The visible hand in economics

Archive for August 2007

Yves Smith think so. His argument is that, even though we didn’t fully appreciate it at the time, Greenspan really really cared about equity markets. He was scared of them, and he didn’t want to go out there and nail them as much as he should have. By being ‘hostage’ to the equity markets, Greenspan surrendered some of the Central Banks integrity. He gave up the hard arse, anti-inflationary image of the Central Bank that Paul Volcker had created.

I’m not sure I agree completely, I mean Greenspan did have the ability to keep inflation in the bag for 19 years. However, his unclear style of speaking and his refusal to target a clear level of inflation did create unnecessary uncertainty in the marketplace, and to some degree, may have damaged the inflation fighting power of the Federal Reserve.

A Reserve Bank governor needs to be a clear speaker, who finds the mere idea of inflation repugnant. That is why Don Brash did such a good job.

I was having a discussion with my girlfriend yesterday on a blog post by Tyler Cowen. There are a lot of interesting points in the post, but the one that struck me and led to the discussion was:

“The median photograph of you is probably the best approximation of your physical attractiveness “

The reason Tyler gives for this is that there is a random sample of photos taken of a person, so on average a photo will show what you look like. Compare this to the method we actually use to judge how good we look; the mirror. In the mirror we make ourselves look as good as we can, so it gives us an upwardly biased sample of how we look. So based on this, we should use photos to tell how good we look, a scary thought.

This is where the discussion between my girlfriend and me appeared. She said that the sample of photos was biased, as people often know there photo is going to be taken and act appropriately. We interpreted this in two different ways:

Matt: So the sample of photos is biased upwards, since people pose when they are having their photo taken. As a result, I look even worse then my average photo!

Rosie: It depends on the person. When Matt knows a photo is going to be taken he makes stupid faces. As a result, the sample of photos is biased downwards.

I don’t know. I don’t think any of this bodes well for my attractiveness. At least I have economics ;)

Winston Peters has come to the rescue of the elderly by delivering a gold card. Now blah blah people are complaining that the discounts are not enough and blah blah people are annoyed they don’t get discounts on power. I don’t really care about that. What excites me the idea of why firms may be willing to get involved in this scheme.

Now there could be reputation effects, advertising etc etc. However, there is an even simpler solution, price discrimination. Generally, the elderly have more elastic demand for many goods, as they are on lower incomes then people that are in their prime working age. As a result, firms want to charge a lower price to the elderly, than they do to people who are still working full time. That is why there are all sorts of discounts schemes for elderly people already.

However, there is a cost to setting up these scheme, which may be sufficient to stop firms doing it. Suddenly the government offers to pay to set it up, and firms can price discriminate to their hearts desire. That seems cool, the elderly and the firms are better off, have we got a free lunch here? No.

Someone has to pay for this, and that is working people. They pay taxes, which get used to fund the scheme. Also as the firms can price discriminate, they will now charge a higher price to those with relatively inelastic demand, the people working.

As an intertemporal transfer, this seems ok, except for the fact that the current elderly never had to pay the higher prices and taxes associated with this scheme. As a result, they are getting a free transfer, and the generation that turns elderly once the scheme is scrapped is the generation that will have to pay for it. Still I don’t really care, I just like talking about price discrimination ;)

Hat tip: No minister 

So teachers want a pay rise.  This isn’t really surprising given the inflationary pressure in the economy.  Now I don’t know too much about teachers pay, but I did find it interesting that the teachers union is saying that teachers wages should increase by 7.5%, and that this would reduce the average size of the classroom.

We know why teachers are saying this, they want parents and students to support them, so they have to make it sound like it is in their interest.  However, this isn’t the way I understand the situation.  If teachers pay is increased, and the government does not completely fund it, then less teachers will be hired.  With less teachers and the same number of students, schools will ended up with more students per class.

One possible counter-argument is that we have a skill shortage for secondary school teachers, and as a result by increasing wages we can get more teachers into jobs.  This presumes that schools have the resources to hire more teachers, at a higher wage, which would imply that we have a shortage of secondary school teachers.  But we don’t.  We are on the border of having a shortage of teachers, schools can find the number of teachers they need, but it does take time (average fill rate for secondary teaching jobs is 70%).

