Thursday, October 30, 2008

Treasury on emissions trading & the Australian economy

The Australian Treasury document Australia's Low Pollution Future is a major study of the economics of greenhouse gas emission control for Australia.  It deserves a careful reading. In the main it argues that Australia gains some 'first mover advantages' from dealing promptly with climate change on the assumption that all countries will eventually control their emissions. Thus it is optimistic about the implications of carbon leakages.

Most emphatically it endorses the use of markets to help sort out the race to secure non-polluting new energy technologies.

I approve of the Labor Party's move to proceed with an emissions trading scheme in 2010 and oppose the Coalition move to delay introduction of the ETS on the grounds of the current financial crisis.  The costs of early action in controlling greenhouse gas emissions will be low if markets come to anticipate eventual cooperative global controls.   The Treasury paper shows that the costs will be relatively minor and that there are positives in acting early.

Bud Petal

This is experimental folk music with some class. Good lyrics, listen! Interesting stuff. I also liked this view of the talking chimp.
Thanks Bernd

Wednesday, October 29, 2008

Rudd's politics

PM Rudd loves the dramatic gesture that has symbolic effect - 'apologising' to aboriginals for the claimed sins of our ancestors, ratifying the soon to be irrelevant Kyoto and, last weekend, posing for that inspiring snap of himself - shirt sleeves rolled up - 'getting down to work' with Ken Henry.  A man of action!

Unfortunately since his strength is pretence his policy making powers are unlikely to be strong. That Rudd is a pretender is widely recognised so that Rudd himself is now taking steps to be seen as a 'man of action' not words.  It is however far better for Rudd to be symbolic and inactive* however since we have to live with the consequences of his daft actions.

Rudd's worst policy since taking office is to weaken the incentives for individuals to take out private health insurance - it is estimated 492,000 will cease to privately insure. This policy reduces the availability of health resources in the community including access by the poor to such services.

But pretenders face real difficulties in times of crisis when cool heads not dramatic flourishes are called for.  The single major policy action Rudd has taken in relation to the current financial crisis has proved to be a hasty ill-considered disaster.  The Wall Street Journal gets it right:
World leaders scrambling to rethink financial regulation might pause to consider Australia, where a poorly conceived policy has gone from beggar-thy-neighbor to beggar-thyself in two weeks flat.
On October 12, Prime Minister Kevin Rudd announced that government - read: taxpayers - would fully insure 1.2 trillion Australian dollars ($741 billion) in deposits held at eligible financial institutions such as local banks. The move was meant to cut the risk of capital flight to other countries that had adopted or expanded such guarantees in preceding days.
Mr. Rudd's move had an effect, but not the one he intended. Depositors big and small immediately moved funds from uninsured to insured savings vehicles. Branches of foreign banks and mortgage unit trusts - a breed of mutual fund that invests in prime mortgages - were particularly hard hit. Some managers of uninsured investment funds have frozen withdrawals temporarily to stanch the outflow, a blow to retail investors who suddenly find they can't access their principal.
The Rudd government backtracked on Friday, capping the deposit guarantee at A$1 million and including foreign banks with branches in Australia in the program. It's an embarrassing reversal for Mr. Rudd and might have been prevented with a little forethought. While the opposition Liberals had proposed an A$100,000 cap when the idea for deposit insurance first surfaced this month, Mr. Rudd unveiled his proposal with no advance warning and no formal debate.

Perhaps Mr. Rudd felt global events warranted swift action. But now, having insured in haste, Canberra is forced to repent at leisure. At least Mr. Rudd is providing his peers around the world a valuable lesson: A financial panic doesn't suspend the law of unintended consequences.
Moreover, the prior evidence from the move by Ireland to unconditionally guaranteed bank deposits was widely recognised to have the types of adverse incentive effects that the Rudd scheme has had. European governments were furious with Ireland since funds drained from their banks to those deposits with protected status in Ireland.

Australians elected Rudd on the basis of a bland mee-tooism to replace the most effective Federal government Australia has had in decades. As a nation we will pay a price for this foolish adventurism. My confident preduiction is for more dramatic flourishes and more ill-conceived policies.

* I take the same view with respect to many (not all) university bureaucrats with their elaborate destructive schemes to improve scholarship and teaching in universities - matters they typically have limited expertise with.  If universities are unwilling to scrap these positions put those concerned on permanent holiday status. They will do less damage.

