The FTA and the equity premium

John Quiggin49 Comments

As indicated in my previous post on the FTA, the revised CIE study on the effects of the proposed Free Trade Agreement between the US and Australia has most of the benefits coming from investment liberalization. The estimated impacts on merchandise trade are now so small that a modest adjustment to the elasticities would turn the estimated gains to losses. As the report says (p98) “A high Armington elasticity implies that imports (from any source) are highly substitutable for local production, thus raising the prospect of trade diversion and income losses.”

Nearly all the gains proposed for the FTA therefore arise either from hypothetical dynamic productivity gains (the services gains are also mainly from this source) or from the supposed reduction in the risk premium for equity arising from capital market liberalisation. I’ve had my say on the dynamic gains hypothesis before, so I’ll focus on the equity premium.

First, as these results indicate, the equity premium is a really big deal. In the modelling present here, a reduction of 5 basis points (0.05 percentage points) in the equity premium induces a permanent increase in GNP of around 0.5 percentage points. The analysis assumes linearity as far as the gap between Australian and US equity returns is concerned, so we can take it further and say that reducing our equity premium to be equal to that in the US would raise GNP by around 12 per cent. Pushing the linear extrapolation further (further than it will go, but a reasonable first approximation), eliminating the equity premium altogether would raise GNP by around 60 per cent. I’ve done calculations in the past with very similar results, so I have no problem with any of this.

The difficulty is in the assumption that capital market liberalisation will reduce the equity premium and will have no offsetting adverse effects. The proposed changes are tiny by comparison with the floating of the dollar and the associated removal of exchange controls over the 1970s and 1980s, not to mention the associated domestic liberalisation. Yet there is no convincing evidence that these changes had any net effect on the risk premium for equity. Australian regulators who have to use a risk premium in estimating the cost of capital have looked at this issue repeatedly, and none has yet been willing to base decisions on the assumption that the risk premium for equity has declined recently, relative to the 20th century as a whole.

Then there’s the question of offsetting effects. The most important changes relax restrictions on takeovers. The analysis here is based on the assumption that such restrictions are necessarily harmful. Yet there’s ample evidence at every level to contradict this[1]. The takeover boom in Australia in the 1980s, led by the entrepreneurs was cheered at the time by economic commentators using precisely the reasoning of the CIE. It’s clear in retrospect, though, that the entrepreneurs, and the “white knights” who opposed them, dissipated vast quantities of capital in the 1980s. In fact, the mid-1990s increase in multifactor productivity was due, in part, to the unwinding of the bad investment decisions made in the 80s.

Finally, there’s a question about process here. Comparing this report with the estimates made by the CIE in 2001 before the FTA was negotiated, it’s apparent that the trade gains have declined significantly, as would be expected given the unfavorable nature of the agreement. The response has been to add in hypothetical benefits so great that the aggregate estimated benefit is actually higher than before. Meanwhile, obviously negative aspects of the agreement, such as the extension of copyright and the changes to the PBS have been put in the “too-hard” basket. The fact that the observable choices have consistently favored the FTA supports the view that, in more technical areas like the choice of elasticities, there has probably been a similar tendency to make favorable rather than unfavorable assumptions. Thus, the dubious analysis of capital market liberalisation casts doubt on the analysis as a whole.

fn1. It’s true, as Harry Clarke pointed out a while ago, that the strongest finding is that takeovers are bad for shareholders in the acquiring firm. This implies that we ought to be willing to sell our own assets while discouraging overseas acquisitions by Australian companies. While I can see the logic in this, I’m not willing to push this argument to its logical conclusion.
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Demolish Abu Ghraib

John Quiggin16 Comments

It is hard to overestimate the damage that has been done, not only to the US occupation of Iraq but to the cause of democracy and civilisation as a whole by the exposure of torture and sexual humilation of Iraqi prisoners in Abu Ghraib prison, formerly used for the same purposes, though of course on a much more brutal and extensive scale by Saddam Hussein[1]. If these pictures had been staged by the Al Qaeda propaganda department they could scarcely have been better selected to inflame Arab and Muslim opinion against the West, combining as they do the standard images of torture with scenes specially designed to show the determination of the West to humiliate Muslim men in every way possible.

