The visible hand in economics

Archive for May 2008

Tracy Watkins indicated that the National is in a pickle surrounding compulsory employer contributions in Kiwisaver. One way of keeping these contributions and regaining the support of business would be for National to allow wage cuts on the basis of entry into Kiwisaver (with its compulsory employer contribution). The Standard laments such a move, however there are two reasons why I don’t think it’s a big deal:

  1. In most cases such a policy won’t change anything,
  2. In this cases where the policy leads to lower wages it may actually be “fairer”

Let me explain myself:

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Well we have had an action packed quarter haven’t we – bad employment numbers, bad retail numbers, bad inflation numbers, and tax cuts.

Of course I’ve stated that all these things imply more inflation, but its not what I think thats important – its what the Reserve Bank thinks that matters. On June 5th we get to here what there outlook for economic activity really is – and as a result we will get an idea about how their view of future monetary policy easing has changed (from September 2009 as a starting point in March).

So what is going to happen? The Reserve Bank will heavily reduce their growth forecasts (I’m guessing 0.9% growth over the March 2009 year – with a technical recession over the first half of 2008). A weaker labour market outlook and a downturn in global growth forecasts will be major factors behind this shift – along with a sharper housing market correction. The delay of the ETS will lighten up inflation forecasts while additional fiscal stimulus will lift it again – fundamentally inflation will cross 4% in September, but head under 3% by June.

It is possible they may state that fiscal policy changes (ETS and tax cuts) cancel out – especially given that most of the tax cuts appear out in 2010 – and approximately 50% of consumers are supposed to act in a manner that is “liquidity constrained” (so will not borrow on the tax cuts which are coming).

With inflation expectations elevated and the dollar threatening to bolt with three months of potential rate cuts the Reserve Bank will probably implicitly time rate cuts from March 2009 in the MPS – however with some (real) risk of cuts occurring earlier.

Personally, I think inflation pressures are far more endemic – but I believe that the Bank believes that the risks to growth are too strong to ignore. If this is the way things go down I would expect a short rally in the dollar – before the realisation that the RBNZ was just treading water sets in, dragging the dollar back to where it started.

Conjecture is rife regarding why petrol prices have risen so strongly. There are a number of common explanations:

  1. Rising demand for oil,
  2. The weak US dollar, increasing the US$ price,
  3. Peak Oil (Infometrics article requires a subscription),
  4. Negative real interest rates in the US (as not mining the oil is the same as investing in inventories),
  5. and speculation.

All these factors are playing a part in the saga of ever rising oil prices. However, Calculated Risk has suggested another, highly interesting way that fuel prices could have risen – a backward bending supply curve and multiple equilibrium.

This idea is pretty cool – so I thought I would spend a little bit of time explaining how it could work.

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So far we have discussed Kiwisaver and national savings in fairly loose terms. We know that (part of) the purpose of Kiwisaver was to increase national savings and that our interest in national savings stems from the fact that we want New Zealand to have more productive capital.

So before we can discuss the myriad of burning questions surrounding these issues – and more broadly surrounding New Zealand’s productivity (such as if Kiwisaver achieves the greater capital goal even if it theoretically doesn’t increase savings) we need to ask, what is the savings problem?

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In another of our warm up posts for discussing productivity we are going to discuss why national savings are important.

As Fred states in this comment, savings are effectively deferred consumption. The incentive to defer consumption is based on individuals wish to “smooth consumption” over time (which relies on their time discount rate and expectations of future income) and the return available on these savings. Now the reason that it is possible to make money off your savings is because these savings are used by other agents in the economy who have the ability to pay you back later on – fundamentally these savings are used to invest.

Going back to our good friend supply and demand we know that the supply of funds for capital investment is a function of the interest rate and peoples willingness to smooth consumption while the demand for capital investment is a function of the interest rate and the expected return from the investment. As savings increase in the interest rate (for those who care, assume that the substitution effect dominates the income effect of a higher interest rate) and investment decreases with the interest rate (or at least the expectation of the equilibrium interest rate) we know that there will be an interest rate that makes supply and demand equal.

Fundamentally, the government may want to increase national savings if they believe that current national capital accumulation is sub-optimal for some reason – as in some sense savings=investment. Again I’m going to ask a question which I would love for everyone to have a go at answering – why may the government believe that the current rate of capital accumulation is sub-optimal?

Immediately following the release of the overseas merchandise trade data today the dollar slumped by about 20 basis points, however it didn’t stay down for long, more than recovering from this low point:

Source NBNZ

You might wonder why this fall and rise is even interesting – but the reasons behind it imply that issues such as “menu costs” can be important.  Why?  Well the headline number of today’s result provided a bad headline (monthly trade deficit biggest in 26 years!), but for a small time investment (reading the Statistics New Zealand news release) it would become obvious that the headline number was deceiving and in fact today’s result was relatively positive (as a significant proportion of the additional import activity was the result of one-off capital imports for further oil production).

The menu cost mattered in this case as the opportunity cost associated with time it would require to read the release was high – if a bad headline comes out it is in the dealers interest to react before everyone else!  As a result, a situation like this truly does have a substantial menu cost (which results from the first-mover advantage implicit in the situation) even though, on the face of it, it would initially seem difficult to view spending a minute reading a free release as a significant cost!

Why does all this matter.  Well menu costs can be the basis of price rigidity (although I doubt this in the case of currency trading) and also can be the basis of what we may view as “irrational” behaviour in the marketplace.  If small information asymmetries can have such a large impact on the behaviour of agents, and the equilibrium price, it dilutes the power of the price as an efficient signal to allocate resources.  This does not mean we should give up on prices – it merely shows us the importance of the provision of information in the economy.