Tuesday, October 28, 2008

What's happening?

Guest post by Professor Rabee Tourky, University of Queensland

These are interesting times for economists. I hardly know a serious economist whose attention in the past weeks has not been fixed on the changes in asset prices.

An emerging narrative is that for some years we have seen a bubble in US house prices, asset prices did not reflect the inevitability of this bubble bursting, this was made worse by the behaviour of brokers and bankers who through short-term thinking compounded the belief in the notion that there are never-ending arbitrage opportunities in the market, and that there was a failure in the market for credit default insurance and the prices of credit default swaps. All of this was exasperated by the behaviour of ratings agencies.

This emerging narrative with its various derivatives needs some tweaking before it becomes entirely convincing.

One variant of this narrative adds that all agents behaved rationally in this process, and another distinguishes itself by the thinking that bankers and agency analysts behaved rationally by duping, as it were, non-expert investors (Joe six pack house buyer). I think that it is reasonable to dismiss this second addendum to the narrative and to suppose that we are all adults.

A foundational conclusion in economics is that prices are the (exclusive) transmitters of information regarding relative scarcities. They are formed by equating demand and supply, which are influenced by peoples tastes and in the case of assets their beliefs about future events. There has been very little work about what we mean in an exact sense by prices transmitting information. This is particularly the case when models involve uncertainty. One can  fathom from thoughtful models of price formation under uncertainty that prices of assets reflect beliefs regarding future value.

Prices of derivatives therefore reflect beliefs about beliefs and this hierarchy of beliefs is consistent at equilibrium in an information theoretic sense as well as in a way that avoids the presence of arbitrage opportunities. Mind you I'm not aware of a theoretic work that addresses hierarchies of information involving prices.

Now it is rather difficult for me to imagine a convincing economic model whose conclusion is that assets prices do not reflect and aggregate beliefs regarding future prices and which at the same time does not involve arbitrage opportunities. Of course, there are no arbitrage opportunities in a competitive market. This brings us to the idea that there was an assets bubble in the US assets market.

So what is an assets bubble? Well that's not clear though there is a limited number of theoretical and experimental work on this topic. It appears that an assets bubble has the following characteristics:

1) A rapid increase in the price of an asset.
2) A catastrophic fall in the price of the asset.
3) Analysis showing that either:

The information available at the time of the price increase did not justify the increase in price.

There was some kind of fraud in terms of misrepresentation of the nature of the asset by people who could profit from the formation of the bubble.
There are of course assets bubbles involving fraud and misrepresentation, pyramid schemes come to mind. However, I have not seen models that convince me of the possibility of assets bubbles in which the available information is not reflected in prices. Prices can't tell you the future but they reflect a good guess at the time, and they can be wrong ex post simply because agents were not aware of future possibilities or that their best guess did not realize. Nevertheless, in such cases prices do reflect information available at the time that they are formed. The main thrust of arguments involving the possibility of endogenous bubbles not involving fraud is that the market does not work as expected. Well there is a desperate gap between such claims and the scientific models that we have at present.

So in regard to the assets price increases that we saw in the US, and which eventually collapsed, a main non-economic question to my mind is a legal one. Is there evidence of fraud? In the absence of serious fraud my own narrative regarding what is happing is somewhat different from the emerging narrative.

I do think that there was a market failure in the sense of market incompleteness. In a complete market one can ensure themselves against any economic risk. However, there are occasions in which certain markets are missing. I'll give two very extreme examples. Can one insure herself, using available assets, against the possibility of a world wide medical epidemic of unknown type? Can one insure themselves in regard to the collapse of government and its guarantee of private property?

Similarly, it seems that there was no available means to ensure against the collapse of the entire financial system. Credit default swaps provide a measure of insurance in regard to the default by a single (or multiple) agent(s) but cannot be used for the purpose of ensuring against endemic default.

In short, what we are seeing is the effects of the incompleteness of the kind of instruments available to the market and not the result of too many complicated assets. Derivatives are not weapons of mass destruction on the contrary the price changes are due in large to the incompleteness of the derivatives market.

In this narrative there is some sort of market failure but the nature of this failure probably means that governments and central banks should engage the market in ways that are different from the approach they would take should the emerging narrative prevail.

In the emerging narrative governments ought to reduce the kinds of financial instruments available in the market.

