Monday, 29 September 2014

A meeting of minds

Last week Australia's Competition Policy Review came out with its excellent draft report (report here, my high level reaction here).

I said I'd come back to some specifics in the report, and there's one in particular that stands out as relevant to us here in New Zealand - and that's the Review's conclusion on s46 of the Aussie Competition and Consumer Act (CCA), which is the equivalent of  s36 of our Commerce Act. Most people following this blog won't need a refresher on what s36 is, but just in case it's the bit in our Commerce Act that says
36 Taking advantage of market power
...
(2)A person that has a substantial degree of power in a market must not take advantage of that power for the purpose of—
(a) restricting the entry of a person into that or any other market; or
(b) preventing or deterring a person from engaging in competitive conduct in that or any other market; or
(c) eliminating a person from that or any other market.
The thing is widely seen as a waste of space as it stands, partly because of the language of the section, partly because of how the New Zealand courts have interpreted it, and all against a background of being an intrinsically difficult thing to police in the first place.

Earlier this year our Productivity Commission, in chapter 7 of its report on Boosting Productivity in the Services Sector (available here), said (p135) that "The Government should review section 36 of the Commerce Act 1986 and its interpretation", that "The review of s 36 should take account of the review of competition policy in Australia, with a view to achieving a consistent approach", and that
The review of s 36 should include consideration of the merits of:
 a more flexible approach where courts do not rely on a single counterfactual test for
an abuse of monopoly power [this is a reference to the, shall we say, idiosyncratic approach of the New Zealand courts];
 more of an “effects” approach to gauge whether conduct has harmed dynamic
efficiency, and
 providing for an efficiency defence in cases where the conduct of a firm with substantial market power fails a primary test that it is harming competition.
Lo and behold, that's pretty much exactly where the Aussies have fetched up.

They agree that the language of the section is off kilter, for two reasons.

One is that "take advantage" bit: as they say (p208), "Both the courts and the legislature have wrestled with the meaning of the expression ‘take advantage’ over many years. Its meaning is subtle and difficult to apply in practice".

And then there's the wording of the "purpose" bit. As the Review says (p210),
Presently, the purpose test in section 46 focuses upon harm to individual competitors — conduct will be prohibited if it has the purpose of eliminating or substantially damaging a competitor, preventing the entry of a person into a market, or deterring or preventing a person from engaging in competitive conduct. Ordinarily, competition law is not concerned with harm to individual competitors. Indeed, harm to competitors is an expected outcome of vigorous competition. Competition law is concerned with harm to competition itself — that is, the competitive process.
So they've suggested (p210) skittling "take advantage" completely - excellent - and rewriting the rest of it with more of an "effects" approach (as our Productivity Commission suggested was worth looking it) so as
to prohibit a corporation that has a substantial degree of power in a market from engaging in conduct if the proposed conduct has the purpose, or would have or be likely to have the effect, of substantially lessening competition in that or any other market
As they say, do that, and then s46 becomes
the standard test in Australia’s competition law: purpose, effect or likely effect of substantially lessening competition. The test of ‘substantially lessening competition’ would enable the courts to assess whether the conduct is harmful to the competitive process
And finally they've come up with much the same sort of backstop defence for a business that our Productivity Commission flagged, namely
the primary prohibition would not apply if the conduct in question:
• would be a rational business decision by a corporation that did not have a substantial degree of power in the market; and
• would be likely to have the effect of advancing the long-term interests of consumers.
The onus of proving that the defence applied should fall on the corporation engaging in the conduct
Currently MBIE are beavering away in the background on a review of s36, after their Minister, Steven Joyce, picked up on the Productivity Commission's recommendation to have a rethink.

Save the time and money. I say we send the Aussie Review members a thank you note and a couple of cases of our best Pinot Noir, declare victory, and go home.

Friday, 26 September 2014

We need more cables

Earlier this month the World Economic Forum came out with the 2014-15 edition of its Global Competitiveness Report (you can find a link to downloading it here). It got a bit of media attention at the time, mostly on somewhat invidious chauvinist grounds - we moved up a notch, and the Aussies moved down one.


Other than that, the detail didn't get much of an outing over the mainstream media fences, and that's a shame, because the report is full of interesting comparisons, which make for suggestive diagnostic policy tools. Here, for example, is what our business community rates as the main problematic factors for doing business.


This is an interesting diagnosis, especially as it's not the sort of clich├ęd grumbling you might expect from a business group. In fact, these surveys seem to be pretty accurate around the world. The equivalent French survey, for example, came up with this - quite a different set, and one that looks absolutely on the money.


Coming back to the 'Inadequate supply of infrastructure' theme, here's something that I found disconcerting.

By way of background, the Report covers three groups of things for each country - the essentials; things that make the country work better ("efficiency enhancers"); and things that enable you to compete in the deep end of the international swimming pool ("innovation and sophistication factors"). Those "efficiency enhancers" are made up of six "pillars", one of which is "technological readiness", and which in turn has seven components. Here's how we stack up (score and relative world ranking).


We scrub up reasonably well on technological readiness overall. Indeed, two of them (9.02 and 9.07) count as relative advantages for us, as we do better on those criteria (11th and 14th internationally) than we do on our overall competitiveness (17th). 

But there's one big exception, 9.06: the size of our physical internet connections to the rest of the world let us down badly. And if you want to see how badly, here are the countries most like us on the criterion of available international internet bandwidth*.


