giving him life skills is even better.
As an individual, there is little most of us can do to help the very poor to improve their ability to earn an income. But, as with food, there are many well-run charities that we can support that provide these services economically.
Charity may create perverse incentives, but by creatively targeting our charity, we may minimise these incentives and so maximise the benefits of our giving on society.
As a simple example of perverse incentives, suppose we give money to the first beggar that we see. By so doing, we increase the incentives to beg, which is an unproductive activity. In the margin, our giving may induce more people to forgo a productive job and instead take up begging. Society as a whole looses.
There are other less obvious costs as well. Pedestrians tend to follow similar paths, and beggars will concentrate in areas where pedestrian density is greatest. In Hong Kong's case, that would imply increased congestion around exits to the MTR, an externality borne by all of society.
To some degree, perverse incentives are an unavoidable cost of charity, but there are ways to minimize these negative effects. The first step is to try to ensure that any money we give is used to meet a short-term human need like food, rather than as an alternative source of income to a job. This requires some effort. Instead of giving money, give food. Or even better, give money to a charity that provides food to the very poor- hopefully in a more cost-effective and efficient manner than you can as an individual. Since the marginal utility of food consumption falls rapidly with increased consumption and beggars cannot easily on-sell donations of food, this ensures that hungry beggars have their most basic need met, while at the same time ensuring that they face little incentive to make a career out of begging.
Next, we should view charity as making an investment in the future welfare of the planet, and try to get the maximum long-run return on our investment. As the old proverb says, "Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime." Giving food to beggars may be good, but giving him life skills is even better.
As an individual, there is little most of us can do to help the very poor to improve their ability to earn an income. But, as with food, there are many well-run charities that we can support that provide these services economically.
Charity may create perverse incentives, but by creatively targeting our charity, we may minimise these incentives and so maximise the benefits of our giving on society.
Tuesday, May 8, 2007
Predicting Exchange Rates... using Politics
Does an unpopular politician cause the exchange rate to drop? Maybe. (Take note of the important caveats and limitations in the discussion).
Monday, May 7, 2007
A Common Currency for Asia?
From time to time, the idea of a common currency for Asia, similar to the Euro, is mentioned in the press (see, for example, here). It has been actively encouraged by Robert Mundell, winner of the 1999 Nobel Prize. Here I will briefly answer two questions: Is a common currency for Asia possible? And is it a good idea?
Starting with the second question first, a common currency should increase economic efficiency, for two reasons. In all international transactions, there are costs involved in exchanging wealth from one currency to another. The presence of these costs may reduce the willingness of firms to trade. But more importantly, there are risks involved in transacting between currencies. If I invest in assets denominated in another currency, that currency may appreciate or depreciate, potentially making the difference between turning a profit or a loss on my investment.
To understand the extent of this, in May 2000, one Euro bought 89 cents US. Today it buys $1.36 US. If an American invested in Euro denominated assets in 2000, the currency appreciation alone has earned them a 6.2% windfall gain PER YEAR, compounding, over and above any returns on their assets. In contrast, a European investing in the United States has been loosing the same amount.
Investors are risk averse, and respond to risk by reducing their exposure- in this case, by limiting trade across currencies. They may also spend real resources in trying to protect themselves from currency fluctuations, by "hedging" away currency risk, again reducing economic efficiency. These costs would be avoided by adopting a common currency.
But there are also costs to adopting a common currency. Most importantly, monetary policy will be identical across all economies using the common currency, even though individual countries will be subject to different economic shocks and business cycles. The cost of this loss of monetary policy depends on how flexible prices and wages are, i.e. the degree to which the economy can rapidly adjust in response to macroeconomic shocks.
So to answer the question of whether a common currency is a good idea, we would need to weigh the relative benefits of increased efficiency against the relative costs of losing monetary policy as an effective tool to steer the economy.
Moving on to the second question, whether a common currency for Asia is possible, the simple answer is "not for a long time." To understand why, we can look to the experience in Europe.