As I doubt the government will be stump up all the cash for a 7.5% jump in teachers wages (there are other groups they have to bribe first and foremost), schools will be stuck trying to come up with more money to pay teachers.  Fewer teachers will be hired and class sizes will rise.

So that makes it six finance companies in 15 months. What does this mean for the NZ credit market?

NZ banks should not be significantly effected. Banks are in relatively good shape, and all the recent trouble in secondary, non-bank financial institutes, is likely to increase demand for low yielding, low risk bank products.

However, non-bank financial institutions are going to have one hell of a time trying to find funds in the current tight credit market. The failure of so many finance companies is likely to make thing more difficult for them, by increasing investors level of risk aversion. Without a steady stream of deposits, some efficient and well managed finance companies are going to be flushed down the toilet. That is what happened to Property Finance.

My concern is that this may make it difficult for firms to borrow money. NZ currently has a tight labour market, and NZ firms are making low margins. In this sort of situation, firms are unwilling to remove staff, and as a result need to borrow to stay afloat. Now, something will have to give, either the flow in the credit market will improve, unemployment will creep up, or firms will be run into the ground. Only time will tell I guess.

Update: A couple of finance companies say they are feeling good. They expect regulation to occur, but how should we regulate the non-bank financial sector?

Update II:  So Five star consumer finance has gone under.  Guess it wasn’t really five star ;) .  Look I’m an economist with no sense of humor I just had to say it.  But it didn’t deserve a new post, as the company was small and not that exciting.  It might scare people, but I suspect it was just dead wood.

Supply and demand, the economic scissors. This beautiful diagram explains a significant amount about how economists think:


Now from what I understand, when the two curves cross we have equilibrium. This sets a price where demand and supply are equal. When the price is higher we have a surplus of goods, here some of the firms in the industry can’t sell all their produce, and so they cut prices bringing us to equilibrium. When the price is below equilibrium we have a shortage of goods. In this case competing consumers are supposed to bid up the price until we get to equilibrium.

However, in western society we don’t like to bid up the price, we just sit around. The best example I have of this is my daily pie. I want a chicken pie, I go to the store and they only ever have one, and half the time someone else has taken it. Now instead I buy a curry pie. If the store knew that I also wanted a chicken pie they could have put one more in the oven and I would have paid a higher price, and we would both be better off.   Instead, they think that I have revealed a preference for curry pies and they keep on cooking them.  There is imperfect information here.

How are we supposed to solve the case of the pie, given that western consumers aren’t fond of arguing up the price when there is a shortage. Well I think that firms realise this, and through a process of trial and error they try to increase information, so that they can set the equilibrium price.

The example of this is supermarkets. In a supermarket there always seems to be one type of toilet paper on special. The different manufacturers take turns, lowering there price and sometimes increasing it by more than they dropped it the next week. In this case the firms are trying to discover what the demand curve looks like, they are trying to find out if there is a shortage of their product. Through this process the firm discovers enough information bring us closer to equilibrium, all in the name of maximising profits. How convenient.

I have always been skeptical of open source software, if Microsoft and all of their highly paid programmers can’t get it right, how can a bunch of guys who work on projects for free in their spare time do any better? As a recent convert to Linux I now realize how wrong I was. In fact I now have absolutely no use for any Microsoft products.

As an economist I believe that there will always be a role for propriety software though. To see why I think it is useful to examine what proponents of free software are striving for. With that in mind I have pulled the definition of “free” software off of the Free Software Foundation website:

  • The freedom to run the program, for any purpose (freedom 0).

  • The freedom to study how the program works, and adapt it to your needs (freedom 1). Access to the source code is a precondition for this.

  • The freedom to redistribute copies so you can help your neighbor (freedom 2).

  • The freedom to improve the program, and release your improvements to the public, so that the whole community benefits (freedom 3). Access to the source code is a precondition for this.

As you can see they are referring to free as in freedom to modify and redistribute rather than free as in price. However this implicitly means that the software will be available for free as even if a price is charged for the software, the person who buys it is free to give it to all his friends for free and they can give it to their friends and so on.