It goes without saying that those directly involved, or who knew what was going on and failed to act, should be prosecuted and punished to the full extent of the law. In addition, those in the chain of command whose lapses contributed to the commission of these crimes should be dismissed out of hand. It seems clear that this latter class must include nearly involved in organising the policy of detention without trial, and particularly those involved in the interrogation of prisoners – scenes like these could not occur if the general practices of the prison were not already violent and degrading. But these steps, necessary as they are, will do little more than to prevent the further aggravation of the damage that would be done if these crimes were seen to be condoned in any way.

Only a response on a dramatic scale has any hope of significantly reducing the damage. My suggestion[2] is that the Administration should immediately evacuate and demolish this awful place, and should announce that, before June 30, all those detained by the CPA will either be released or charged with a criminal offence, and, further, that anyone detained after that date will be brought before an Iraqi court. It might be useful to propose a memorial for those who died there and in similar places, though the design and construction should be left to an Iraqi governent.

Of course, this will mean releasing many people who are either insurgents themselves or have given aid and comfort to the insurgents. And, of course, the Iraqi court system is far from satisfactory. But the policy of detention has created far more insurgents than it has captured, as have the raids and searches associated with it. And if Iraqi judges are good enough to produce an arrest warrant for Muqtada al-Sadr, they’re good enough to deal with ordinary Iraqis caught up in military raids,

fn1. I say “of course”, but even the most charitably disposed commentators in the Arab/Muslim world are unlikely to concede so much. The most favorable view that Arabs and other Muslims are likely to hear is that the Americans are no different from Saddam, neither better nor worse.

fn2. Not mine alone, I’m happy to say. As pointed out in the comments thread at CT, Scorpio at Eccentricity made the same suggestion, a couple of days before me. Let’s hope this idea has also occurred to someone with the will and capacity to implement it.

Manifestations

John Quiggin7 Comments

I’ve got quite a few events coming up, including a couple of possible TV appearances. The first will be on the SBS Insight program (a revival of the old Monday Conference format for those who remember it), which is on the topic of tax and public spending. It’s on Tuesday at 7:30 (here are some details).

I’m also doing an interview with Inside Business on Public-Private Partnerships, but I’m not sure if or when this will go to air. Finally, the Senate Committee of Inquiry into the FTA is running a roundtable on Wednesday, which I’ll be attending along with quite a few other participants in the debate.

Mayday

John Quiggin9 Comments

It’s already 1 May in Australia, so I get to make what will no doubt be (among) the first of many posts on the significance of the day.

First, and still the most important in the long historical view is the holiday (a public holiday here in Queensland) celebrating the achievements of the labour movement.

Second, there’s the admission of ten new members to the EU. As far as the historical significance of this event goes, I’m waiting to see whether Turkey is admitted to accession negotiations later in the year.

Thirdly, and of most immediate interest, the anniversary of Bush declaration of victory looks as good a time as any to date what seems increasingly certain to be a defeat [at least for the policies that have been pursued for the last year] . Of course, this judgement may turn out to be as premature as was Bush’s statement a year ago, but the decline in the US position has been almost as rapid as the collapse of Saddam’s regime, and the events of the last few days have seen the process accelerating.
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Science vs the right: Part 2 (Australia)

John Quiggin86 Comments

Update 30/4As this one still seems to be alive, having veered from the Murray to libertarianism to the appropriate mode of address for yours truly, I thought I’d move it back up to the top of the page

The most important representative of party-line science in Australia is the Institute of Public Affairs[1], which models its approach closely on that of rightwing thinktanks in the US[2]. It has promoted critics of scientific research on passive smoking , funded by the tobacco industry, (for an IPA defence of this practice, read here), critics of scientific research on global warming (funded by the fossil fuel industry), and has more generally bagged scientists and research organisations whose research produces commercially inconvenient findings. Targets have included the World Health Organization, the National Health and Medical Research Council and of course, the International Panel on Climate Change, as well as many individual scientists.

