Friday, 31 July 2015

29th isn't good enough

This tweet from the World Economic Forum just caught my eye...

...and, as you do, you wonder where New Zealand is. The WEF's article on the countries with the best infrastructure has a link to its Global Competitiveness Report site and the associated competitiveness database, which you can play around with. Here's our ranking on infrastructure: a global 29th.

Not so good. If you unpick the details behind the infrastructure rating, you'll find it's largely down to relatively poor roads (a global 35th) and rail (a global 39th): on the other hand our ports (11th) and air transport (14th) are pretty good, and electricity and telecoms okay though not great (24th).

So there you have it: we're aiming for the productivity and income levels of a UK or a Germany, and we're trying to do it with the infrastructure of a Malaysia or a Saudi Arabia.

Ain't gonna happen.

Wednesday, 29 July 2015

Where has inflation gone?

I know, I know, the media are already full of coverage of today's speech by Graeme Wheeler, the Governor of the Reserve Bank (short version here, full thing here), and you probably don't want much more, especially if you've already had enough of the partisan point-scoring.

But I would like to expand a bit on the graph below, from the speech, which shows inflation consistently coming in below the Bank's target mid-point in recent years, and which has been fuelling some of the criticism of the Bank - either because its forecasting has been poor, or (hence or otherwise) because it's been running monetary policy too tight.

I'm interested in the blue, non-tradables, part, which is the only bit under our control. It's been lower than usual, and we partly know why (investment in capital equipment and a larger labour force have boosted capacity, so growing demand can be accommodated without inflation). But even after that's accounted for...
Non-tradables inflation has been about ½ of a percentage point weaker on an annual basis than the Bank’s modelling estimates would suggest is normal for this phase of the economic cycle, even allowing for the stronger growth in economic capacity. This underestimate of inflation has also occurred in other countries and could be due to several factors. For example, inflation expectations may be weaker than survey data suggests, the tradables component of non-tradable products and services may be higher than previously thought, or online commerce may be increasing competition and squeezing margins in non-traded sectors, such as retail.
I'd love to think that increased competition - from online commerce or other sources - is helping to discipline price increases for our domestic goods and services. That aside, it's clear that both here and overseas our overall state of knowledge about this unusually low inflation is inadequate. Until that gap is filled in, there's the possibility that central banks everywhere may be needlessly on guard against an inflation threat that isn't there.

Great expectations

The latest monthly business opinion survey from National Australia Bank had this interesting item.

The interesting bit, for me, was that top right hand box: the high "hurdle" rates of return that businesses typically require new investment projects to meet. There is a big puzzle here: the hurdle rates are well above the weighted average cost of capital (WACC) that finance theorists, and regulators, say should be adequate for companies to earn. The sectoral distribution of the hurdle rates makes more sense, and looks to be broadly in line with back-of-an-envelope guesstimates of the relative riskiness of the different sectors, but the levels of the hurdles looks remarkably large.

Turns out that this isn't peculiar to the sample of companies the NAB surveyed: it seems to be well nigh universal. In the latest issue of the Reserve Bank of Australia Bulletin, there's an article, 'Firms' Investment Decisions and Interest Rates', which confirms NAB's findings for Australia...

...and which also summarises international research that found exactly the same thing overseas. For example
Studies of firms overseas have found that they also use hurdle rates that are above their cost of capital. Jagannathan, Meier and Tarhan (2011) surveyed firms in the United States in 2003 and found that a typical firm used a hurdle rate several percentage points above its WACC. Brunzell, Liljeblom and Vaihekoski (2013) found a similar result for Nordic firms. Similarly, firms in other countries also appear to use hurdle rates that are not sensitive to the cost of capital
I think we can safely assume that New Zealand businesses are in the same boat (anyone aware of specific research on topic?)