Over at the NBR comment page Trinh Le from NZIER discusses the research by John Gibson and herself into Kiwisaver and aggregate savings (here and research).

The idea that Kiwisaver can actually reduce national savings is an important one – and something that one of us will post on soon, either before or during our upcoming discussion on productivity.

For now it would be useful for you guys to have a look at this article and tell us what you think. Do you think Kiwisaver will actually increase national savings – if so (or not) why?

In a previous post we mentioned the Infometrics and Labour tax cut calculator.

Now NZIER have updated their tax cut calculator that compares Australia and New Zealand – the excel model can be found on their front page (or here in the future):

I also talked to Dr Nolan about the set of tax calculators that have been released and he asked me to remind everyone that the October 2008 cuts will only give you half of the total shown in the calculators – as they are in per annum terms but October-April is only six months long. So someone on 60,000 will get a $430 tax cut this financial year, and then a $860 cut over the 2009/10 financial year.

Furthermore, the level of wage growth assumed by the Labour and NZIER calculators both assume wage growth of about 3%pa – marginally slower than the current rate.

Update: David Farrar at Kiwiblog also mentions a Deloitte Tax Cut Calculator that was sent to him. I don’t know if excel has ever been this popular :)

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Given my belief that these tax cuts, without corresponding cuts in (unproductive types of) government spending, will lead to greater inflationary outcomes I’ve decided it is important to argue the complete opposite case – namely that tax cuts will not impact on inflationary pressures and interest rates.

The common view I work off when stating that tax cuts increase inflationary pressure is that tax cuts increase “aggregate demand“, which in turn will lead upward pressure on prices, and therefore an upward shift in interest rates.

However, there is another popular view that has been raised by Stephen Kirchner of Institutional Economics. Specifically this view states that tax cuts have supply side effects on the economy (which increases the supply of goods in the economy and so reduce inflationary pressures) and some degree of Ricardian equivalence holds – such that any increase in budget surpluses will lead to borrowing from the private sector, as they expect tax cuts later. He makes these arguments here and here (I made a similar argument here).

Furthermore, tax cuts may reduce wage pressures – thereby leading to lower inflation. How? Say that the nominal wage is fixed and there are tax cuts – it this case the whole tax cut immediately goes to the employee. However, unless the employee has significant market power, the employer will be able to extract some of the surplus gained from tax cuts over time, by offering smaller wage increases.

Given these supply side arguments why am I still concerned about inflation?

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Chris Worthington at Infometrics Ltd just created a tax cut calculator, it can be found here:

Enter your personal income and see what the Budget will do to it in October 2008, April 2010, and April 2011 (as there is no tax cut in April 2009 – likely a result of inflation concerns). This calculator does not include any of the working for families business.

Update: A new tax calculator including working for families was released by Labour, it can be found here: (h.t. the Standard)

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Both Kiwiblog (more on budget) and the Standard (more) have already mentioned tax cuts – giving us two different views about their situability.

Instead of looking at this, I’m going to have a quick look at the Macro-economic concerns stemming from this tax policy. First lets ask Mr Market what he/she thinks:

Source NBNZ

That was a 70 basis point increase in our trade-weighted index of our dollar (update, as of 4.25pm the lift hit 100 basis points, if we keep going we might get back to where we were before the employment numbers came out :) ) – compared to the 40 basis point fall from the poor retail numbers and the 50 basis point fall from a reduction in employment. Damn!

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At his rates blog and his blog on stuff Bernard Hickey often has a number of insightful things to say. Sadly this piece where he forces himself to agree with Winston Peters is not one of them.

Specifically he states:

In fact, a GST cut is the perfect tax cut right now. It is a deflationary tax cut targeted at the poorest and at those with the most squeezed disposable incomes.

This is a common misconception which results from the way us economists often teach people to think of inflation. For this error I apologise. However, fundamentally, a cut to GST rates is just as inflationary as a cut to personal income tax rates. As I’ve stated here:

inflation is the rate at which prices grow – not the price level

The inflation that economists are scared off is the rate at which the price level grows. Read the rest of this entry »

Recent posts by two of the most prominent New Zealand left wing blogs (the Standard and New Z Blog) lament the fact that the wage people are paid does not necessarily relate to the effort they put into their work. As a policy solution to this inequitable result of the free market both blogs suggest that the government provides tax cuts that give the poor more.

However, no matter how sympathetic I am to the idea that effort and reward aren’t correlated in a way that most people would view as “fair”, I don’t think that adding further progressivity to the tax scale is the appropriate mechanism with which to achieve this social goal.  Furthermore, I don’t think the trade-off between production in society and the achievement of our “equity” goals is appropriately mentioned in these posts.
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at LAANTA has replied to my reply on his post on the problems with utilitarianism.

In this reply he states two issues that he sees with my view of utilitarianism, namely:

  1. The assumption that utilitarianism doesn’t involve assumptions between what is right and wrong is plainly false,
  2. Justice and efficiency concerns are incomparable because one is non-consequential and the other is consequential.

I plan to reply to the reply of the reply under the flap :P

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No right turn and the Standard are concerned about Nationals mention of a $50 a week tax cut, that mainly goes to the well off.

The fundamental concern seems to be redistribution. I/S expresses it succinctly by stating that he sees the elections choice as between:

a party who distributes wealth for the benefit of the many, or a party which distributes wealth for the benefit of the few

However, if the concern relates to redistribution it is important to ask two questions: What is the trade-off between redistribution and economic growth? Are tax cuts the appropriate mechanism for redistribution?

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