The mode is identical to that of Milloy and Tech Central Station. Where the general scientific basis is strong (as in arguments about the safety of GM foods) opponents are assailed as anti-scientific irrationalists. Where it is weak (as in the cases of smoking and global warming) the IPA demands equal time for sceptics, even sceptics who have done no original research and have no relevant qualifications. The strategy is one of selective citation of evidence that supports a predetermined outcome, mixed with protestations of support for open inquiry and the scientific method. As far as I know, the IPA has never found a case where the evidence supports more environmental regulation, or even a continuation of existing regulations.

The latest target of the IPA, and one close to home for me[3], is the sustainable management of the Murray-Darling Basin.
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Googling the capital markets

John Quiggin8 Comments

The Google IPO has now been announced, and there are some more figures to analyze. In addition, I wanted to talk a bit about the option, suggested by one of the commenters on Kevin Drum’s blog of arbitraging by short-selling overpriced dotcoms and buying those with more reasonable valuations.

Looking at this NYT report, that doesn’t seem likely to be an option.

In 2003, Google reported an operating profit of $340 million on sales of $960 million. But the 2003 figure appears to understate the company’s cash profit margin, since it includes very high expenses related to stock options that will probably decline in future years. On a cash basis, Google had an operating profit of $570 million in 2003, and an operating margin of 62 percent.

Given those figures, Google will easily command a market valuation of at least $30 billion, and perhaps much more. EBay, which had an operating profit of $660 million on sales of $2.2 billion last year, is valued at $54 billion; Yahoo, with sales of $1.6 billion and operating cash flow $428 million, is valued at $36 billion.

I’m not an accountant, but I think the “operating profit” referred to here is EBITDA (earnings before interest, tax, depreciation and amortisation): in any case, it’s more than the profit accruing to owners of equity. So it appears that all of these well-established businesses are valued at more than 100 times annual earnings.

As I recall, the ratio for profitable companies during the hyperbubble was around 400, so some progress has been made. But these values still look bubbly to me. To match an investment in 10-year bonds, without allowing for any risk premium or for the inevitable increase in long-term interest rates, all these companies need to more than quadruple their earnings, then maintain those earnings for at least 20 years. Maybe Google can do this, and maybe Yahoo can do it, but it’s most unlikely that both of them can.

At one time, I would have tried hard to think of an explanation consistent with some notion of aggregate market rationality, in which capital markets allocate capital to its most productive us. In the light of the evidence of the last ten years – the dotcom bubble, the US dollar bubble, the (still continuing) bond bubble – I no longer bother. Capital markets are driven by fashion (in this case, the continuing desire to be part of the Internet happening, in the face of mounting evidence that it provides almost exclusively public goods), fear and greed. On average, capital markets do a better job than Soviet central planners, but I think they do less well than the mixed economy that was dominant during the postwar Golden Age.

Eventually, no doubt, reality will prevail. If I knew that was going to happen within the next twelve months, I’d be shorting the remnants of the dotcom sector for all I was worth. But, as Keynes apparently didn’t say, the market can stay irrational longer than you can stay solvent.

The FTA

John Quiggin9 Comments

I’ll be participating in a Senate Roundtable on the proposed FTA with the United States next week, and things have been livened up with the release of a new study from the Centre for International Economics with the following optimistic bottom line

The most probable effect on macroeconomic welfare after a decade, as represented by real gross national product (GNP), is an increase of $5.6 billion per year above what it might otherwise be.

Not surprisingly I think this is estimate is way of the mark (warning: big JPEG coming up).
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Brooks makes sense

John Quiggin2 Comments

Like nearly everyone else, I’ve been deeply disappointed by David Brooks’ Op-ed columns in the NYT. But it’s not only out of a sense of fairness that I’m giving a favorable link to his latest – it’s not only good relative to the other stuff he’s written but better than most other commentary[1]. Referring to the debates over the Clarke and Woodward books, occurring at a time when Iraq looks like sliding into chaos, he says

This is like pausing during the second day of Gettysburg to debate the wisdom of the Missouri Compromise.

Right though this is, it’s obviously helpful to the Republicans, as is the observation that

many Americans have decided that it’s time to persevere and win.

But his final para raises the real issue

Over the next weeks, U.S. forces are going to jump from the fires of unilateralism to the frying pan of multilateralism. What’s going to happen when our generals want to take on some insurgents but Brahimi and the sovereign Iraqi appointees say no?   