We don't know exactly (or even approximately) why this happens. I've always thought that part of the explanation was a principal-agent problem: the CFO is bombarded with potential projects from ambitious executives with self-aggrandising projects, and needs some device that might help sort out the viable from the vanity (though a high hurdle rate will also have the downside of encouraging hitting fours and sixes at the expense of lower-risk steady accumulation of runs). But I'm also rather attracted to two other possible explanations canvassed in the RBA article: this one...
the level of the hurdle rate may be greater than the WACC if the potential investment has greater non-diversifiable risk than the overall operations of the firm
...and this one
managers might value the option to defer an investment until its expected net present value is greater. In the absence of more sophisticated analysis, using a hurdle rate in excess of the WACC may be a reasonable approach to account for this option value of waiting (McDonald 2000)
If I were still a regulator - and particularly a regulator looking at a sequence of projects rather than a company's overall rate of return -  I think I'd be somewhat perturbed about these results. For good reason, more enlightened regulators tend to err a little on the side of generosity when it comes to regulated WACCs, since for dynamic efficiency it is far better to slightly overcompensate than undercompensate. But when you see the prevalence of these high hurdle rates, well in excess of WACC, you wonder if there's something that the standard regulator's WACC calculation is missing.

Tuesday, 21 July 2015

Monetary policy has turned neutral

Just a quick update on where overall monetary conditions have got to - if you haven't come across the Monetary Conditions Index before, this or this will see you right -  given that the Kiwi dollar has plunged and interest rates have moved lower.

The graph is the historical record based on monthly data from the Reserve Bank: the star shows where we are today (based on 90 day bank bills at 3.07% and the TWI at 70.4).

In sum,we've already arrived at a 'neutral' setting for overall monetary policy. That's reasonable, given some slowdown in the economy and inflation still lying below the RBNZ's target range. We'll know on Thursday whether the RBNZ will fire the next 0.25% gun and take us towards the 'easy' end of policy, and then there'll be a pause till September 10.

It's just as well there's a pause for thought: I'm not sure - at least not yet - that there's a compelling case for a whole clatter of further rate cuts. Yes, the dairy price has plunged, and yes the latest ANZ and NZIER surveys were weakish, but on the other hand the latest BusinessNZ/BNZ PMIs for manufacturing and services were both solid. A time out is just the ticket: to see what the net trend really is, and to give some further time to try and get the Bank's head around the reasons for our unusually low rate of non-tradables inflation,

Friday, 17 July 2015

If it ain't broke...

Every general election, we the people get offered proposals to change our monetary policy regime. Some are predictable: "debauch the currency and devalue ourselves into prosperity". Some want to wind back the clock: "more jobs, not less inflation". Some are bizarre: "let's try some of that quantitative easing stuff they're mainlining overseas".

And that's all fine. In a democracy we're entitled - even obliged - to give the central bank its marching orders. But just for once, I'd like to see our politicians give it a miss in 2017 and leave the damn topic alone.

I felt like that anyway, but I've also just read an article in the latest issue of New Zealand Economic Papers, "Monetary policy and interest rates under inflation targeting in Australia and New Zealand". I'd post a link for you, except that NZEP, the scholarly journal of the New Zealand Association of Economists, is unfortunately one of those traditional charge-for-it academic journals (I should have raised this at the recent Association AGM, but never mind). If you're in academia, you've probably got a subscription: if not, I looked in the usual places for you, to see if there was a work-around by way of Working Paper or what have you, but no luck. Moving right along.

The authors are experienced monetary policy guys (Hakan Berument at Bilkent University in Turkey,  Richard Froyen at the University of North Carolina, Chapel Hill, in the US). And the gist of what they found is that our inflation targetting regime has brought about a step change in people's expectations about inflation. They now think it will be stably low, and that belief has consequently also affected the volatility of long term interest rates, which now don't jump about anything as much as they used to. People have greater confidence any shorter-term shocks will be just that, shorter-term, and that the central bank is on the case.

The authors wondered if our inflation targetting would do even better than a well dug in central bank (they chose the Fed) that doesn't explicitly do the inflation targetting thing. The answer was no...
Our results are, however, consistent with inflation-targetting regimes in Australia and New Zealand having resulted in inflationary expectations as well anchored as in the United States - a substantial change from less stable pre-inflation-targetting regimes
How much better are we than we used to be? Pre targetting (April '85 to January '90), the variance of the (monthly) 10 year Government stock yield was 4.1%. Over the targetting period February '90 to October '12, the variance was 3.1% - but that included the gyrations of the GFC. Ex GFC (February '90 to August '08) the variance was 2.6%. Better, but not massively better.