From the point of view of sophisticated economic development, this is not the sort of company we should be keeping.

So my thought is, the sooner someone can lay pipe in competition with Southern Cross, the better.

*Note A fair amount of the Report's data is based on subjective 1 - 7 sorts of scales. Not this bit. The definition (from p543 of the Report) is "International Internet bandwidth is the sum of capacity of all Internet exchanges offering international bandwidth measured in kilobits per second (kb/s)" and the source is International Telecommunication Union, World Telecommunication/ICT Indicators 2014 (June 2014 edition) 

What a terrific report

Australia's Competition Policy Review came out with its draft report (pdf) earlier this week, and it was an absolute humdinger. The terms of reference (pdf) gave it broad scope to roam across competition, regulation, legislation, and institutions, and it went for it.

I was frankly delighted with where it got to. It's not often you find yourself agreeing with almost everything in a long report (the main bit runs to 299 pages) but for me this was one of those times. There's a good case for lifting the report holus bolus and plonking it down  here at home, too, where applicable (we're ahead of the Aussies in some places, and behind them in others).

There's so much in it that's worthwhile that I'll stick to some of the highlights this time round, and come back to some individual topics later.

Most importantly, there was a clear statement of the value of competition. In a lot of well-meaning circles, you get "competition, but...". You'll hear "competition, but also allow companies to bulk up to be internationally competitive", or "competition, but not at the expense of cooperation", or "competition, but not where it might have socially inequitable outcomes", or "competition, but not in this unique sector where it can't work". Rather, the Review called it like it should:
Competition policy sits well with the values Australians express in their everyday interactions. We expect markets to be fair and we want prices to be as low as they can reasonably be. We also value choice and responsiveness in market transactions — we want markets to offer us variety and novel, innovative products as well as quality, service and reliability.
Access and choice are particularly relevant to vulnerable Australians or those on low incomes, whose day-to-day existence can mean regular interactions with government. They too should enjoy the benefits of choice, where this can reasonably be exercised, and service providers that respond to their needs and preferences. These aspects of competition can be sought even in ‘markets’ where no private sector supplier is present.
Maximising opportunity for choice and diversity, keeping prices competitive, and securing necessary standards of quality, service, access and equity — these are the things Australians expect from properly governed markets. A well-calibrated competition policy aims to secure these outcomes in commercial transactions and, where appropriate, also in the provision of government services (p15)
That point about "Access and choice are particularly relevant to vulnerable Australian or those on low incomes" is an important one that is often overlooked. The rich kids can get into the best schools in the state system because their parents can buy into the school zone with the expensive houses: it's the poor kids who are stuck with the sole dysfunctional choice on offer. Increased choice, through more suppliers, public and private, competing for their custom, is especially important for the poorer and more marginalised, as they're the groups with the least choice currently.

More markets, competition and choice in the provision of what the Review calls 'human services' (education, health, social services) could be one of those occasions where we can have it all - more efficiency and more equity:
Designing markets for government services may be a necessary first step as governments contract out or commission new forms of service delivery, drawing on public funds. Over time a broader, more diverse range of providers may emerge, including private for-profit, not-for-profit and government business enterprises, as well as co-operatives and mutuals.
If managed well, moving towards greater diversity, choice and responsiveness in the delivery of government services can both empower consumers and improve productivity at the same time (p17)
The Review has backed the idea of a specialised agency to advocate for competition - quite right, and we should have one too. The likes of an ACCC or Commerce Commission can sort of do it, but it may not be the right place - "Too often this has fallen by default to the ACCC, which can be an uneasy role for a regulator to fulfil" (p57) - and multitasking agencies like MBIE may not run with it strongly enough (my view, by the way, not the Review's). It's also picked up on the idea of 'market studies', which our Productivity Commission has also been looking at:
Australia needs an institution whose remit encompasses advocating for competition policy reform and overseeing its implementation...
This new body would be an advocate and educator in competition policy. It would have the power to undertake market studies at the request of any government, and could consider requests from market participants, making recommendations to relevant governments on changes to anti-competitive regulations or to the ACCC for investigation of breaches of the law (p6)
Although Australia, like us, has made a pretty good job of liberalising markets over the past couple of decades, the Review also did a fine job of exposing some residual absurdities. Some of my favourites:
A pharmacist must obtain approval from the Commonwealth to open a new pharmacy or to move or expand an existing pharmacy. A pharmacy may not open within a certain distance of an existing community pharmacy...A pharmacy must also not be located within, or directly accessible from, a supermarket (pp109-10)
In Western Australia, licences to grow table potatoes, as well as the price, quantity and varieties grown, are all regulated by the Potato Marketing Corporation...The Potato Marketing Corporation, not consumers and producers, determines the quantities, kinds and qualities of potatoes offered to consumers in Western Australia. In fact, it is illegal to sell fresh potatoes grown in Western Australia for human consumption without a licence from the Potato Marketing Corporation (p114)
...the taxi industry is virtually unique among customer service industries in having absolute limits on the number of service providers...The scarcity of taxi licences has seen prices paid for licences reach over $400,000 in Victoria and NSW, which indicates significant rents in owning a licence and is at odds with the claim that licence numbers are balanced given market conditions (pp137-8)
The NSW Rice Marketing Board retains powers to vest, process and market all rice produced in NSW, which is around 99 per cent of Australian rice. A party wanting to participate in the domestic rice market must apply to the Board to become an Authorised Buyer. The NSW Rice Marketing Board has appointed Ricegrowers Limited (trading as SunRice) as the sole and exclusive export licence holder.
Sensibly, the Review suggests knocking all of these on the head, and dealing to a bunch of other recidivist issues while you're at it (such as parallel imports, retail trading hours, the shipping lines).
The thing's an absolute compendium of pro-market ideas - the need to deal with the potential for planning and zoning legislation to overprotect incumbents, for example, or with unnecessary restrictions on entry into professional services - and I can't recommend it highly enough.