In the narrative I outline above the idea is for governments to intervene to help complete the market - one extreme idea is to provide its own derivatives that can help ensure against the kind of systemic collapses that we have seen. In the second narrative governments should disengage from the markets in all ways except for making explicit the kind of insurance it provides that guarantees the ongoing operation of the financial system. They should encourage financial innovation and even participate in that process.

Monday, October 27, 2008


An interesting story that I have known about for years - but which has only just resurfaced - oxycodone is replacing heroin as the drug of choice among former heroin users. It has most recently resurfaced at Sydney's "Safe Injection Room" AKA the Labor Party shrine to Stupid Public Policy. Oxycodone is a opioid pain killer legally produced and provided on a subsidised basis under the PBS. Some doctors prescribe it without a great deal of care. The community gets left with the bill for this dangerous addictive drug that, when properly used, is an effective analgesic but which can provide a longer, cheaper fix for dope fiends than heroin.

It is preposterous that the public have to pick up the massive bill for abuse of this drug. Doctors who dispense this drug carelessly should not be practising medicine - indeed they should be charged with supplying opiates illegally, the SIR should be shut down and those addicted to the drug should be legally forced to detoxify. It isn't difficult - detoxify with assistance or go to jail. Once detoxification is achieved all ex users should be subject to random drug tests to confirm their abstention with a 'do not pass go' implication.

I have made several attempts to understand the implications of the heroin drought and its seeming success at permanently weaning addicts of heroin. One possible explanation is the rise in the use of substitute prescription pain-killers. I have searched the literature quite a bit but comprehensive data and analysis seems unavailable. The evidence is overwhelming that use of such drugs is skyrocketing but the extent to which this is displacing heroin is unclear.

BTW these trends are occurring around the world.

The interesting economic story is that pharmos large pharmaceutical firms have moved into an illicit drug market and now supply legal close substitutes for heroin. The perfect product since people rapidly become addicted and the government foots the bills paid to these pharmos large firms for the life of the addict. Isn't capitalism marvellous?

People have suggested that the switch away from heroin involved a move toward addictive stimulants such as cocaine and amphetamine. This seems implausible to me as levels of usage of such drugs have not increased enough to suggest this is plausible. But the role of prescription analgesics has not been properly examined. It should be.

Western European banks exposed to 'emerging markets' bubble

Will Europe initiate a new wave of problems from the financial crisis? The focus is on the collapsing bubbles in emerging markets (and here) and their implications for what are mainly European lenders. London stocks crashed 5% again this morning as new dimensions of the current crisis became apparent.

This story, HT to commenter observa, is frightening.
"The financial crisis spreading like wildfire across the former Soviet bloc threatens to set off a second and more dangerous banking crisis in Western Europe, tipping the whole Continent into a fully-fledged economic slump.

Currency pegs are being tested to destruction on the fringes of Europe’s monetary union in a traumatic upheaval that recalls the collapse of the Exchange Rate Mechanism in 1992.

“This is the biggest currency crisis the world has ever seen,” said Neil Mellor, a strategist at Bank of New York Mellon.

Experts fear the mayhem may soon trigger a chain reaction within the eurozone itself. The risk is a surge in capital flight from Austria – the country, as it happens, that set off the global banking collapse of May 1931 when Credit-Anstalt went down – and from a string of Club Med countries that rely on foreign funding to cover huge current account deficits.

The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect.

They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles.

Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn.

Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash is a vastly underestimated risk. It threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America.

Austria’s bank exposure to emerging markets is equal to 85% of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the IMF.

Exposure is 50% of GDP for Switzerland, 25% for Sweden, 24% for the UK, and 23% for Spain. The US figure is just 4%. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns.

The IMF’s experts drafted a report two years ago – Asia 1996 and Eastern Europe 2006 – Déjà vu all over again? – warning that the region exhibited the most dangerous excesses in the world.

Inexplicably, the text was never published, though underground copies circulated. Little was done to cool credit growth, or to halt the fatal reliance on foreign capital. Last week, the silent authors had their moment of vindication as Eastern Europe went haywire.

Hungary stunned the markets by raising rates 3% to 11.5% in a last-ditch attempt to defend the forint’s currency peg in the ERM.

It is just blood in the water for hedge funds sharks, eyeing a long line of currency kills. “The economy is not strong enough to take it, so you know it is unsustainable,” said Simon Derrick, currency strategist at the Bank of New York Mellon.

