Category: Economics – General

A lot or a little, part 2

John Quiggin7 Comments

This CT post on Stiglitz and the cost of the Iraq war reminded me to get going on one I’ve had planned for some time, as a follow-up to this one where I pointed out that the $500 billion in aid given to Africa over the past fifty years or so is not, as is usually implied, a very large sum, but rather a pitifully small one, when considered in relation to the number of people involved, and the time over which the aggregate is taken.

What are the sums of money worth paying attention to in terms of economic magnitude. I’d say the relevant order of magnitude is around 1 per cent of national income[1], say from 0.5 per cent to 5 per cent. Smaller amounts are important if you’re directly concerned with the issue at hand, but are impossible detect amid the general background noise of fluctuations in income and expenditure. Anything larger than 5 per cent will force itself on our attention, whether we will it or not.

To get an idea of the amounts we’re talking about, US national income is currently about 12 trillion a year, so 1 per cent is $120 billion a year. A permanent flow of $120 billion a year can service around $6 trillion in debt at an interest rate of 4 per cent, so a permanent 1 per cent loss in income is equivalent to a reduction in wealth by $6 trillion.

For the world as a whole, income is around $50 trillion, so the corresponding figures are $500 billion and $25 trillion.

What kinds of policies and events fit into this scale?
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Lowering the NAIRU

John Quiggin96 Comments

Among the relatively few points the opposition has scored in this Parliament has involved the unwillingness (or, in the Opposition’s telling, inability) of Treasurer Wayne Swan to respond substantively to a question from Malcolm Turnbull about the level of the NAIRU (non-accelerating inflation rate of unemployment), AKA “the concept formerly known as the natural rate”.

At this point I was going to refer readers to Wikipedia but, as with quite a few economics articles, it’s not entirely satisfactory. However, rather than complain, I’ve edited it to include a slightly better explanation.

Coming back to Australia, the fact that inflation is rising suggests that, if the NAIRU exists, we are now below it. It doesn’t seem as if there is much scope for fiscal and monetary policy to be tightened further. Given the risk of a breakdown in global credit markets, raising interest rates any further seems very dangerous. And the tax cut promises (which should be kept – the credibility of political processes is more important than the risk of inflation) mean that the scope to tighten fiscal policy is limited.

What remains is the possibility of reducing the NAIRU by improving the performance of labour markets. Education and training will help in the long term, but not so much in the short run. What is needed is to take advantage of the tight labour market to reduce long-term unemployment and to bring discouraged workers back into the labour market. At this phase of the cycle, the best policy instrument to achieve this goal is a targeted wage subsidy. Employers who take on workers moving off unemployment and disability benefits, or re-entering the labour force after a long absence should receive a subsidy for a period of say, three to six months. I’ll try to post a bit more on this, and why it’s superior to suggested alternatives like cutting minimum wages, before too long.

Here comes the big one

John Quiggin53 Comments

My column in last week’s Fin was about the spreading crisis in financial markets. In the same week, we saw the first indication* that the crisis was spreading to the market for credit derivatives. The possibility of a full-scale financial crisis arising from these markets, which financial market bears have been talking about for years. Whereas the losses from sub-prime loans and related derivatives markets are likely to be in the hundreds of billions, the nominal volume of outstanding contracts in the credit derivatives markets is in the tens of trillions, and interest rate swaps are in hundreds of trillions.

Such amounts cannot possibly be repaid by anybody, so a breakdown in these markets would imply either wholesale bankruptcy or a government rescue involving the abrogation of existing contracts on a scale unprecedented in history. Either way, as noted in the article, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.

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One-percenters underbid by McKinsey

John Quiggin89 Comments

I’ve put up quite a few posts supporting the conclusion of the Stern review that large cuts in C02 emissions could be achieved at very modest economic cost. Mostly, the analysis has focused on policies aimed at reducing developed country emissions by 30 per cent by 2020 and 60 per cent by 2050, and the typical conclusion is that the cost would be around 1 per cent of national income. For Australia, at current income levels that would be about $10 billion per year. Today’s news reports a study by McKinsey estimating a much smaller cost, around $3 billion per year. I haven’t seen the report yet but a quick Google found a similar study for the US.