The development of the Euro in Europe was the result of a drawn-out political process start started with the European Common Market in the late 1950's (see here for a history). It took almost 50 years from the start of the political process to the common currency we have today, and each of the countries involved has sacrificed independent monetary policy to be set by a joint central bank, housed in Frankfurt, Germany.
Consider the situation in Asia. Suppose that the major economies of Asia agreed to a joint central bank. Where would such a central bank be situated? The largest economies are Japan and China, so they are the obvious candidates. However, at the current time it is inconceivable that either country would be willing to allow the central bank to be housed in the other country! And that is just a trivial matter next to the more important agreements that would have to be reached on how monetary policy would be set, and what objectives the central bank should seek to achieve! Developing a common currency requires a high degree of political co-operation and integration, neither of which is evident in Asia!
To be clear, I do not expect to see a common currency in Asia within my lifetime.... and I expect to live a long time!
Starting with the second question first, a common currency should increase economic efficiency, for two reasons. In all international transactions, there are costs involved in exchanging wealth from one currency to another. The presence of these costs may reduce the willingness of firms to trade. But more importantly, there are risks involved in transacting between currencies. If I invest in assets denominated in another currency, that currency may appreciate or depreciate, potentially making the difference between turning a profit or a loss on my investment.
To understand the extent of this, in May 2000, one Euro bought 89 cents US. Today it buys $1.36 US. If an American invested in Euro denominated assets in 2000, the currency appreciation alone has earned them a 6.2% windfall gain PER YEAR, compounding, over and above any returns on their assets. In contrast, a European investing in the United States has been loosing the same amount.
Investors are risk averse, and respond to risk by reducing their exposure- in this case, by limiting trade across currencies. They may also spend real resources in trying to protect themselves from currency fluctuations, by "hedging" away currency risk, again reducing economic efficiency. These costs would be avoided by adopting a common currency.
But there are also costs to adopting a common currency. Most importantly, monetary policy will be identical across all economies using the common currency, even though individual countries will be subject to different economic shocks and business cycles. The cost of this loss of monetary policy depends on how flexible prices and wages are, i.e. the degree to which the economy can rapidly adjust in response to macroeconomic shocks.
So to answer the question of whether a common currency is a good idea, we would need to weigh the relative benefits of increased efficiency against the relative costs of losing monetary policy as an effective tool to steer the economy.
Moving on to the second question, whether a common currency for Asia is possible, the simple answer is "not for a long time." To understand why, we can look to the experience in Europe.
The development of the Euro in Europe was the result of a drawn-out political process start started with the European Common Market in the late 1950's (see here for a history). It took almost 50 years from the start of the political process to the common currency we have today, and each of the countries involved has sacrificed independent monetary policy to be set by a joint central bank, housed in Frankfurt, Germany.
Consider the situation in Asia. Suppose that the major economies of Asia agreed to a joint central bank. Where would such a central bank be situated? The largest economies are Japan and China, so they are the obvious candidates. However, at the current time it is inconceivable that either country would be willing to allow the central bank to be housed in the other country! And that is just a trivial matter next to the more important agreements that would have to be reached on how monetary policy would be set, and what objectives the central bank should seek to achieve! Developing a common currency requires a high degree of political co-operation and integration, neither of which is evident in Asia!
To be clear, I do not expect to see a common currency in Asia within my lifetime.... and I expect to live a long time!
So You Want to Go to Harvard?
A recent article in the New York Times on students interviewing for Harvard here (thanks to Newmarks Door for the pointer) is food for thought for students wanting to study in top universities. I have had the priviledge of discussing future education plans with many students since coming to HKU 6 years ago; here I'll outline a few thoughts that might help you in your plans.