Brooks might want to ponder the point that the Bush Administration appears to have no answer to the question he has posed here. They have set up rules that let them ignore the supposedly sovereign government they plan to establish, but it’s obvious that any such action will bring the whole structure crashing around their ears.

fn1. Obligatory blogplugging: That’s old-media commentary, of course. This whole post is a subtle reminder that blogs, including this one, have already moved on from point-scoring and asked the questions that are now being raised by Brooks.

50 per cent

John Quiggin4 Comments

One of the most pleasant aspect of being a Research Fellow is guest lectures. I give guest lectures in a number of different courses, ranging over several faculties and sometimes different universities. This gives me all the things I like about teaching, including (since a change is as good as a holiday) generally attentive audiences, and a chance to present material that’s not the standard textbook, but not new or rigorous enough to justify an academic seminar. On the other hand, all the unpleasant stuff – booking rooms, litigious students complaining about their grades, administrators trying to promote customer-centric shareholder value in a dynamic enterprising university, and so on – is taken care of for me.

I tend to do most of my guest lectures around mid-semester, since this is what fits the standard course structure best, and I’ve got quite a heavy load (by my very relaxed standards) this week. I’m just between lectures, then rushing off to a seminar in town[1], but I thought I’d pass on the reaction to my lecture today on the economics higher education.

I started with the human capital and screening theories. I’m a violent partisan of human capital theory and opponent of screening theory, and didn’t try to hide this, but my success rate in convincing the students was, based on a small sample, only 50 per cent.

One student came up to me at the end and said “Thank you. I learned a lot”. Another came up to the lecturer responsible for the course and asked “Will this be on the exam?”.

fn1. For those interested, it’s The US-Australia free trade agreement: folly or our future? at a meeting of the Australian Institute for International Relations from 6-7.30pm, April 28 at 46 George Street, Brisbane. For details, contact Colin Kennard (telephone 3371 2454, email c.kennard@uq.edu.au).

An interesting nondenial

John Quiggin14 Comments

From ABC News (slightly rearranged for readability)

Prime Minister John Howard’s office has denied allegations that he took instructions from broadcaster Alan Jones to reappoint Professor David Flint as head of the Australian Broadcasting Authority (ABA). ..Rival broadcaster John Laws has aired an allegation that Mr Jones told him he had pressured the Prime Minister to have Professor Flint reappointed. John Laws said on Southern Cross radio in Sydney this morning that he was at a dinner party with Mr Jones and others on November 28, 2000, when Mr Jones warned him not to criticise Professor Flint…. “Alan Jones then went on to say in fact, ‘I was so determined to have David Flint reelected that I personally went to Kirribilli House and instructed John Howard to reappoint David Flint or he would not have the support of Alan Jones in the forthcoming election’,”

“The Prime Minister does not take instructions from anybody in the media about appointments or indeed anyone else in the discharge of his responsibilities as Prime Minister,”

the spokeswoman said.

He has no knowledge of any conversation that may have taken place between Mr Laws and Mr Jones at a dinner party.”

Now suppose that (most improbably) a videotape turns up showing Alan Jones telling Howard that he should reappoint Flint or lose his (Jones’) support. Howard could perfectly plausibly say that he doesn’t take orders (instructions) from Jones, and that he was going to reappoint Flint anyway. And of course, there’s no reason to suppose that Howard has any knowledge of what Jones said to Laws. No-one ever suggested he did.

Update 29/4 It didn’t take long for the nondenial quoted above to be subject to the same kind of close reading I offered – people are used to the need for this kind of thing now. After a pointless round of “not to my recollection” and “I don’t recall”, Howard has finally produced a clear denial.

I specifically deny any conversation remotely resembling what has been alleged,” Mr Howard said.

“If somebody approached me, somebody from the media with a threat that they would withdraw support from me if I didn’t do such and such I would to use the Australian vernacular tell them to get lost.”

The only problem is that Laws has witnesses who recall Jones’ statement to him. Of course, it’s entirely possible that Jones lied to Laws when he claimed to have spoken to Howard. Equally, it’s possible that Jones and Howard are both lying now. In the light of his thirty years in political life, are there any readers who have sufficient faith in Mr Howard’s word that they are willing to dismiss out of hand a second-hand report from a dinner party three years ago?