I suspect the report is over-optimistic in the sense that it estimates the cost of doing the job in the most technically efficient fashion, whereas any feasible policy to induce adoption of the necessary measures will have higher costs. But it’s easy to show that the order of magnitude estimate must be approximately right. You can see this by looking at an absolute upper bound assuming we just replace all energy generation by expensive but feasible sources like solar (given the costs of generation, the extra cost required for large grids and pumped storage to smooth out supply variability is a rounding error here). That cost is no more than 10 per cent of income. Taking account of the obvious adjustment responses such reduced consumption in response to higher energy prices implies an even tighter bound, maybe 5 per cent of income.

The most important criticism to be made here is that it is increasingly evident that a 60 per cent reduction in emissions by 2050 may well not be enough. That suggests that, after exhausting the easy options to improve energy efficiency, substitute away from energy intensive activities and so on, there will be a residual 40 per cent of energy demand, almost entirely electricity, that has to be delivered with less than half the emissions of current best practice. Taking Australia’s current consumption of around 250 Twh/year, that’s 100 TwH at a cost of maybe $25 billion a year (=25c/Kwh) or 2.5 per cent of GDP.
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AARES

John Quiggin74 Comments

I’ve been at the annual conference of the Australian Agricultural and Resource Economics Society for the last few days. I’ve been coming to these for nearly 30 years, and it’s always good to catch up with old friends and colleagues. For many, it’s the first time they’ve seen me without a beard, and quite a few failed to recognise me until I accosted them.

The big change in 30 years has been the rise of environmental and resource concerns at the expense of old-style agricultural economics. Most of my early papers dealt with now vanished policies like the wool price stabilisation scheme, and the analysis of production systems needed to inform such policies. Now the conference has continuous sessions on both water and climate change, and only a handful of papers on production economics.

Ross Garnaut spoke on Tuesday and his talk was pretty sobering. Short version – as regards the likely consequences of business as usual, Stern was an optimist. Unless the world acts decisively, and well before 2020, we’ll have emissions higher than the highest of the IPCC scenarios Stern looked at. What’s worse new information on feedbacks suggests that the models relating emissions to temperature change are also likely to be on the conservative side, as the capacity of sinks to absorb emissions declines.

The positive side of this, I guess, is that the problems arise from China (and to a lesser extent India) growing fast, and that means China has more resources to address the problem, if we can only get the politics right.

One aspect of the latter is the near-certainty that we won’t be able to get away much longer with the notion of historical rights for high-emission countries like the US and Australia. By 2050, under any plausible agreement, we’ll have uniform emission entitlements per person, for everyone in the world, at a level well below our current emissions.

Howard’s economic record

John Quiggin74 Comments

If there was one thing John Howard and Peter Costello could reasonably have expected as part of the historical judgement on their terms as PM and Treasurer, it was a positive assessment of their record as economic managers. But a game isn’t over until the final whistle, and the last few months have produced some unpleasant data. Howard and Costello have left higher inflation and (if you impute the whole of the current tightening phase to their policies) higher interest rates than they inherited from the Keating government. Given that the ratio of household indebtedness to income has grown massively, the effective burden of interest rates is far higher now than in 1996.

A judgement based on inflation and interest rates is unfair in some senses. The big achievement of the last 15 years has been to avoid a recession. While most of the credit for this outcome must go to the Reserve Bank (particularly for getting policy right in the Asian crisis of 1997) and some is down to luck, the government should at least be credited for not doing anything to muck things badly enough to derail the Bank’s economic management (I’m assuming here that the housing bubble, to which the government’s policies contributed greatly, will deflate gradually rather than popping us into a recession. That would be a really nasty legacy for Howard and Costello to leave).

Unemployment has also fallen quite a lot, though until quite recently, the improvement in headline figures masked a deterioration in broader measures of employment and unemployment, particularly for men.

The problem for Howard and Costello is that they chose the criteria on which they wanted to be assessed. They never cared much about unemployment, abandoned the whole idea of an unemployment target early on, and their occasional policy interventions were either focus-group driven exercises like “work for the deal” or ideological costcutting like the Jobs Network.

By contrast, they ran hard on “keeping interest rates at record lows” and now have to live with their failure.

The Great Australian Dream

John Quiggin42 Comments

I’ve been meaning for ages to write a post about house prices, but haven’t come up with an analysis that satisfies me. Still, here goes.