1) EVERYONE wants to go to Harvard- and nearly everyone who applies fails to get in. So be realistic.... apply by all means, but have a plan B, because you'll probably need it. And just to be safe, have a plan C, D, and E as well. When I talk to students, nothing worries me more than those who have not thought seriously about what they'll do if their plans don't work out. Life is too valuable to waste, waiting and hoping that you might get in if you apply again next year.
2) I DIDN'T go to Harvard. (If you're curious, you can trace my progression through universities here or here). There are many other excellent universities in the world, and going to any good university will open many excellent career opportunities to you. Sure, going to Harvard would give you an advantage, but there are other ways of achieving your career objectives.
Aside from those general principles, a few more that are specific to students contemplating postgraduate studies in Economics:
3) If you are not desperate to do research, than a PhD is not for you. Some top undergraduate students choose to stay on at university simply because it is what they know. Like most things in life that are worth doing, a PhD is difficult and requires persistence. If you start a PhD without complete commitment, you'll probably drop out without finishing, wasting a few years of your life in the process. By the end of your second year of undergrad, you should have some good ideas on where you WANT to be in future. Actively work towards that end.... don't just drift into further studies.
4) As an application of 3), if you can be persuaded NOT to do a PhD, you probably should not do one. (If you come to me for advice, I will first try to persuade you that you should do something else).
5) You MUST take lots of Maths courses. You can bluff your way through most undergrad courses with very limited maths. But economics gets increasingly mathematical the further you study; writing descriptive essays, no matter how polished, will probably not get you a PhD, let alone a job.
6) And finally, a PhD from a bottom-ranked university may give you very few career choices. Don't loose sight of the role of your studies- they're ultimately a means to obtaining the career you want, not an end in themselves.
1) EVERYONE wants to go to Harvard- and nearly everyone who applies fails to get in. So be realistic.... apply by all means, but have a plan B, because you'll probably need it. And just to be safe, have a plan C, D, and E as well. When I talk to students, nothing worries me more than those who have not thought seriously about what they'll do if their plans don't work out. Life is too valuable to waste, waiting and hoping that you might get in if you apply again next year.
2) I DIDN'T go to Harvard. (If you're curious, you can trace my progression through universities here or here). There are many other excellent universities in the world, and going to any good university will open many excellent career opportunities to you. Sure, going to Harvard would give you an advantage, but there are other ways of achieving your career objectives.
Aside from those general principles, a few more that are specific to students contemplating postgraduate studies in Economics:
3) If you are not desperate to do research, than a PhD is not for you. Some top undergraduate students choose to stay on at university simply because it is what they know. Like most things in life that are worth doing, a PhD is difficult and requires persistence. If you start a PhD without complete commitment, you'll probably drop out without finishing, wasting a few years of your life in the process. By the end of your second year of undergrad, you should have some good ideas on where you WANT to be in future. Actively work towards that end.... don't just drift into further studies.
4) As an application of 3), if you can be persuaded NOT to do a PhD, you probably should not do one. (If you come to me for advice, I will first try to persuade you that you should do something else).
5) You MUST take lots of Maths courses. You can bluff your way through most undergrad courses with very limited maths. But economics gets increasingly mathematical the further you study; writing descriptive essays, no matter how polished, will probably not get you a PhD, let alone a job.
6) And finally, a PhD from a bottom-ranked university may give you very few career choices. Don't loose sight of the role of your studies- they're ultimately a means to obtaining the career you want, not an end in themselves.
Friday, May 4, 2007
Unrest in Macau... lessons for China
Macau has been in the world headlines recently, for both good and bad reasons. A few weeks ago, I discussed Macau's rapid growth (real GDP grew 16.6% last year: see my earlier post here). Now they're back in the headlines, for protests that turned violent and police firing warning shots into the air (a YouTube clip of the action is here).
So what are Macau residents protesting about? In economics, we often focus on average or aggregate wages, without paying enough attention to the full distribution of those wages. I was guilty of that in my earlier post, in which I argued that average real wages have grown spectacularly in recent years. It turns out that while many people in Macau are benefitting from growth, a significant minority feel that they're being left behind, and are seeing no benefits from the increased construction, gambling, and associated service industry growth.