Romania raised its overnight lending to 900pc to stem capital flight, recalling the near-crazed gestures by Scandinavia’s central banks in the final days of the 1992 ERM crisis – political moves that turned the Nordic banking crisis into a disaster.

Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik.

The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

Traders are paying close attention as contagion moves from the periphery of the eurozone into the core. They are tracking the yield spreads between Italian and German 10-year bonds, the stress barometer of monetary union.

The spreads reached a post-EMU high of 93 last week. Nobody knows where the snapping point is, but anything above 100 would be viewed as a red alarm. The market took careful note on Friday that Portugal’s biggest banks, Millenium, BPI, and Banco Espirito Santo are preparing to take up the state’s emergency credit guarantees.

Hans Redeker, currency chief at BNP Paribas, says there is an imminent danger that East Europe’s currency pegs will be smashed unless the EU authorities wake up to the full gravity of the threat, and that in turn will trigger a dangerous crisis for EMU itself.

“The system is paralysed, and it is starting to look like Black Wednesday in 1992. I’m afraid this is going to have a very deflationary effect on the economy of Western Europe. It is almost guaranteed that euroland money supply is about to implode,” he said.

A grain of comfort for British readers: UK banks have almost no exposure to the ex-Communist bloc, except in Poland – one of the less vulnerable states.

The threat to Britain lies in emerging Asia, where banks have lent $329bn, almost as much as the Americans and Japanese combined. Whether you realise it or not, your pension fund is sunk in Vietnamese bonds and loans to Indian steel magnates. Didn’t they tell you?" (my bold).
And, it is partly this anticipated crisis that is keeping the US dollar so strong. These events are also impacting on Australia with the value of the Aussie dollar setting at cl;ose to 60 cents today:
Over the past two weeks, the financial crisis has started to cascade through the emerging world. Iceland, Hungary, Ukraine and Pakistan have all sought emergency packages from the IMF.

A long list of other developing nations is at risk, including Argentina, the Baltic states, Bulgaria, Romania, Croatia, Serbia, Turkey, South Africa, Indonesia and South Korea. They have in common their current account deficits, which are becoming increasingly hard to finance.

Currency markets have been the most visible marker of the loss of confidence. Over the past week, the currencies of Brazil and Mexico have fallen because of concern about commodity prices.

The US dollar and the Japanese yen are seen as the two safe-haven currencies.

The euro is seen to be particularly vulnerable as fears that Eastern European nations will default on their foreign debts strike Europe's banks.

The Australian dollar has been one of the weakest of the major traded currencies, dropping even further against the US dollar than the New Zealand dollar.

The Reserve Bank believes it is being used as a proxy for taking short positions in the commodity market, but its fall also reflects the unwinding of investments by Japanese households and generally negative sentiment about the current account.

Australia has long been fortunate that its currency market is sufficiently deep and sophisticated for Australian banks and businesses to be able to swap their foreign currency debts into domestic currency.

There has always been strong global demand for Australian dollar exposure. The result is that the devaluation of the Australian dollar has not, of itself, caused a balance of payments crisis by pushing up the Australian dollar value of the foreign debt.

However, it is cold comfort to know that it has been foreign investors in our currency rather than local banks that have been burned. With the gross value of the foreign debt standing at around $1 trillion, the fall in the currency from its peak of US98.5c to its current US67.5c has inflicted paper losses in the region of $300 billion on supporters of our currency.

The pool of investors interested in financing an expanding current account deficit is likely to have diminished as a result of these losses. (my bold).
Much more yet to unravel.

Sunday, October 26, 2008

Billy Connelly on ING?

Misdirected enthusiasm?
Thanks Bernd

Sell your house?

I noticed in today's press that a large number of fairly expensive houses being put up for auction in my suburb yesterday and that all were passed in.  The story was much the same across Melbourne. A plausible guess is that either those with big mortgages are trying to 'sell up' in anticipation of a possible housing price collapse or that 'smarties' are just trying to lock in tax free capital gains with thoughts of buying back more cheaply in a year or so time.

Several people have asked me what to do about the imminent recession and I have hedged the issue.  I am not a qualified financial advisor and like most economists I do not know how the current crisis will pan out medium term.  I do think that a recession in Australia is inevitable but the severity of this is unclear. Moreover, I agree with Gregory Mankiw that we cannot rule out a really severe recession - the D word is not redundant yet, although it seems unlikely given enhanced macroeconomic management prowess.  The escape clause that it 'might' happen reflects ignorance of the current situation.  Policy makers are guessing.