Tuesday, 23 September 2014

More evidence of free trade payoffs

Post-election, thoughts have turned - finally - to policy. It's reported in the Herald that among the likely policy initiatives over the next three years, John Key "identified progress on a trade deal with South Korea, which is close to a conclusion, and the Trans Pacific Partnership as priorities".

A bilateral deal with South Korea is definitely a good idea: I know, in an ideal world we've have comprehensive multilateral trade agreements, but it's not an ideal world, and take what you can is the order of the day. These bilateral agreements can be quite handy: our agreement with China, for example, gave us a clear competitive advantage against the Aussies in the dairy trade with China (as I wrote up here).

Whether the TPP ever gets off the ground, and whether it will in fact be a genuine free trade agreement, is anyone's guess. There have been leaks about the negotiations that have raised suspicions of TPP as potentially protectionist of US intellectual property, rather than helping to free up trade, and I've also seen speculation that the Japanese will make sure that any agricultural trade liberalisation in the TPP will get watered down to meaninglessness.

One worry I've got is that a 'bad' TPP will taint the arguments for free trade, which tend to struggle at the best of times against the loud voices of anti-trade ideologues and of formerly protected interests. The voice of the family buying cheaper T-shirts and food tends not to get much of a look in.

So I thought I'd just point to some new research about one of the big free trade deals - NAFTA, the North American Free Trade Agreement of 1994. At the time the usual suspects came out in force against it: you might remember Ross Perot running for President in the US in 1992 on fears of the "giant sucking sound" of American jobs going down the gurgler towards Mexico (and finding nearly 20 million American voters to agree with him).

The latest research comes from the Peterson Institute for International Economics in Washington, "a private, nonprofit institution for rigorous, intellectually open, and honest study and discussion of international economic policy...The Institute is completely nonpartisan". The summary is here and the whole thing (pdf) is here.

How did this contentious agreement work out? Pretty well, as it happens, though one of the lessons is that proponents of freer trade need to be more realistic about the payoffs: it's not just the opponents that can go off the deep end. That said, the benefits were real: look at this.


This shows the initial level of  goods trade between the NAFTA countries (blue), the extra trade that would have happened in any case as the NAFTA economies grew (dark green), and the impact of NAFTA (light green). Trade was basically twice as large as it would have been without NAFTA. That's a bit of a heavy-handed summary on my part,  and the authors are more nuanced, but the guts is that trade got a large boost.

This increased trade in turn fed through into higher incomes everywhere. As the authors say, these higher levels of trade boosted GDP in all the countries involved (I've left out the footnotes):
Ample econometric evidence documents the substantial payoff from expanded two-way trade in goods and services. Through multiple channels, benefits flow both from larger exports and larger imports. As a rough rule of thumb, for advanced nations, like Canada and the United States, an agreement that promotes an additional $1 billion of two-way trade increases GDP by $200 million. For an emerging country, like Mexico, the payoff ratio is higher: An additional $1 billion of two-way trade probably increases GDP by $500 million. Based on these rules of thumb, the United States is $127 billion richer each year thanks to “extra” trade growth, Canada is $50 billion richer, and Mexico is $170 billion richer. For the United States, with a population of 320 million, the pure economic payoff is almost $400 per person. 
The same is true of the proposed agreement with South Korea, as MFAT's briefing page on the negotiations points out:
An independent joint study into the benefits and feasibility of an FTA was completed in 2007. It found that New Zealand and Korea are two of the most complementary economies in the Asia-Pacific region and that an FTA would deliver economic benefits for both countries. The analysis, by the New Zealand Institute for Economic Research and the Korean Institute for International Economic Policy, suggested that the FTA would provide gains to real GDP between 2007 and 2030 of US$4.5 billion for New Zealand and US$5.9 billion for Korea.
Opponents of trade liberalisation, in short, would take US$10 billion of benefits from a Korean agreement alone, and scatter them to the winds.

Friday, 19 September 2014

Decisions, decisions

The US Fed met earlier this week, and said what people had expected it to: if things pan out as the Fed expects, it will stop its asset buying programme ("quantitative easing") after its October meeting, and on the interest rate setting front it said that "it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends".

The financial markets quite liked the sound of it,with (for example) American shares going on to hit a new record high. But there was one item from the Fed's published deliberations which caused some markets (including both the Kiwi dollar and the Aussie dollar) to have a spasm, and that was the range of views within the Fed about the future path for the policy interest rate (the 'Fed funds' rate). It's published as a graph, which I've shown below: it's sometimes called the 'dots plot'. It shows each attendee's view of where the Fed funds rate ought to be at the end of each of 2014, '15 and '16, and there's a 'longer run' opinion which we'll come back to.