What lies beneath this dissatisfaction? It's not as if the people who were protesting are worse off than they were before the rapid growth! Well, it turns out that people appear to derive utility not just from the level of their income, but also from their relative status in the economy. That is, I'm happier being poor if you are also poor. But if I observe you becoming better off while I am not, that imposes a negative externality on me. I feel worse off, even if I enjoy the same level of consumption as before. It's called the "relative income hypothesis" (RIH).
I would expect that the power of the RIH to affect utility is non-linear. If changes in status occur only slowly (for example, over generations), consumers slowly adjust to their new-found status or lack thereof, without any major loss of utility. However, the more rapid is the change in status, the more difficult is the adjustment process, and the greater is the loss of utility.
Coming back to Macau, rapid economic growth results in rapid changes in relative status. The Macau SAR government should be very careful to try to redistribute wealth from the newly wealthly to those who have not benefitted from growth to ensure political stability. The simplist way to achieve this would be to levy a progressive tax on income, and offer more generous social welfare payments to the poorest of Macau society. Given that there are currently no income taxes in Macau, this may be a very difficult policy change to make. Maybe that's why I'm an economist and not a politician!
Need I point out that Mainland China, with growth of approximately 10% for many years now, has the potential to replicate the tensions in Macau, but on a much larger scale. Only time will tell whether the government in Beijing is doing enough to ensure social stability, by ensuring that the poor are not completely left behind by China's rapid development.
So what are Macau residents protesting about? In economics, we often focus on average or aggregate wages, without paying enough attention to the full distribution of those wages. I was guilty of that in my earlier post, in which I argued that average real wages have grown spectacularly in recent years. It turns out that while many people in Macau are benefitting from growth, a significant minority feel that they're being left behind, and are seeing no benefits from the increased construction, gambling, and associated service industry growth.
What lies beneath this dissatisfaction? It's not as if the people who were protesting are worse off than they were before the rapid growth! Well, it turns out that people appear to derive utility not just from the level of their income, but also from their relative status in the economy. That is, I'm happier being poor if you are also poor. But if I observe you becoming better off while I am not, that imposes a negative externality on me. I feel worse off, even if I enjoy the same level of consumption as before. It's called the "relative income hypothesis" (RIH).
I would expect that the power of the RIH to affect utility is non-linear. If changes in status occur only slowly (for example, over generations), consumers slowly adjust to their new-found status or lack thereof, without any major loss of utility. However, the more rapid is the change in status, the more difficult is the adjustment process, and the greater is the loss of utility.
Coming back to Macau, rapid economic growth results in rapid changes in relative status. The Macau SAR government should be very careful to try to redistribute wealth from the newly wealthly to those who have not benefitted from growth to ensure political stability. The simplist way to achieve this would be to levy a progressive tax on income, and offer more generous social welfare payments to the poorest of Macau society. Given that there are currently no income taxes in Macau, this may be a very difficult policy change to make. Maybe that's why I'm an economist and not a politician!
Need I point out that Mainland China, with growth of approximately 10% for many years now, has the potential to replicate the tensions in Macau, but on a much larger scale. Only time will tell whether the government in Beijing is doing enough to ensure social stability, by ensuring that the poor are not completely left behind by China's rapid development.
Blogging Economists
Some very well known economists wrote blogs, as this story discusses. I can identify with many of the reasons they give, but mostly this is an experiment. In economics, "learning by doing" is an important way to develop expertise. What better way to think about writing for a diverse audience about economics than actually doing it! Like Drezner, I plan to do this for about a year. Maybe also like Drezner, I'll still be doing it in five years! Is that a violation of "rational expectations?"