Most of the standard advice that I hear dispensed is that those with a lot of debt should lighten up a bit lest asset prices take a sharp further plunge leaving borrowers with hefty debts assets of diminished value. That sounds very plausible but, to be clear, this advice is:

(a) Possibly incorrect - with lower interest rates residential real estate may be more resiliant than we expect.
But this seems unlikely. There was pressure on house prices prior to the current financial crisis.  There will be quite a few fixed interest mortgages held during a period where prices seem likely to slide a lot.
(b) Probably too late given that, as observed, the wealthy are already trying to 'sell up' without success. It will become increasing difficult to abandon the sinking ship.
(c) Socially disfunctional though individually rational given that it worsens the downwards pressure on prices of such things as real estate.

Meanwhile here is a cheery, optimistic very American guide to riding out the slowdown.  Opportunities abound according to Business Week even though on balance you might lose your shirt. As a people Americans as a people are too optimistic - they need to understand that intent and resolve are not everything. Optimism is a bias.

Saturday, October 25, 2008

More on the economic crisis

I have been heavily involved in other things and too busy to make a comprehensive update on the crisis. My last long post on it took a lot of time to write - I presented some of the material at a La Trobe University seminar organised by the SRC and the radical group Socialist Alternative.

But a few stand out references on the crisis are beginning to appear.  The Economist last week  had excellent discussions. Their leader - Capitalism at bay -  makes many points I made in the long post.  The extent to which government becomes more important in the future depends on how the blame for the current crisis is attributed.  Even with respect to financial reregulation The Economist points out that severe financial crises occurred recently in highly regulated systems of Korea and Japan. 'What's needed is not more government but better government'. 

The Economist has organised a fascinating online discussion between Joseph Stiglitz (favouring increased financial regulation) and Myron Scholes (not favouring it).  An excellent debate which Stiglitz wins but where Scholes is by no means disgraced.  Both agree on the need for strengthened capital requirements but disagree about the value of 'financial innovations' and the need to manage them.  Really good!

The Economist reports on impacts in Asia that should concern Australia.   They mention former Malaysian PM Mahathir Mohamad's blog and it is worth looking at. Referring to the Asian Crisis and current events:

'When as a result of the so-called trade in currencies the companies in the poor countries faced bankruptcy, the Governments were told not to bail out any company or bank which was in deep trouble. The Americans claimed that these companies or banks were inefficient and they should be allowed to go bankrupt and perish. Better still they should be sold at fire-sale price to American investors.

....Yet today we see the US Government readying US700 billion to brazenly bail out banks, mortgage companies and insurance companies'. (Outch!).

They also discuss China at length which is a topic of key interest to Australia which has also taken a dig at US hypocrisy.  I liked this paper from the Wall Street Journal (HT Rabee) which argued that the 8% growth forecasts the world is relying on to restore our fortunes depend on the Chinese property market not collapsing.   Chinese investments in housing are about 10% of the economy and there are evident weaknesses in this market despite the fact that 15-20 million Chinese head off to live in cities every year.  Buyers are spooked by a weakening economy and weakening prices.  Reduced demands for construction will bite into demands for deal and, of course, iron ore exports from countries such as Australia. SteelGuru (again, HT Rabee)  observes that dramatic reductions in Chinese steel demand are already occurring.  It is interesting stuff and much more substantive than Kevin Rudd's assurances that China will save Australia's bacon. The Economist makes its own observations with particular reference to Australia - prices of various types of steel have fallen 20-70% and iron ore stockpiles are claimed to be accumulating in China.

The financial turmoil seen in recent weeks are starting to have the real effects that lead industries to cut back on investment plands and jobs.  The extent to which this will now happen is the substantive global economic issue.  The Economist coverage of such issues this week is absolutely outstanding.

Monday, October 20, 2008

The end of free market fundamentalism not of the mixed economy

Capitalism these days does not resemble the 'free markets' model of it that is often conceptualised by its critics on the left. All economies have substantial public sectors - in Australia, for example, government absorbs about 1/3 of output produced. Therefore it is best to refer to 'mixed economies' which have dominant private sectors but large public sectors which provide public goods, redistribute incomes, stabilise the macroeconomy and deliver a social safety net which protects those vulnerable to extreme events. Where the limit should be drawn on the boundary of public economic activity is an issue that lies at the centre of modern political debates but it is 'mixed economies' not laissez faire capitalism that provide the dominant global economic system.

