According to this NYT, the Pentagon is considering a leasing deal with Boeing for tanker planes. Everything you’d expect in a PPP story is there, including the obligatory reference to “innovative financing”.

Although I don’t keep careful track, I had always thought of Alan Wood as being relatively optimistic about the performance of the US economy, and its implications for Australia. But his latest piece puts him firmly in the camp of the ultrabears. He endorses the calculations of British economist Wynne Godley

But according to Godley’s calculations, using conservative assumptions about US growth, interest rates and private borrowing behaviour, this can’t go on. As the private sector swings back to saving, even if only modestly, the US is heading for current account and budget deficits of the order of 8 per cent or 9 per cent of GDP, with implied foreign borrowing rising from about 25 per cent of GDP to 60 per cent.

The US may be able to sustain the deterioration for some time if it is seen as the best place to invest, as it may be because of the poor economic performance of Europe and even more so Japan. But it is unlikely to be sustainable politically or in financial markets indefinitely. Investors have already taken a pretty big haircut betting on US share prices and the dollar.

So how to adjust? A huge rise in US exports relative to its imports would do it, but that needs a powerful demand expansion outside the US, and how is that going to come about given the state of the European and Japanese economies? Well, a large depreciation of the US dollar could do the trick, but is likely to be resisted by US trading partners.

Godley’s conclusion, which seems all too plausible, is that the US economy will not recovery properly and there will be a long, depressing era of growth recession. Unless, of course, the US can revive the new-economy miracle. Don’t hold your breath.

I’ve been putting forward much the same viewpoint for years, and I’ve done the same calculations on the current account blowout. But a deficit of 8 or 9 per cent is one of those trends that can’t be sustained and won’t be.

I disagree with the assumption that, because US trading partners don’t want a depreciation, they can prevent it happening. I see the adjustment coming through a combination of low growth, inflation and real depreciation – basically a rerun of 70s stagflation.

In the course of the discussion of liberalism and neoliberalism, I happened across the Index of Economic Freedom, which purports to measure the degree of economic freedom available to people in different countries. The top two countries for 2003 were Hong Kong (a dictatorship) and Singapore (a one-party state where oppositionists are routinely prosecuted for defamation etc). The situation was even worse in 1995 when another dictatorship (Bahrein) held the number 3 spot. Japan, a democracy, but one where a single party has had a monopoly of power for decades held fourth spot. The idea that you need an authoritarian government to promote economic freedom certainly seems to appeal to the Heritage Foundation, which publishes the index.

Another notable thing about the 1995 list is that the leading countries have not exactly been star performers in the subsequent period.

Update 21/3 As a number of commentators have pointed out, I was arguing pretty sloppily in attributing to the Heritage Foundation the view that ‘you need an authoritarian government to promote economic freedom’. I withdraw this claim. A more soundly-based inference is that there is not much correlation between economic freedom (at least as measured by this index) and political freedom.

I didn’t get around to blogging on Warren Buffett’s comments on derivatives when he made them a week ago, but I think that bloggers (including me, I admit) tend to be too concerned with immediacy. In this spirit, I’m reprinting a post from last year, with some topical bits deleted.

Another look at possible disaster scenarios for the world economy, this one perhaps the scariest of all. The starting point is a crisis in derivatives markets arising when ‘counterparties’ (those owing money on the transaction) for one of the big New York banks, such as J.P. Morgan Chase, refuse to pay up, either because they can’t or because they allege fraud. This has already happened in a small ($1 billion) way in the case of Mahonia, one of the shonky subsidiaries set up by Enron with the aid of JP Morgan. If it happened on a large scale it could cause a cascade of defaults. How big could it get? The short answer is “Huge”

“At the end of 2002’s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”

That’s trillion , not billion. For comparison, annual US GDP is around $10 trillion.

The ratios involved are staggering. JP Morgan alone is involved in assets with a gross value of 23.2 trillion, or around 500 times the firm’s capital base. This is comparable to the leverage exercised by Long Term Credit Management before its collapse. But before you panci too much, virtually all of this is hedged in some way.

(“Notional value” is the total value of the contract, and J.P. Morgan’s direct exposure to those derivatives was $51 billion as of Dec. 31, or less than 1% of the notional value, according to the firm. About 80% of the company’s exposure was with investment-grade counterparties.)

The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.

How likely is it to happen? In view of the extent to which standards have been compromised in the financial world, some significant breakdown in derivative markets, leading to the failure of at least some players, seems more likely than not. On the other hand, the full-scale meltdown scenario, while far more plausible today than even a year ago, remains a low probability event.