Wednesday, May 2, 2007
China's Golden Week
Mainland China introduced its "Golden Week" holidays in 1999, giving workers 7 days off in order to stimulate domestic travel and consumption. It currently has 3 such golden weeks; the "Spring Festival" (Chinese New Year) in January or February, "Labour Day Golden Week" (starting May 1) and "National Day Golden Week" (starting October 1). What is the effect of these on the economy? Should they be extended, or shortened?
The common perception is that the "Golden Week" holidays have had mixed success in stimulating domestic consumption. I would be more harsh, and argue that they've been a failure. The main driver of economic growth in Mainland China has been export growth, especially with the United States. China has opened up to the rest of the world economy and, as a result of cheap labour and economies of scale, has transformed itself from an impoverished state into a less impoverished factory for the world's consumers.
But missing almost entirely from this transformation is consumer demand. Estimates of domestic savings suggest that households save approximately 50% of incomes (compared with negative savings in the United States, for example). Consumption demand remains tiny relative to income levels, with or without forced vacations for workers.
A more important question is why households choose to save so much instead of consuming it. Households should use their savings to seek to smooth their consumption levels over their lifetimes. In an economy with high growth rates (and therefore projected higher income levels in the future), this would suggest low savings rates now, to be made up by higher savings rates later- which is the opposite of what we see!
So why do households save so much today? I believe this has more to do with the state of the health sector in Mainland China, combined with risk averse consumers. It is now widely recognised that good health care is practically unavailable to consumers without money, and even for the wealthy, consumer rights are limited. In response to such uncertainty, risk averse consumers will tend to save too much, to avoid the possibility of dying prematurely for want of wealth to pay for care.
Education is likely to play a role in China's excessive savings as well. As China continues to develop, an increasing share of the population will attend university. In the absence of readily available student loans, parents pay for their children's education, requiring a very high savings rate from the parents. In contrast, if the student pays for their own education by taking out a loan, repayment of that loan will require a much lower effective savings rate from the student. This is because the student, armed with a university degree, will earn a much higher income than their parents.
So to increase domestic demand, I suggest the following policy changes.
1) Reform health care. Central to this will be enforcing patient rights.
2) Ensure the provision of efficient health care insurance that is financially accessible at all levels of society. I'm sure that there are many world-leading insurance companies who would love to have a share of the health insurance market in Mainland China. Insurance companies may also play an important role in enforcing efficient care for their clients as well.
3) Ensure student loans are readily available to academically qualified students, so that individuals can pay for their education based on their own future earnings, rather than requiring high savings of parents.
I believe that these measures would have a far greater effect on consumption than any number or mix of national holidays!
The common perception is that the "Golden Week" holidays have had mixed success in stimulating domestic consumption. I would be more harsh, and argue that they've been a failure. The main driver of economic growth in Mainland China has been export growth, especially with the United States. China has opened up to the rest of the world economy and, as a result of cheap labour and economies of scale, has transformed itself from an impoverished state into a less impoverished factory for the world's consumers.
But missing almost entirely from this transformation is consumer demand. Estimates of domestic savings suggest that households save approximately 50% of incomes (compared with negative savings in the United States, for example). Consumption demand remains tiny relative to income levels, with or without forced vacations for workers.
A more important question is why households choose to save so much instead of consuming it. Households should use their savings to seek to smooth their consumption levels over their lifetimes. In an economy with high growth rates (and therefore projected higher income levels in the future), this would suggest low savings rates now, to be made up by higher savings rates later- which is the opposite of what we see!
So why do households save so much today? I believe this has more to do with the state of the health sector in Mainland China, combined with risk averse consumers. It is now widely recognised that good health care is practically unavailable to consumers without money, and even for the wealthy, consumer rights are limited. In response to such uncertainty, risk averse consumers will tend to save too much, to avoid the possibility of dying prematurely for want of wealth to pay for care.
Education is likely to play a role in China's excessive savings as well. As China continues to develop, an increasing share of the population will attend university. In the absence of readily available student loans, parents pay for their children's education, requiring a very high savings rate from the parents. In contrast, if the student pays for their own education by taking out a loan, repayment of that loan will require a much lower effective savings rate from the student. This is because the student, armed with a university degree, will earn a much higher income than their parents.