In the sense of being 'mixed economies', capitalism has performed spectacularly well through history. It has raised many societies from desperate poverty to prosperity. Moreover, it has performed spectacularly well in increasing incomes around the world and in reducing poverty over the past few decades. For example, numbers living in extreme poverty around the world - those earning less than $1US per day - fell by between 1/2 to 1/3 of their 1970 levels by 2000. Developed countries have experienced what can only be described as an extended period of sustained economic expansion with Australia, for example, enjoying what is perhaps the longest period of sustained economic expansion in its history - a continuous, strong economic expansion for 17 years. Living standards have improved markedly, inflation has remained low and unemployment rates fell in 2007 to their lowest level in 34 years.

The tremendous success of capitalism is part of the source of its recent dramatic problems. With continuous prosperity those aspiring to accumulate wealth have responded to the current prosperity with what Adam Smith would have called an 'overwhelming conceit' - modern economists describe this as an enhanced 'optimism bias'. Citizens have leveraged up by borrowing incautiously to purchase housing and financial assets in the expectation that their values would steadily increase in line with the continuing prosperity. Caution and fear have been forgotten by many. Those with longer memories have sounded warnings about this new found 'irrational exuberance' but these warnings have typically been ignored.

The current financial crisis has ended the exuberance and raised perennial questions about the 'staying power' and adaptability of capitalism. The crisis has led to speculations about the extent to which there will be increased future government control of the economy and the type of regulatory reforms that are likely to occur. For a few (incredibly naive) individuals it has raised question about whether capitalism should be replaced by a socialist system where party bureaucrats direct what investments should be undertaken and what society should consume. For all sensible people the question is what are the lessons for regulating capitalism more effectively?

This Slate article (HT to Cato at Catallaxy) eloquently summarises my view on the implications of the financial crisis for the evolution of our economic management ideas. The crisis in my view offers little support to the enemies of capitalism but it does confirm that extreme libertarianism or 'free market fundamentalism' (FMF) has a limited role in thinking about how financial markets, at least, should operate. Market regulation has failed in certain areas but capitalism as a whole has not.

Putting the issue in these terms suggests that the changes we will observe as a consequence of the current crisis will mainly take the form of rethinking the way we regulate capitalism rather than having thoughts about an overall failure. Indeed, when the issue is posed thus, really nothing very new is actually being suggested. Almost none of my economics colleagues - or the economic researchers I know of internationally - would subscribe to FMF, at least in the sense that Slate understands it. Most practical economists regard libertarianism as an intellectual disability that exhibits itself in a way akin (although, in effect, opposite to) the ideological rants of doctrinaire socialists and naive revolutionary socialists with their crazed insistence that markets can never work so that governments must run everything. For most economists the 'mixed economy' comprising mainly markets but with significant government involvement and with social democratic values imposed to 'civilise capitalism' (but with a general preference for liberalising trade and a dislike of 'nanny state' paternalism) is the reality and provides the core reference economic/political model.

Most economists I know learnt their economics from a text such as Paul Samuelson's famous Economics. This text - and a generation of imitators which followed it - acknowledged the supreme value of markets in efficiently distributing resources but emphasised that markets often do not work well so they therefore need regulation. We know market failures arise with external environmental costs and with public goods (Adam Smith recognised this) that are best provided by regulated natural monopolies. We know generally that monopoly power itself should be controlled. Moreover Samuelson was a reader and interpreter of Keynesian economics so he saw the imperative for active macroeconomic management. As Samuelson's students, most of us take for granted the standard Keynesian view that the economy cannot be relied on to gravitate towards equilibria where all markets clear and resources are fully employed. While Keynes himself was focusing on economies which had high levels of unemployment the general point he made is that economies cannot reasonably be considered to be self regulating. Hence there is a need for regulation.

In the 1970s and the 1980s a small (though influential) group of economists and right-wing political figures began to blame the high levels of inflation and unemployment that then prevailed in developed economies on the theories of Keynes. The argument was that governments, by attempting to 'pump prime' economies when they experienced downturns, would inevitably create sustained inflation which would, in turn, become built into people's expectations thereby leading to the eventual need for restrictive monetary policies to demolish these damaging expectations. By doing this such policies would necessarily drive higher unemployment. High rates of inflation would come to be expected and taken for granted in setting lending rates and wages so that monetary expansions would not increase demand but simply raise inflationary expectations and simply defer the time that recession had inevitably to be experienced.