On most standard measures. Australian house prices have been far above their long-run equilibrium value for at least five years, and the gap seems to be widening. But the length of the strength of the boom has convinced most people that high prices are here to stay, at least until they are replaced by even higher prices.

If this belief were suddenly reversed, and the prices returned to say, 2000 levels (even adjusted for changes in prices and incomes since then) there would be an awful lot of financial distress, with hundreds of thousands of households having negative equity.

This is already happening in the US and to some extent the UK. Compared to the US we have nothing like the volume of bogus subprime loans. On the other hand, price increases have been even greater, so there’s more room to fall.

If there is a really dire economic scenario facing the Rudd government over the next few years, this is it. By contrast, a slowdown in the export boom and a gradual deflation of the housing bubble would be a much better outcome.

A million foreclosures

John Quiggin26 Comments

The news that over a million homes went into foreclosure in the US in 2007, affecting about 1 per cent of all households or around 3 million people, supports the view that foreclosure has taken over from bankruptcy as the primary mode of financial catastrophe.

As with bankruptcy, however, the high frequency of financial distress is partly offset by the fact that US law and standard contractual arrangements are more friendly than in other countries. Compared to those in other places (at least in Australia) US mortgage contracts have commonly favored borrowers in two important ways. First, they have been fixed rate contracts with no, or limited penalties, for early repayment. That means that borrowers can stick with their fixed rate if market rates rise, but can refinance at lower cost of market rates fall.

Second, most mortgages are non-recourse, meaning that the lender can take the house but cannot recover the debt from the borrowers income or other assets. That means that once the value of the house falls below the amount owing (equity becomes negative) the borrower can walk away from the house and the debt. As Felix Salmon notes, the difficulty of pursuing deficiency payments means that most loans are non-recourse in practice even if the contract says otherwise

In the jargon of financial assets, the standard contract gives borrowers both a put option on the house (the ability to walk away) and a call option on the debt (the ability to pay early). Both of these make the contract more valuable to borrowers and less valuable to lenders. There’s quite a good discussion of all this from Tanta at Calculated Risk, though the author makes heavy weather of the put option and seems to me to be unreasonably exercised about the fact that households are now treating their debts to banks with the same calculating attitude that corporations have long shown to their workers and other creditors, paying them if it is profitable to do so and defaulting otherwise.
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Cracks in the foundations

John Quiggin60 Comments

The decision of the US Federal Reserve to cut interest rates by 0.75 per cent is as clear a sign of panic on the part of the monetary authorities as we’ve seen since the 1987 stock market crash. It’s not entirely coincidental that it followed a dreadful week on Wall Street, and a couple of awful days on world stock markets while the US was closed for the long weekend.

Still, stock markets have fluctuated quite a bit in the last 20 years without producing this kind of reaction. The really alarming events have been happening in bond markets and, in retrospect, the most alarming happened just over a month ago.*

That’s when Standard and Poors cut the credit rating of ACA Financial Guaranty Corp from A (strong investment grade) to CCC (just about the worst kind of junk) in one move. This event showed the weakness of two of the most important defences against the kind of credit derivative meltdown that market bears have been worrying about for years.

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Happy New Year

John Quiggin32 Comments

A bit belatedly, Happy New Year to everyone. Some optimistic wishes for 2008

* The end of the Bush era will prove to be the end of political power for the Republican party in its current (religious right/militarist/pro-rich class warfare) form, and will be followed by a return to reality-based politics

* The crisis in Pakistan will provoke the world’s leaders into serious action on nuclear disarmament. Pretty clearly, unless this happens, nuclear weapons will sooner or later fall into the hands of someone who wants to use them. There was quite a good article in Prospect unfortunately paywalled, making the point that Gordon Brown could take a lead on this if the UK (one of the prime examples of a country maintaining nuclear weapons for no better reason than national pride) was willing to offer disarmament as a bargaining chip.

* The Rudd government will deliver the goods on education, industrial relations and global warming. Despite some silly mis-steps, I’ve been favourably surprised so far at how well things have turned out.

* The slow-motion financial crisis will stay slow-motion producing a gradual reversal of the explosion of dubious debt derivatives seen over the past decade, and a relatively smooth rebalancing of household and national balance sheets.