So to increase domestic demand, I suggest the following policy changes.
1) Reform health care. Central to this will be enforcing patient rights.
2) Ensure the provision of efficient health care insurance that is financially accessible at all levels of society. I'm sure that there are many world-leading insurance companies who would love to have a share of the health insurance market in Mainland China. Insurance companies may also play an important role in enforcing efficient care for their clients as well.
3) Ensure student loans are readily available to academically qualified students, so that individuals can pay for their education based on their own future earnings, rather than requiring high savings of parents.
I believe that these measures would have a far greater effect on consumption than any number or mix of national holidays!
Greenspan Speaks on US Housing Equity Withdrawal....
The United States has enjoyed high growth rates compared with most other developed countries in recent years. In part, this has been due to rapidly increasing property prices fuelling increased consumption. Household consumption has grown based on home owners withdrawing equity from their homes (by taking out larger mortgages, for example), and spending part of this withdrawn equity on consumption.
In the long run, this behaviour may generate risks for the economy, as the ability of households to continue to withdraw equity depends on continued increases in the price of houses.
In a recent paper by the former Chairman of the US Federal Reserve, Alan Greenspan (and co-author James Kennedy) carefully calculate how large a share of consumption in recent years was due to home owners extracting equity from their homes. I find the results somewhat alarming.
Consider the following figure from their paper. US households have been spending approximately 1% more than they earn for the past two years (fat solid line). But if we subtract consumption and repayment of non-mortgage debt that is financed by equity withdrawal from their spending, they are in fact living within their means, with a savings rate of just over 1% (thin solid line). The difference between these lines may be interpreted as the extent to which the housing market has fuelled consumption demand.
In the long run, this behaviour may generate risks for the economy, as the ability of households to continue to withdraw equity depends on continued increases in the price of houses.
In a recent paper by the former Chairman of the US Federal Reserve, Alan Greenspan (and co-author James Kennedy) carefully calculate how large a share of consumption in recent years was due to home owners extracting equity from their homes. I find the results somewhat alarming.
Consider the following figure from their paper. US households have been spending approximately 1% more than they earn for the past two years (fat solid line). But if we subtract consumption and repayment of non-mortgage debt that is financed by equity withdrawal from their spending, they are in fact living within their means, with a savings rate of just over 1% (thin solid line). The difference between these lines may be interpreted as the extent to which the housing market has fuelled consumption demand.
To try to see how this has affected Real GDP growth in the US, I've reproduced the offical GDP numbers for the US, adjusted by the difference between the two lines. The first figure below is in terms of levels, while the second is in terms of growth rates. (The correction for 2006 is based on the average for the first three quarters only, the latest figures contained in the paper).
Taken at face value, the effects don't look too alarming. Even thought most economists would agree that the growing difference between these lines is unsustainable, it is small, at about 2.3% of GDP in levels in 2006. Under normal circumstances, we might expect that households would slowly reduce their equity withdrawals over time, which would slow GDP growth a little, but probably not by enough to cause a recession.
The problem comes if the correction is forced to occur more quickly. Now that house prices are actually falling in the United States, the ability of households to extract equity has effectively evaporated in most areas. If consumption were to fully drop by the amount of the equity withdrawals, then it is likely that the resulting 2.3% drop in real GDP would more than offset any increases in other sectors of the economy, and so cause a recession.
The problem may also be further compounded:
1) If house prices were to continue to fall, we could see equity withdrawal go into reverse: households reduce consumption by more than 2.3% to try to increase savings to offset their loss of wealth.
2) Other components of the economy are dependent on housing and consumption. It is likely that investment spending would also decline significantly in response to a major fall in consumption.
Only time will tell if this is correct, but I remain pessimistic.
For my earlier views on the US economy and the role of housing see here and here.
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