Significantly, the Reserve Bank changed how it implemented policy in April '99 from a system only monetary policy tragics could understand (targetting 'cash settlement balances') to one everybody could understand (the cash rate). That made a huge difference to people being able to form a clearer view of what was going on: the variance in the 10 year yield for the cash rate period went down to a very much smaller 0.6% (including the GFC) and to a minuscule 0.2% (ex GFC).

So we've bagged one of the big benefits claimed for inflation targetting - as they quote the Harvard economist (and chess grandmaster) Kenneth Rogoff saying,
with long-term inflationary expectations more firmly anchored, long-term interest rates might jump around a bit less, and businesses and investors might find it easier to draw up long-term contracts
As one example, the fact that we've got a working market in longer-term fixed rate mortgages is one of the side benefits of the inflation targetting regime.

So my plea to the pollies is this.

Back off. We've got a working system that's done what it said on the label. It takes forever for new monetary systems to get bedded in and for people to get their heads around them: a central bank's credibility takes decades to lock down. We've got there: let's stay there.

Saturday, 4 July 2015

A cautionary tale

I've just finished reading The Fall of the Celtic Tiger (Oxford University Press, hardback 2013, paperback 2014), a fine book cowritten by my old classmate at Trinity College Dublin, Donal Donovan, and our former monetary economics lecturer, Antoin Murphy. Well worth reading from many perspectives: the story of how the best performing economy in Europe became a financial basket case is gripping, and it's got many lessons for countries elsewhere, including for us.

One is the importance of keeping a very close eye on the structural fiscal balance - the true shape of the government's books, shorn of cyclical influences. The Irish government of the first half of the 2000s spent up large on the back of a cyclical and unsustainable boom in revenue, a lot of it emanating one way or another from the massively overheated Irish property sector. In reality, its spending (and the future commitments it also entered into) left it hugely exposed, financially, when its revenues plunged.

At the time, as the book explains, watching the structural balance wasn't much in vogue, and it didn't help that when the first estimates were eventually made of the true Irish position, they didn't correctly pick up the sheer awfulness of the fiscal books. These days we're more on the ball - though the media attention at Budget time is still disproportionately on the government's headline fiscal numbers and not enough on what's really happening under the bonnet - and I was pleased to see that Treasury continues to beaver away at improved ways of calculating where we really are.

I was also struck by how quickly the Irish fiscal situation deteriorated when the balloon finally burst, and there's a lesson there too. Here is what the level of Irish government debt looked like before things went to hell in a handbasket (based on the data in Table 6.1 of The Fall of the Celtic Tiger).

That looks good, doesn't it? Despite the big spendup, revenues were so large that the government could scatter cash to the four winds and still have enough left over to work government debt down to what looks like a conservative level of just under 25% of GDP. You'd think that debt at that level was low enough to be able to cope with anything the domestic or global economy might throw at you, wouldn't you?

But it wasn't.

So when our Fiscal Strategy Report says,
The Government has five fiscal priorities:
2 Reducing net government debt to 20 per cent of GDP by 2020, including repaying debt in dollar terms in 2017/18
5 Using any further fiscal headroom – including from positive revenue surprises – to get debt down to 20 per cent of GDP sooner than 2020 
I say, right on.

And finally there is the whole issue of overheated property markets: as you read the book, you find yourself asking, are we on the same slippery slope to a property bust as the Irish were?

On balance I'm inclined to think not. We do have some of the same characteristics as the Irish did: a surge in property demand from growth in incomes, strong net immigration, and a monetary policy imported from elsewhere that doesn't suit our circumstances (in Ireland's case it was the common eurozone monetary policy, in ours the Fed's which has, for example, helped drive our fixed rate mortgage rates to low levels). But we don't have others, notably the reckless lending of the Irish banks in general and their huge lending to property development companies in particular.

But sorting out what's happening in real time is as hard here as it was in Ireland. You can easily miscategorise things: what looks to you like a 'genuine' increase in housing demand meeting a near-fixed short-term supply curve could as easily be the early to mid stages of a speculative bubble. And often enough there may be elements of both stories happening at the same time.