Incidentally there are 17 dots but only 10 attendees who have a monetary policy vote: non-voting attendees' views are included as well.


What caused our local currencies to sell off was that some of the attendees at the meeting thought that the Fed funds rate ought to be raised quite a lot, quite quickly. If that happened, the gap between our local Kiwi and Aussie interest rates and US ones might close faster than previously expected, reducing the relative attractiveness of our local currencies.

The substance of the decision was interesting enough, but what was more interesting to me was what it shows about how monetary policy decisions are made, and what the Fed's take is on the potential long-term performance of the American economy.

First of all, I'm glad to see that monetary decisions in most places these days are a lot more transparent than they used to be. We don't have people's names against the Fed's dots, but at least we have the dots, and we do have names when it comes to the policy decision itself (an 8-2 split for it). Ditto for the Bank of England's policy decisions (7-2 at the latest one). Typically, the European Central Bank is the uninformative one out: the official announcement is the bare bones minimum, and while the President is a bit more forthcoming at the press conference - "On the scale of the dissent, I could say that there was a comfortable majority in favour of doing the programme" - I don't think this old style secrecy is at all consistent with what should be expected in a democracy from the experts delegated to make these important decisions on our behalf.

It also gets you thinking about whether the policy decision should be made by a committee or by an individual. The distinction is a little arbitrary - even single-person regimes like ours, where the Governor formally sits alone on the hot seat, have a lot of collective advisory mechanisms going on in the background, and committees tend to have informal leaders - but it's still useful.

The strongest argument for the committee is that collective decisions are usually better decisions: the best argument for the individual is the accountability pressure to get it right. And there are counterarguments both ways too: committees get groupthink, individuals get arrogant. I generally lean towards the individual approach (even though it looks like the minority approach these days).

Looking at the dots, I wonder if they say something about the way collective decisions are made. For example, I have some difficulty with the dot that says the Fed funds rate ought to be close to 1% by the end of this year, ditto with the dots saying it still ought to be close to zero at the end of 2015, and a lot of difficulty with the dot that says it should be close to 3% by the end of next year. These are in my opinion not credible views as straight down the line analysis. Rather they're there, I think, as a kind of "devil's advocate" marker, a psychological nudge to the rest of the voting members towards higher or lower rates. Maybe the decision's all the better in the end for these nudges from the fringes. Maybe. Can't say it's shifted me from one decisionmaker giving it their best shot.

The other interesting thing that comes out of these meetings is the "long run" estimate of where the interest rate should be. It's the Fed's stab at what the "neutral" rate would be when the economy is where it ought to be, in terms of growing at its long-run sustainable rate of GDP growth and generating an acceptable long-run rate of inflation. We can see those estimates, too (on the right hand side of the graphs below).

The edges of the shaded bit show the highest and lowest estimates, and the darker bit in the middle is the trimmed set of views after dropping the three highest and three lowest (so any "nudges" don't count). In passing, it's good to know that the cyclical outlook is looking solid, with not a single attendee picking a return to recession, or anything like it, while inflation is expected to remain well contained.



The best take the Fed has on the US economy is that in the long-run it can grow at a tad over 2% a year, with unemployment (not shown here) around 5.5%, while inflation stays at 2%, and the Fed funds rate would be 3.5-4.0% (from the dots graph).

Two per cent a year isn't a lot, and there's quite a debate within the US about whether in fact it's lost its mojo, and if so, why (permanent damage from the GFC? over-regulation? diminishing returns from technological innovation? demographics? international competitors eating its lunch?).

You end up wondering how New Zealand stacks up by comparison. And the answer is, pretty well. Taking a bit of licence with the numbers in the Reserve Bank's latest Monetary Policy Statement, especially those in Table A and Table D, I'd say our long-run growth rate is in the region of 2.9%, our long-run unemployment rate is in the low 5% area, our long-run inflation rate is about 2%, and the long-run neutral interest rate is an official cash rate in the region of 4.5%. Why we come out with a somewhat higher inherent interest rate isn't too clear, but otherwise we scrub up pretty well.

Friday, 12 September 2014

Where would you expect to see high returns on equity?

Last week I posted some data showing the pre-tax rate of return on equity (ROE) for different sectors of New Zealand business, based on the latest Annual Enterprise Survey (AES) from Stats, and taken back over the past five years. Going by hits on the post, there was a lot of interest - partly, I think, because profitability is an interesting and important concept, and partly because nobody else seemed to be mining the rich seam of data in the AES, or not in public at least, so the results were new to a lot of people.

One of the conclusions I came to was that some sectors seemed to be achieving rates of profitability that looked rather high for the kinds of activity they're in, with wholesaling, retailing and construction, in particular, earning what looked like high rates of return for what looked like relatively workaday industries (although recently high ROEs in housebuilding were more explicable, given the very large post-earthquakes demand for scarce housebuilding resources). It's possible that there are subcurrents in the data that are exaggerating the ROEs being earned: for example, some industries don't need much capital invested in them, so any profits at all get compared with a small investment, giving you a large ROE. Or returns to human capital are being misattributed to physical or financial capital. But overall it still looked to me as if some industries seemed to be earning quite generous profits, given what they do.