When I put my economist hat on (let’s be honest, I never take it off) I think that if all software was free the quality of software would suffer. What does a developer of free software get for the time he puts into writing a new piece of software? Not really much more than kudos from the community. So there is a big trade off here, with free software the people are working on software use it themselves so they are able to detect problems and add new features very easily, but at the same time if there is no financial reward from developing software then people have the incentive to put their effort elsewhere. This problem is particularly bad for software that is extremely complicated or requires a lot of time to develop. In this case we either get a software that is no where near as good as the proprietary version or the amount of time required to develop the software means progress is very slow.

As an example I use a mathematical program called Mathematica for a lot of my work and haven’t been able to find anything anywhere near as good that is “free”. I am also an avid gamer and have noticed that the standard of open source games is pretty terrible which makes sense given the amount of time required to develop a game.

So while I am huge fan of Linux and open source software , I think that aiming for all software to be free isn’t a good idea as there are certain cases where this provides the wrong incentives.

So, our labour market is looking extremely tight. According to the department of labour all nine of the main occupation classes are currently suffering from labour shortages, and these shortages are likely to continue into the medium term. So the country needs more workers, and it takes time to breed them, so why don’t we get them in from overseas?

The government seems concerned about letting people into the country as it might cause inflation. But if we are actually suffering from a chronic labour shortage, a few extra pairs of hands will surely help suppress inflationary pressures.

As long as the individuals we bring in are more productive than the average New Zealander everyone is better off. Whats the problem?

A commenter on the ‘Democracy and Growth’ post below said that he didn’t think “…growth was ever a putative justification for the invasion of Iraq”. While that may be the case, it didn’t stop the US from using post-war Iraq as a playground for a few ideologically driven economists. Using a regime that reminds one of the IMF’s widely criticised Structural Adjustment Programs (just Google it if you think I’m being selective in my link choice here), the US has drastically reformed Iraq’s economic policy.

Dismantling the public service, privatising much of the public sector and removing any bias towards Iraqi companies in the granting of contracts has resulted in massive unemployment and poverty in the formerly wealthy nation. Dani Rodrik links a couple of other interesting article in this post.

Admittedly, there is debate over how well the Iraqi economy is doing these days. However, whatever the goals of the invasion, they could have done better in the aftermath than pursue policies that even the IMF is now moving on from. Development economics has come a long way since the inception of SAPs and the reconstruction of Iraq was a great opportunity to show what can be done.

Rod Oram has had another crack at explaining why he thinks higher output will lead to lower inflation. His argument is, that higher output can help us reduce housing, labour, and business capacity constraints which are dogging the economy.

The first point seems to be his main one, that there are too few houses and so building more houses will reduce house prices . He has a point here, but not a strict point about inflation. House prices rising doesn’t mean inflation, it means that there has been an increase in the price of houses relative to other goods. However, house prices increases can drive inflation by making people feel wealthy, and thereby increasing their rate of general consumption. As a result, all that matters is the rate of growth (return) in house prices, which is driven by short-run demand factors (as supply takes time to adjust).

Now, growth won’t help increase house construction enough to drive house prices down, the constraints holding up house prices are structural. Councils refusing infill, the difficulty of getting consents to build property, these are the reasons that house construction activity has been sub-par. As a result, its not a matter of keeping interest rates low, it is more a matter of regulatory constraints.

His second point is that we need to increase labour skill training and capital to increase output. Yes that would increase output, however it is not current growth that drives investment, it is the expectation of future growth. As a result, the current goal of monetary policy of stabilising prices is the best way of driving efficient long-run investment (by reducing uncertainty).

The third point is that businesses need to innovate. Again this is a business decision, government policy is not trying to stifle innovation and so this doesn’t do anything to defend the idea that keeping interest rates down will reduce inflation.

Ultimately, I think in this second article he switched tack slightly, and discussed situations where we could grow, rather than attacking monetary policy as he did in the first article, which we wrote about. However, I don’t believe that he has shown that all things constant higher growth leads to lower unemployment, all he has done is changed some of the parameters (making people more productive etc).

  1. Tourist arrivals were strong, up 3.6% on July last year.
  2. Net migration for the year to July was weak at 8,966.
  3. The merchandise trade balance continued to deteriorate, with a deficit of $6.3bn for the year to July.