In my judgement this analysis is broadly correct but this is no argument for FMF. Instead it provides a case for maintaining moderate rates of monetary expansion, for targeting low inflation rates and for using monetary policy sparingly. Moreover, it has literally nothing to do with arguments for deregulating financial markets although this is an association often observed.

Since Samuelson wrote the early version of his famous textbook, economists have become more concerned with the role of uncertainty in markets and with the prospects for people taking actions in the face of this uncertainty that can produce market failures. Often these failures involve principal and agent problems. Here participants in markets acting as agents for others take advantage of private information to engineer good outcomes for themselves at the expense of society. Contrary to Gordon Gekko's famous dictum, greed in this setting is not good - it damages society. Self-interest does not drive the social advantage.

Considering recent events and concentrating primarily on the US economy we can discern these conflict-of-interest issues as key causal factors in the current crisis:

1. There have been severe 'principal and agent' problems in US mortgage markets. Partly this was due to the actions of brokers who provided mortgage loans to house buyers and who received a commission for doing so based on loans sold not loans that were successfully repaid. These brokers had individual incentives to provide loans to non-credit worthy borrowers because this maximised their advantage but left society exposed to huge systematic risks and bad debts.

This outcome was fed in part by comprehensive attempts in the US to increase home ownership levels through an attack on underwriting standards that began in the early 1990s. Academics and regulators applauded the decline in these standards as an 'innovation' in mortgage financing that would help to increase levels of home ownership among the poor and particularly among minority groups. The resulting disastrously high levels of foreclosures were partly a reflection of bad values and partly an issue of misplaced social romanticism.

In fact, high levels of mortgage foreclosures in the US started to occur in 2006 well before there was a dramatic decline in US property prices when the US economy was quite strong. However the surge in foreclosures that has occurred in 2008 - and which has occurred in prime as well as subprime markets - has dramatically increased pressure on property prices and worsened the financial crisis.

It is important to note that the financial crisis that has developed is not one primarily of bankruptcy and bad debts. The mortgage and credit card losses experienced in the US could have been paid for amounts already contributed by the US Government in bailouts. The key problem in current markets is fear that loans may be awarded to those with solvency issues. The problem is exacerbated by the fact that those most actively seeking loans are those with solvency concerns - this is adverse selection. Hence there has emerged a resulting freeze on lending that cripples business and households. This fear is an intangible that can best be met by restoring confidence through short-term public guarantees and through governments taking equity in financial institutions to make clear their market viability.

2. Rating agencies (for example Moodys, Standard and Poors) who have derived fees for providing accurate signals concerning the credit worthiness of various securities are subject to conflicts of interest because the issuers of securities pay these agencies to have their securities rated. This gave rise to what can only be described as rorts. These agencies nominally only provide 'advice' that can be accepted or rejected but this advice in fact often has quasi-official status with many institutions (including Australian local governments) only being allowed to invest in certain instruments if they do have a AAA ranking. Relying on these private firms to provide financial information in a setting where rating agencies face incentives to deceive and where they are bound by ideological biases, amounts to an inappropriate privatisation of regulation.

3. US Lending institutions (such as Fannie Mae and Freddie Mac) who issued mortgages to sub-prime borrowers did so with a degree of abandon because they believed that the value of their loans was subject to an implicit government guarantee - this is an instance of what economists call 'moral hazard'. Here lenders will exercise reduced care over lending deposits because the value of deposits is guaranteed. Indeed, the earlier Savings and Loan Crisis of the 1980s and 1990s resulted from a liberalisation of the capacity of S and L institutions to lend to a broader class of risky borrowers while at the same time deposits were being guaranteed by the US Federal Government. Politicians and regulators should have learnt more from this earlier disaster. The S and L crisis eventually cost the US taxpayer $160 billion while the current crisis -which involves the same type of moral hazard - will cost the US government up to $1.25 trillion! The failure to learn has brought about increasing costs!

Providing such things as 'deposit guarantees' looks like a sensible regulatory device to the person in the street. It is not however if it encourages the managers of such deposits to gamble wildly on the understanding that governments will come to the rescue should things not work out. It then can become a 'heads I win, tails I don't lose much' proposition - a fact that knee-jerk populists like Kevin Rudd do not understand when they guarantee the deposits of a subset of Australian financial institutions but do not consider broader ramifications.