That, however, was based on a rather subjective view of the relative riskiness of each sector of business. And it seemed reasonable to do that, at least for some sectors: without doing any sophisticated analysis at all, I'd have rated the more infrastructural activities like electricity, water, gas, transport, and warehousing as relatively low risk, everyday activities that would be consistent with earning modest ROEs, and indeed that's exactly what the AES data show. But for all I know there's more risk in some sectors than amateur navel-gazers might guess from the outside, and higher ROEs might well be appropriate compensation for those real risks.

Which was why I was interested to come across this guest post, 'The Industries Plagued by the Most Uncertainty', on the Harvard Business Review blog site. The three authors came up with one of these 2 x 2 tables, with an index of technological uncertainty along the horizontal axis and an index of demand uncertainty on the vertical axis. Here are the results: they're on American data, but I don't think that makes much difference, though we obviously don't have some of the industries that the States does (such as aircraft manufacture, or big pharma).


This seems to me to provide quite a nice anchor for the ROEs you might expect to see in an industry: it may not cover absolutely everything that an equity investor might expect to be compensated for, but it certainly captures two of the major kinds of risks, In the bottom left, you'd expect lower ROEs, since there isn't a lot of demand or technology risk that investors need to be compensated for, and you'd expect higher ROEs in the top right corner, where both risks are high. And when you look in detail the results, they seem commonsensical. The utilities, for example, feature where you'd expect them (bottom left), as do the high tech sectors (top right).

The bottom line is that I'm still left with some of the same conundrums as before. Why, for example does wholesaling, which on this analysis is one of the least risky business activities (and which you might have guessed was, without ever seeing this analysis), earn an ROE in New Zealand in 20-22% territory? Twice the return that manufacturing earns?

And it's not just industry sectors earning more than you'd think they ought - there are also some strange examples of industries earning less than you'd think they should be. Agriculture on this analysis is reasonably risky - it squeaks into the top right quadrant - but in New Zealand it earns a pitiful, pre-tax, 5% return on equity in recent years.

So there are some real puzzles here. And even for those of us who reckon that markets in general are a pretty good way of getting the most out of our resources and best delivering what people want, you find yourself wondering if something isn't working out the way it should.  On face value, these patterns of profitability don't sit comfortably with the view that competition will deal to excessive profitability, or (consequently or independently) that capital is being allocated to its most productive use.

Thursday, 11 September 2014

An inequality story in four graphs

Inequality isn't one of my core research interests, but over the last few days I've found myself absorbed in lots of interesting bits of research on inequality all arriving at once (I wrote up one of them yesterday).

Here's the latest one, which I've extracted from the OECD's mammoth Education at A Glance 2014, which appeared last week. The four graphs are quite large, which would make for an over-long post, so I've put them "over the fold", as they say. The gist of it is that we've got a developing problem in equitable access to good educational outcomes: right, on to the graphs.

So far so good

Today's Reserve Bank monetary policy decision came as no surprise - as predicted, for example in this survey, the cash rate was left unchanged. Can't argue with the decision, either: more "wait and see" was exactly right while we see the ramifications of previous rate increases (which are indeed cooling the housing market), lower export prices (especially in the dairy trade), and, of course, what the post-election government looks like.

I was also encouraged by a graph (below) which the RBNZ included in the Monetary Policy Statement, and which showed that the rate of domestic non-tradables inflation is very modest indeed outside of the construction sector.The overall non-tradables inflation rate is 2.7%, but on the RBNZ's estimates nearly all of this is down to the understandable cost pressures in the building trades.


I'd thought that our home-generated non-tradables inflation, other than on the building site, was running hotter than this, and didn't like the look of it, but so far, so good. Looking ahead, domestically sourced inflation will pick up from here, given that the currently strong economy is running above its "potential output" level, so let's hope that the Bank's view is correct that "the pick-up in non-tradables inflation is assumed to be gradual, and annual non-tradables inflation is forecast to peak at 3.4 percent in 2016". I'm a bit more agnostic about a 'cost plus' mentality in the more sheltered parts of the New Zealand economy, but let's see.

Another interesting graph (below) was the one showing the relationship between export prices in our main trading partners and import prices here in New Zealand.


The Bank has been fortunate that global events have helped keep local imported inflation low: export prices in our main trading partners have actually been falling, reflecting sub-par or outright weak economic conditions in some of our import suppliers. At some point the international tide will turn, and the global economic cycle won't be flattering our apparent inflation control quite so much: if there's a place the Bank does not want to find itself in, it's the one where imported inflation rises and domestic non-tradables inflation rises around the same time. That would produce some really ugly headline inflation rates.

Finally, and maybe this is just an issue of shades of terminology, I was left wondering how to reconcile this statement on the Kiwi dollar in the 'Policy assessment' bit - "Its current level remains unjustified and unsustainable. We expect a further significant depreciation, which should be reinforced as monetary policy in the US begins to normalise" - with this one on p17 of the Statement: "The New Zealand dollar is assumed to remain relatively strong given New Zealand’s relatively favourable economic outlook and positive interest rate differentials". I suppose the overall message is, "we expect the Kiwi to come a cropper, but maybe not as much of a cropper as it deserves, and it mightn't be tomorrow or the day after", which is probably as specific as anyone is ever able to be in the very inexact art of exchange rate forecasting.