Have you seen the latest estimate for Fonterra milk payouts, $6.40! I know that Holy Cow was a terrible pun to make, but that’s a huge payout.

Supposedly Fonterra was able to hedge sales at $US0.71 during the time when our dollar was at $US0.80. When that good bit of management is combined with the continuing rise in world dairy prices you need up with a payout like this. To put it in perspective, last season farmers received $4.50/kg, so it is up by nearly 50%.

Hopefully we can convince farmers to invest some of this money into productive infrastructure, to increase our capital base. However, I think it is more likely that they will buy investment properties and some new quad bikes, as quad bikes are awesome ;)

Update:  They didn’t say anywhere that they hedged at $US0.71, I was just tripping.  Anyway, $6.40/kg is still heaps.  I wonder if these prices are sustainable?

The RBNZ has made it easier for banks to borrow money off them, in order to stave off a squeeze in credit in the banking sector. This sounds fine to me, and the measures they put in place seem reasonable, there was one thing I did not understand though. It says that the bank is selling more short-term bonds, wouldn’t this contract the money supply and reduce liquidity?

Maybe the reporter put it down wrong, but making it easier for banks to borrow money, and then providing them riskless assets to buy with it doesn’t sound like a way of increasing liquidity in the New Zealand credit market. Hopefully the RBNZ does a release soon, and explains to me how I’m an idiot, or if you’re quick maybe you can beat them to it ;)

In this article, Rod Oram discusses the two options he sees for battling inflation:

  1. Raise interest rates to slow growth, thereby reducing the pressure on our limited resources.
  2. Increase the resource base

Both of these ‘strategies’ would reduce inflationary pressure. One would reduce aggregate demand; the other would increase aggregate supply.

The first strategy is what NZ is doing (and most countries try to do when inflation comes out of the bag). The second ‘strategy’ would be preferable, as it would increase the number of goods we can buy as a nation. However, Rod didn’t tell us how we are supposed to increase our resource base. According to him we can ‘grow it’, so as the economy is growing the resource base will magically grow as well.

I don’t agree with this idea, but I’m going to try and rationalize what he is saying, and then say why I think it won’t work. Many people have been saying that if we had lower interest rates, investment would be greater, which is an increase in our resource base. As a result, this may be his solution, lower interest rates increase investment, which increases aggregate supply. The problem is, if we kept interest rates at a lower level, we are implicitly allowing a greater level of money supply growth into the economy, which will in turn cause upward pressure on inflation. Which effect dominates depends on the productivity of new capital investment, as if new capital is very productive then the increase in resources requires an increase in the money supply for prices to remain constant.

New Zealand currently has relatively low capital productivity (capital productivity has only risen 1.2% in the last 10 years), and at the margin, this level of productivity will be even lower. This implies that any increase in the supply of resources from a lower interest rate will be very small, and as a result inflationary pressures will be strong.

Furthermore, when a firm makes a long-run investment decision what matters is the long run (risk adjusted) cost and benefit of that investment. In this case the short-term interest rate is not of importance, it is the long-run rate of interest that matters (as interest rate changes can be insured against). Uncertainty for the firms investment decision comes from issues of price, if the level of inflation is high there will be significant volatility between the price of goods (as prices would change at different discrete time periods) making the return on the investment more volatile than in a low inflation environment. As firms are risk averse, higher inflation will lead to lower long run investment – implying that trying to grow our way out of inflation will not work.

One of my favourite development economists, Daron Acemoglu, has a new paper out. Acemoglu is generally of the view that a country’s level of wealth can be traced back to the country’s institutional development. In a fascinating earlier paper he argued that the institutions set up by European colonists are a major predictor of the current wealth of colonised nations. His new paper proposes that the wealth of a nation is not correlated with the level of democracy in that country, nor is it correlated with regime change towards democracy in the country.

It seems that a trend among Western democracies is to promote democracy as the way forward for developing nations. This has particularly been the case with the US’s recent foreign policy under the Bush/Cheney regime. Does this paper suggest that efforts to ‘nation build’ and push countries towards democracy does little for their economic well-being? Hopefully, it will force nation-builders to be more rigorous about the way that they justify intervention in favour of democracy in developing countries. Suggesting that it’s the one, true path to economic growth will no longer be enough.

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