[A side issue in all this is that ‘gold bugs’ (that is, supporters of a gold standard with a conspiratorial view of the world) are prominent in promoting concerns about derivatives. The link as far as I can tell, is the belief that central banks and/or big institutions like JP Morgan are using futures contracts (one of the most basic forms of derivative) to keep down the price of gold. I don’t buy this, but I’d be interested if anyone has any related angles of which I’m unaware]

A week ago, I wrote of “the developing attitude of the Republican establishment towards government debt, which is essentially that of banana republic populism”. Now I’m seeing the analogy everywhere. On reasoning identical to that I put forward a few days ago, Paul Krugman says

I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared — the ultra-establishment Committee for Economic Development now warns that “a fiscal crisis threatens our future standard of living” — investors still can’t believe that the leaders of the United States are acting like the rulers of a banana republic. But I’ve done the math, and reached my own conclusions — and I’ve locked in my rate.

It would be nice to imagine that Krugman reads my blog, but I will content myself with the more modest claim that I’m attuned to the Zeitgeist.

Update Google reveals that on Feb 8, Krugman used the phrase “sheer banana-republic irresponsibility” to describe Bush’s fiscal policy. So I probably picked it up from him, then forgot about it. The Zeitgeist works in mysterious ways.

Further update Max Sawicky responds with two arguments against Krugman. One is based on the efficient markets hypothesis which, as I observe in the preceding post has been conclusively refuted by the experience of the NASDAQ boom. Max says

Krugman says the bond market hasn’t figured out what’s going on yet. Excuse me? P Krugman is a keener judge of interest rate movements than the bond market? I don’t think so.

I disagree. If I can be a better judge of the value of dotcom shares than the whole of Wall Street (and I clearly was, as noted below) what’s implausible about Krugman (who’s a good deal smarter than I am) being a keener judge than the bond market.

Max’s second point is a restatement of the old left line in favour of deficits. He says

Deficit delirium in the end is a conservative political stance. It precludes the necessary growth of the welfare state. What became a tactical gambit under the Clinton Administration — the use of deficit scares to fend off tax cuts — has become a civic religion. It’s bad religion.

Again I disagree. I accept the Keynesian case for temporary deficits in periods of recession, but a sustained budget deficit must be financed either by inflation (a tax on money holdings, and not a particularly good one) or debt (deferring tax from the present to the future). I don’t have a religious objection to either option, and sometimes they are necessary but, they are rarely the best option. In my opinion, the most economically and politically sustainable way to finance public expenditure is through broad-based taxes on income, wealth and consumption, including hypothecated levies that bring home the link between tax and expenditure.

The third anniversary of the peak of the NASDAQ boom has produced a fair bit of commentary. As an economist, I think the biggest impact, still only dimly-perceived, is the refutation of the efficient markets hypothesis.

I’ll start with the introduction from a piece I wrote for the Fin last year, which ran under the titleMarket theory unravels

Although the name gives the general idea, the efficient markets hypothesis is hard to state in simple terms. To complicate matters further, the hypothesis comes in a variety of intensities, from weak to very strong. The weakest version simply says that it is impossible to predict shares prices based on their past behavior. This is bad news for day-traders and chartists, but does not matter much to the rest of us.

In the strongest version of the efficient markets hypothesis, market prices for assets such as shares represent the best possible estimate of their value, taking account of all available information, public or private. Moreover, markets yield the most efficient possible allocation of risk. Markets are not perfect, but, they are claimed to be better than any alternative institution, including governments.

Although the statistical evidence generally doesn’t support strong versions of the efficient markets hypothesis, statistical testing is never going to finally refute an idea that’s so obviously appealing to a lot of people.

But I think the experience of the NASDAQ bubble has fatally undermined the efficient markets hypothesis, for several reasons.

First, in terms of scale, financial magnitude and worldwide publicity, it was far bigger than any previous bubble. Trillions of dollars in market capitalisation were lost and at least one trillion dollars was dissipated in investments that ranged from unsound to absurd. Millions of individual investors made and lost large amounts of money.

Second, it was widely recognised and denounced as a bubble, even as it developed. Here’s a piece I wrote in 1999 criticising dotcoms in particular, but the speculative nature of the boom had been recognised as early as 1996, when Robert Shiller coined, and Alan Greenspan popularised the phrase ‘irrational exuberance’.

Third, all the ‘checks and balances’ that are supposed to prevent a bubble were present and all were ineffectual or counterproductive. It’s hard to recall, but there was a time when people believed that stock market analysts served a positive role in informing financial markets. Accountants, debt rating agences and regulators have been as thoroughly discredited as analysts, but all clearly failed to their job.