Wednesday, 10 September 2014

Inequality in New Zealand

Yesterday evening in Auckland we had another interesting Law and Economics Association (LEANZ) event, with Max Rashbrooke talking on 'Inequality in New Zealand', largely based on his book Inequality: A New Zealand Crisis, published by Bridget William Books last year. Max is a fine presenter, and he's also got an interesting website (a joint project with the New Zealand Council for Christian Social Services), Inequality: A New Zealand Conversation, which among other things includes a calculator where you can figure out where you lie on New Zealand's income distribution. You may have also seen it on the Herald's website, where (according to Max last night) it rapidly got 100,000 hits.

As the hitcount shows, inequality is clearly much further up the public agenda than it used to be, partly influenced by work along Max's lines and partly propelled by the various debates set off by Thomas Piketty's Capital in the Twenty-First Century.

My own take - as I'll be explaining in another forum shortly so I'll keep it brief here - is that I can understand some focus on inequality per se, and particularly the inequality that's left after we've taken account of the impact of the progressive income tax and social welfare systems, but I've always been more concerned about inequality of opportunity than I am about inequality of outcomes.

I'm having to reconsider that a bit, though: as Max said last night, and others have also argued, you may not be able to separate out the two concepts of outcomes and opportunity so neatly. It's possible (for example) that high inequality might reduce a country's rate of growth, which is a bit of a problem for us fans of equality of opportunity: maybe a deeply unequal society can't generate the high rates of growth that equality of opportunity enthusiasts would champion as one of the best ways to help those at the bottom of the income ladder. Standard & Poor's for example came out recently with a report that said precisely that about the US economy: "Standard & Poor's sees extreme income inequality as a drag on long-run economic growth. We've reduced our 10-year U.S. growth forecast to a 2.5% rate. We expected 2.8% five years ago".

There's also a line of argument that says inequality actually interferes with people's ability to take fair advantage of opportunities. Here's what's been catchily called The Great Gatsby Curve (originally by Alan Krueger, chairman of the Council of Economic Advisers in the US, in 2012). This version comes from a Canadian economics professor, Miles Corak, who updated the original graph with more countries. You can find his write-up here at his website. Max also put a version up as a slide yesterday.


If you haven't seen it before, here's how it works. The horizontal scale is a country's income inequality, as summarised by its Gini coefficient: the further to the right, the more unequal. The vertical scale is a bit of a mouthful, but what it means is the percentage of a person's earnings that can be explained by their parent's earnings, so it is a measure of intergenerational mobility: the further up the axis you are, the more parents' income determines their kids' outcomes, so the less mobile a country is.

What you get is an overall pattern where the more unequal countries tend to be the less intergenerationally mobile. We, and Australia, don't show up too badly, by the way: we're a bit above the median level of inequality in this particular sample of counties, but on the other hand we're more open than many. We have much the same level of income inequality as Spain, the UK or Italy, but parents' income explains far less of our children's incomes than they do in those countries.
There are those who would make a strong argument from this graph - that it's the inequality that is causing the lack of mobility, and in turn that would tend to take you down a policy route emphasising redistributive policy.

I don't think that's necessarily true: I'm rather inclined to view both these outcomes (inequality and immobility) as caused by a third factor again, namely the social and economic openness of a society. In the UK you've got the class system; in much of continental Europe you've got insider/outsider labour markets. I'd still be tempted to bang away at those sorts of barriers to equality of opportunity: as far as I'm concerned, you can jack up the progressivity of the income tax system all you like, but it's not going to make a blind bit of difference to the career prospects of the young Arab girl in a French slum.

In any event, you can see the sorts of interesting ideas that arise at these LEANZ seminars. So sign up with LEANZ - you can do it here - it's a charity and can do with the subs and any spare donations you care to make. And if you've got any ideas you've been wanting to share, these seminars are a great opportunity to take them out over the fences (my hands are clean - here's a write-up of the LEANZ presentation I gave a wee while back).

Thanks finally to Ed Willis at Webb Henderson who organised the event and provided the premises and the drinks and nibbles.

Monday, 8 September 2014

Two 5 - 0 defeats

Chorus got bowled like ninepins this morning by the  Court of Appeal, having earlier been skittled by the High Court.

The cases were about the Commerce Commission proposing a big reduction in the price Chorus could charge for UBA, or as it is formally defined, "the additional UBA service component, which allowed access seekers to supply broadband services over Telecom’s copper access lines without investing in their own equipment or software". In other words, the bits and bobs that carry broadband traffic across the gap between the copper line from your place and the start of an ISP's network.

The reduction (roughly halving the price) had been based  on a benchmarking exercise, where the Commission (as required by the Telecommunications Act) looked at the prices overseas for UBA as a quick and dirty proxy for what it might well cost here. There's lots more about the exact details of the benchmarking comparability exercise, but that's the gist of it.

The Court's decision is here as a pdf and there's a shorter media release pdf if you prefer. Chorus's reaction is here: essentially, not surprised by the outcome, but felt they had to make a point about what they see as a regulatory regime mess around pricing of broadband services.

I'd reckoned, as I said some time ago, that (a) Chorus had very little chance of succeeding and (b) in any event the whole exercise was a waste of money, but Chorus went ahead anyway. And this morning, sure enough, they got squashed like a bug. Chorus had raised five issues: the Court said No to each and every one of them, as the High Court had earlier. While Chorus has said it is studying the decision, and I suppose could take it to the Supreme Court, after two successive 5 - 0 defeats you'd think they'd flag the game away.