Which is why I thought this chart was so interesting. It's by Ronan Lyons, an assistant professor at Trinity, and it appeared a few days ago in this article on the Irish economy blog. It's his estimate of the strength of the different factors that were driving the Irish housing boom/bubble.

As you can see, different things mattered at different times. As the boom started (1995-2001), you had decent sized contributions from a variety of sources - people's incomes (blue), demographics (green), bank lending (red), and those too-low eurozone interest rates (yellow) all played a part. The bubble period of 2001-2007, however, was driven overwhelmingly by loose lending.

Wouldn't it be useful to see the same analysis done here?

Thursday, 2 July 2015

Gini needs friends

I've been away at the NZ Association of Economists' annual shindig - full conference programme here, with links to abstracts and to quite a few of the full papers, including my own one on why our Commerce Commission should have the right, and obligation, to carry out market studies - and it's been the usual interesting mix.

This afternoon I went to the session on 'Income and Inequality' - yes, I know, it's very trendy these post-Piketty days, but I went all the same - and I learned something that maybe I should have known before, but didn't. Here it is.

A conventional way of looking at income distribution is to calculate the 'Gini coefficient' (0 if everyone earns the same, 1 if one person earns it all). And the session presented by Treasury's Christopher Ball - a reprise of the recent Treasury Working Paper written by him and Victoria's John Creedy - showed us how inequality measured by the Gini coefficient has behaved over the past 30 years, as shown below. The 'market' line shows the distribution of pre-tax incomes, the 'disposable' line shows the distribution of post-tax post-transfer-payment incomes, and the 'consumption' line shows the distribution of consumer spending.

This chart has been all over the blogosphere already - mostly because people have wanted to point out that, contrary to what the fuss about Piketty might have led you to believe, income inequality peaked some 20 years ago and has either stabilised or dropped since - so I won't belabour it much further. My only comment would be that I suspect the low level of inequality in 1984 was somewhat artificial and somewhat undesirable, in the sense that the wage freeze and fixed wage relativities of late Muldoonery were gummaging up the efficient workings of the labour market: pay rates were not able to move to reflect supply and demand for different occupations. But in any event, there you have it: inequality rose mid '80s to mid '90s, then steadied or maybe declined.

You knew that. I knew that. But what I certainly didn't appreciate was how misleading a Gini coefficient can be, looked at in isolation, and I learned that from a very interesting paper presented by Athene Laws (of Motu Economic and Public Policy Research) and co-written by Athene, Victoria's Norman Gemmell, and the ubiquitous John Creedy.

Athene's big point,which I've taken from the abstract of her paper - was that
In answering distributional questions that are important for many economic phenomena, researchers and analysts should not solely examine cross-sectional aspects to the neglect of income dynamics and mobility across time. 
In other words, the Gini coefficient is based on a cross-section of income in a single year. But what if, one year, I start off  working as a wage slave, the next year I make pots of money from a book or an app, the year after I make nothing when my second book or app goes phut, the year after that I'm back working for someone else. One year I'll have been right up the wealthy end of the income distribution, the next year right down towards the poor end.

On average, I may have done reasonably okay over time. And if everybody else has been experiencing the same thing, they'll have done reasonably well, too. Over time, we may all end up much the same, which means when you look at our incomes over a longer time-frame, the Gini coefficient could well turn out quite low, even if the Gini snapshot of any individual year still shows quite a wide disparity of earnings. And Athene's data (based on access to an anonymised sample of IRD tax returns) showed precisely that pattern: there is income mobility over time, and the longer the timeframe you use to look at people's earnings, the less the actual income inequality.

So that's what I learned: never trust a Gini coefficient on its own. It may or may not be telling you something interesting, but at a minimum it needs to be read alongside what's happening to mobility. That doesn't mean that you can wave a magic mobility wand and all inequality concerns are wizarded away: unfortunately, there seems to be evidence that in some places equality of opportunity is diminishing, and the gateways to those good years at the top of the income spectrum are getting narrower (eg as the kids of the already well-to-do get a bigger share of entry to the better universities). But it does mean that you need a bigger picture of what's going on than Gini alone can tell you.