Most notable of all, but less noticed was the failure of counter-speculators to burst the bubble. George Soros lost billions in 1998 and 1999 by short-selling stocks that were grossly overvalued. By the time the bubble reached its peak three years ago, the bears had all retired to lick their wounds – it was only when the bulls finally ran out of money that the madness stopped.

The implications of rejecting the efficient markets hypothesis are profound. As I observed in the AFR piece quoted above

Judging by the experience of other bubbles, share markets will take years to recover from the 1990s. The social and political implications will emerge even more slowly. Political programs like privatisation, cultural attitudes based on the idolisation of ruthless CEOs, and much of the ideological framework of the last two decades have been founded on the efficient markets hypothesis. They will not vanish overnight. But they are doomed, nonetheless.

Brad DeLong has a piece linking to Rajnish Mehra’s survey of the literature on the equity premium puzzle, that is, the fact that the risk premium demanded by investors in private equity is much higher than seems reasonable on the basis of standard assumptions about individual preferences and capital market efficiency. My view is that no monocausal explanation can work but that the puzzle implies that the obvious gaps in financial markets (the absence of private unemployment insurance and the big wedge between borrowing and lending rates for individuals) have profound effects on the supply of equity capital.

To misquote Marx, the problem now is not to explain the equity premium but to derive its policy implications. To some extent, of course, the implications depend on the explanation. Still the framing of the problem as a puzzle has led to an excessive focus on puzzle-solving. Simon Grant and I have been looking at this question for a number of years. You can read our survey article here (PDF file).

Some of the implications reinforce common ideas. For example, the common view that recessions are socially very costly (compared to a stable rate of output growth with no booms and no recessions) is hard to sustain on a standard welfare analysis assuming efficient capital markets. Consideration of the equity premium implies that recessions are indeed socially costly.

Other implications are more surprising at least to those who have imbibed the current conventional wisdom. In this piece (PDF file), which just came out in Economica, we show that, if explanations of the equity premium based on market imperfections are accepted, the rate of return for public investments should be lower than the rate demanded by private investors in projects with similar risk characteristics. An immediate implication is that, other things (such as operational efficiency) being equal, privatisation will reduce welfare and nationalisation will increase it. Of course, other things are rarely equal, so the analysis supports a mixed economy with some services being provided by public enterprise and others

In this piece, which came out in the American Economic Review last year, we show that market failure explanations of the equity premium puzzle support the Clinton plan to invest some of the Social Security fund in stocks as opposed to the Bush plan of creating individual accounts.

The struggle for economic literacy goes on. At the Age Ken Davidson points out, again, the nonsensical thinking behind the use of “net debt” as a policy target. Meanwhile, at the SMH, Ross Gittins gives a good explanation of movements in the exchange rate, pointing out that the $US/$A rate fluctuates around the “purchasing power parity” value of $A1.00 = $US0.70 and that an appreciation in the exchange rate is not good for everyone, particularly not for exporters.

I have two small quibbles with Ross. First, he misses the chance to point out that the $US/$A rate is not “the” exchange rate, or even the most important one.

Second, he says that we’ll never see a return to parity ($A1.00 = $US1.00) noting that the PPP rate of $A1.00 = $US0.70 is below parity because Australia had higher inflation than the US in the 1980s. But when it hit $A1.00 =$0.48, the $A was about 40 per cent below PPP. It’s just as likely, in the long run, to fluctuate 40 per cent above PPP which would reach parity. (I confess that I took a small bet on this some time ago, at long odds, but, as I often do, underestimated the time it would take to return to, and overshoot, the long run equilibrium value).

While I’m catching up on my email, I’ll point to this updated Budget simulator from Nathan Newman.

An excellent piece in the Times (free registration required) on the balance sheet manipulations associated with public-private partnerships in the UK.

The National Audit Office (NAO) said that Network Rail was a state entity: its assets and liabilities should be kept on the Government’s balance sheet, because the Government would bail it out if it ran into difficulties. But the ONS classified Network Rail as private, on the basis that Whitehall did not directly control it. Despite the urging of the Statistics Commission, ONS and NAO have still not agreed: they have agreed to differ, on the flimsy basis that the ONS was governed by EU accounting rules while the NAO was not. Yet the Treasury seems happy to let the ONS’s view prevail, which has the useful result of reducing the national debt by something in the order of £25 billion.

The Treasury’s attitude to London Underground is similarly ambiguous. It has happily issued to Tube contractors letters of comfort, which are effectively a guarantee that the Treasury would be the lender of last resort, while claiming that private contractors deserve a healthy premium under the Public Private Partnership (PPP) because they are bearing the risk.

National institutions like hospitals and railways must be kept on the books because governments will never let them go bust.

I had a go at this topic, pointing out the similarities to the Enron fiasco, here.