Chorus didn't get anything helpful about any incoherence in the regulatory regime, either. The reverse, if anything, when the Court of Appeal said at [44], "the mandatory requirement for the Commission to carry out the “benchmarking” exercise...is itself designed to implement the statutory purpose, not to contradict or undermine it". In other words, the Telco Act is internally consistent.

So now on we go to the Commission's final word on the UBA price, which will be determined by modelling the actual costs of an efficient provider in New Zealand (Chorus had exercised its right to object to the benchmark stab at the price and to have local costs estimated explicitly). According to its media statement welcoming the decision, the Commission says it expects to have the first draft of the "real" cost (my words) in December.

Who knows what that price will be, but I wouldn't be in the least bit surprised if it came out within cooee of the original benchmarked stab at it. As I've said before,  my experience across a number of contexts is that  often benchmarking gets you to an approximately correct place, and far quicker and much more cheaply than the model-building route. I didn't start at that position - in fact, I originally thought the exercise would be too flaky to rely on - but what you find, when you get your hands dirty, is that you can say, the cost of this thing is somewhere around X. It might really be 1.1 times X, or 0.9 times X, but it sure isn't twice X or  half X. And that shouldn't be too surprising: in areas like telecoms, for example, companies tend to be delivering much the same sort of thing with the same sort of technology.

It's all moot now, as we're donkey deep in the formal cost modelling, but I'll say it anyway: I have a soft spot for simple, practical-enough regulation options like benchmarking. For all our general preference for light handed regulation and our national propensity to come up with a cheap and cheerful Number 8 fencing wire answer to things, our current regulatory approaches seem to be favouring ever more complicated, ever more expensive, ever slower, ever more intrusive options, as anyone who's had anything to do with the regulation of electricity lines businesses (for example) would agree.

We're currently having a review of the telco regulatory policy regime. It would be nice, as an outcome, if simplicity and speed got more of a look in than they do now.

Friday, 5 September 2014

Where the profits come from

In the last couple of posts I've been looking at the profitability of different sectors of New Zealand business, using the data from Stats' latest Annual Enterprise Survey.

For some reason the fascinating data in the Survey don't seem to get a great deal of airtime, so partly to make the case for greater use of it, and partly because the trends in the data are fascinating, and as a little bit of a public service (the numbers need a degree of assembly), I've pulled together this composite picture of business profitability over the past five years.

I've broken down some of the line items into sub-sectors where it seemed interesting, though there are still lots of sub-sector alleyways I haven't gone up, for example within agriculture and manufacturing. And in some sectors I've split out an "ex government" breakdown (eg in education and health where government is a big player) to get a better feel how private business is faring in those sectors. Profitability, by the way, is pre-tax return on equity. The years are financial years ending in March.


You'll see the unsurprising effect of the overall business cycle on profitability: ROE across all industries was only 6.2% in recessionary 2008-09, and has worked its way higher to the latest 9.1% (and I wouldn't be surprised if it edged higher in 2013-14). There may be additional cyclical stuff going on in the manufacturing ROE too: I wonder if that fall in the 2013 year was down to the impact of the high Kiwi dollar?

And you can see the impact of the Canterbury earthquakes in the 'health and general insurance' line, which took a hammering in financial 2011 and 2012. You see it again, less directly, in the ROE on residential construction in 2013, which rose to extravagant levels. There's quite a bit of year to year volatility at a sub-sector level, so I wouldn't read volumes into the latest reported 48.4% ROE on housebuilding, but whatever the number is, it's clearly happy days in the building trades.

Generally the pattern of profitability is much as you might expect a priori, with (for example) the utility/infrastructure end having a relatively low ROE. I'd hoped to unpack that 'information media and telecoms' line a bit more to see the infrastructural component, but confidentiality issues mean that Stats was only able to release a breakdown for 2013, so I flagged it away.

As I've noted before, some of the returns look on the high side for the kind of business they are - wholesaling, retailing, and construction in particular (the ROE on the various parts of construction was quite high even before the earthquakes). At a blind guess, before seeing the data, I'd have picked their ROEs as somewhere around the mid teens, but they're well north of that. It's hard to go past the thought that these are all non-tradable sectors that don't face the degree of competitive pressures more trade-exposed sectors like manufacturing have to cope with.

And while I'm open to anyone who can show some other realistic explanation of the high returns in these domestic sectors, I doubt that there's enough domestic competition to adequately constrain ROEs, either. Look at the comparison with the banks, for example: there are some sceptics who wonder about high profits from a banking oligopoly, and it was the explicit premise behind the formation of Kiwibank, But the returns from wholesaling, retailing and construction are all substantially above the ROE in banking, even if you take a generously high view of the banks' ROE (15.8% in the latest year).

The professional services sectors show an interesting pattern, too. The reported ROEs for the likes of science, architecture, doctors and vets, IT professionals, and lawyers and accountants are all quite high. And I don't have a problem with that (always assuming that the high ROEs aren't the result of gatekeeper restriction on supply). You'd expect it: these are scarce, often highly specialist skills that you'd imagine can command high returns as high productivity inputs.

But clearly there's something odd in attributing all of the return to the monetary capital invested in the business. The reported return on shareholders' funds grossly exaggerates the return on the capital invested, as it conflates the return to the tangible assets with the real source of the high returns - the intangible capital between the professionals' ears. And in turn that makes me wonder about some of the conclusions that Thomas Piketty comes to in Capital in the Twenty-First Century, where that 'high' rate of return on capital that he quotes must also be inflated by including returns that should more properly be attributed to a different factor of production. And the inflation will be getting worse as high knowledge activities progressively account for more of a modern economy
.
In any event, that's only one of the ideas that might come to you when you start using this data. There's lots more there - I've chosen to focus on ROE, but you could look at sales or profit per employee, balance sheet structures, margins on sales - so if you've got an interest in the performance of New Zealand business, tuck in. It's an invaluable resource.

Wednesday, 3 September 2014

Outrageous fortunes

Yesterday I posted some data showing the profitability of different sectors of New Zealand business, based on Stats' brand new release of the Annual Enterprise Survey for 2013. And based on a quick squizz at the data I concluded that "you start thinking deep, dark thoughts about whether there are strong enough competitive pressures at work to constrain the profitability of some lines of activity".
I've done a bit more fossicking in the data, and I've ended up thinking even darker thoughts about the state of competition in parts of retailing - and the supermarkets in particular.

Here is what has been happening to the pre-tax rate of return on equity (ROE) in the main sectors of retailing. I've taken the data back to 2009 (which is where Stats started publishing more detailed sub-sector breakdowns), which helps to sort out whether any high recent ROEs are just a cyclical artefact of the recently strong economy rather than evidence of structurally limited competition.


There is no credible explanation for the high ROE of the "supermarket, groceries and specialised food" sector other than limited competition.

This is not a sector where you'd expect high ROEs because of the exercise of scarce, highly specialised skills. And it's not a "high beta" sector exposed to a high degree of cyclical risk - unlike the car yards (who made no money in the tough market of 2008-9) or the sellers of consumer durables (who lost money in 2008-09). If anything, the supermarkets' profitability increased in the tough times.

Let's be clear - the supermarkets are fully entitled to these ROEs. There's nothing wrong with charging what the market will bear. And if you were a duopoly behind reasonably formidable barriers to entry, you'd expect to coin it, too.

But the sooner a hard nosed, low priced Costco or Aldi comes along and upsets their apple cart, the better off we'll all be.

Monday, 1 September 2014

Good profit, bad profit

Many people are ambivalent about corporate profits: they don't know whether to cheer a successful business or boo an exploitative rort. Look at the recent reactions, for example, to the 45% increase in Air New Zealand's after-tax profit:  is this good management of a New Zealand business icon (especially when compared with the humongous losses at Qantas), or, as commentators from the Prime Minister downwards have wondered, a right royal rip-off of travellers on the regional routes?

I've got no problem per se with businesses making money hand over fist. Quite the contrary: that's kind of the point of it all, and in any event healthy profits are the engine that drives investment, hiring and innovation. Where I join the critics is when the profits aren't made on the battlefield of competitive markets: if, instead, they're being coined behind a monopolistic or oligopolistic or protectionist or regulatory moat, then there's good economic reason to push back against the profiteering.

As it happens, on Friday Statistics New Zealand released some data that throws light on the profitability of New Zealand businesses. It's the latest Annual Enterprise Survey, for 2013. It's fascinating - no, really, it is - and it leaves you wondering why some sectors make so little money and why others make so much.

Here's a table I've constructed from the Survey results, on industries' pre-tax return on equity in financial years 2012 and 2013.


Some of this is reasonably well-known: agriculture, for example, while it may be the backbone of the economy, generates a remarkably low 5%-and-a-bit pre-tax return on the equity invested in it.

But some of the other results are rather more surprising.

Why is the ROE in wholesaling so high? It looks to be one of the more humdrum, everyday sectors with (you'd think) not a lot of reason to be earning the sort of ROE a higher-risk, higher-innovation line of business might earn. But there it is, up among the higher earning sectors.

And then you look at retail trade, again earning one of the higher ROEs. And it's at this point, if wholesaling hadn't already got you beginning to think along those lines, that you start thinking deep, dark thoughts about whether there are strong enough competitive pressures at work to constrain the profitability of some lines of activity.

If you go down into the details of the Survey, within retailing (on 2013 data) you find that the accommodation and food services bit of it had an ROE of 15.3% (unusually high that year, it was lower in 2011 and 2012). Car yards and petrol stations did all right, too, with an ROE of 20.2% (again, to be fair, it had been quite a bit lower in the previous two years). There's an assorted 'other' category, where the ROE was 23.1%. But then you come to the 'supermarket, grocery stores and specialised food retailing' segment, and guess what: you find an ROE of 33%. And it had been a lot higher again in 2011 (46.7%) and 2012 (45.1%).

These are outsize rates of return, that - given the bread and butter nature of the sector - are not consistent with fully effective competition in the retail trade.

I'd say the same about construction, except that there are obviously unusual post-earthquake market conditions distorting the numbers which likely explain some or all of the observed ROEs in 2013 - particularly residential building's 48.5% (up from 29.9% the previous year and 27.8% in 2011), But there also looks to be an element of entrenched super-normal profitability in areas such as construction services (ROE averaging 31.2% over the past three years) and heavy and civil engineering construction (21.7% over the past three years). Non-residential building construction on the other hand had quite a modest average ROE (14.2%).

Perhaps there is another, better explanation. But for now, what these figures say to me is this: we have a bunch of domestic, non-tradable sectors that look as if they badly need more effective competition to drive down profits to more sensible levels.