4. There are particular problems associated with the complexity of recent innovative financial products that have proliferated in global capital markets. Warren Buffett has described derivative contracts as instruments of 'financial mass destruction' which seems an accurate description. While these instruments can potentially be used to reduce risk - their stated rationale - their value depends on the credit-worthiness of the counterparties to them. Those issuing these securities - particularly when they are very complex - also have incentives and the ability to make fanciful assumptions about their likely profitability and to thereby inappropriately boost their own apparent financial standing. These problems cannot be swept under the carpet. They call for regulation. Indeed, there is nothing particularly new about this claim. Issuers of totally unregulated credit market derivatives have been known to pose a threat to the international monetary system since 1997 when the super-leveraged hedge fund Long-Term Capital Management failed.

The difficulty here was not that the problem was not recognised but that no-one acted to do anything about it. A few economists with extreme libertarian views - Alan Greenspan is a standout - got into positions of extraordinary political and economic power and maintained that these derivatives were simply an effective way of reducing risk without considering circumstances where they might become worthless thereby destabilising financial markets. Simply put they ignored the obvious and cloaked their viewpoint with an FMF ideology that ignored the implied risks.

There are further examples but these illustrate the main argument. In all cases there are market failures that result from particular people having asymmetrical information advantages in the face of uncertainty. People take advantage of such information asymmetries and failures to improve their own self-interest and to the detriment of society. The problem here is not the 'greed' of these agents, as moralising politicians suggest, since greed has been an important driver of human affairs since the start of history. The failure to foresee and to address these problems is a regulatory failure not an intrinsic defect of capitalism or of people's greed-driven values.

There were five other macroeconomic events that fostered the current dire situation:

(i) High rates of savings in China and among the oil exporters which - despite local investment booms - could not be absorbed entirely locally in the economies that gave rise to them and which therefore spilt over into international capital markets driving down global interest rates;

(ii) The long-term overvaluation of the US dollar (or equivalently the undervaluation of the Chinese currency) that facilitated the high rates of Chinese savings and which led to the debt-financed consumption-led boom in the US and other countries that was partly financed by resulting excessive balance of trade surpluses;

(iii) Inappropriate monetary policy responses in the US and elsewhere to the glut in global loanable funds markets that kept interest rates too low for far too long;

(iv) A boom that became a bubble in global asset and particularly housing markets as a consequence of the low borrowing costs and the exuberant expectations that reflected a sustained period of economic prosperity;

(v) As already mentioned, the commitment to increase levels of home ownership in the US that encouraged unprecedented levels of low quality subprime mortgages but which provided ammunition that the excessively deregulated financial sector ignited.

In addition, developments in the international economy have changed the economic environment in other ways we are only starting to understand. Globalisation has been seen as a boon by economists because it so effectively increased world trading opportunities. This is undoubtedly true but globalisation does have a downside in fostering financial complexity and possible contagion of financial shocks from one economy to another. The interdependence it engenders induces vulnerability of the global economy to shocks in particular economies. Moreover, with globalisation, financial institutions tend to become 'large' anyway so that shocks that do occur are also large.

Finally, the changing bases of economic power in the global economy have shifted our preceptions of how it works. In my view some of the stresses that are being observed currently signal the beginning of the end of US and European dominance in economic affairs and a shift in power toward emerging countries such as China, India as well as countries in Eastern Europe, the Middle East and South America. That the US has had its excessively high consumption standards facilitated by excessive savings in emerging countries like China suggests that the imperial empire (the US) is borrowing to sustain a continued role that is increasingly non-viable given the march of history. The world will be a better place when countries such as China do develop into major economic powers with their own substantial scientific and artistic identities and the US should welcome not fear this. But the implications of such developments are only starting to be appreciated and understood. They imply the need for the US to rethink its role as a dominant economic power.

What are the implications of the current crisis for the future of capitalism? There is no possibility that the countries will adopt socialist administrations of the type currently residual in North Korea and Cuba despite the incoherent ramblings of radicals. Presumably those arguing for a socialist society on the basis of current problems have in mind a theoretical model of socialist perfection that will replace a capitalist system with its obvious defects. But this is committing the same logical fallacy that critics on the right make when they compare current imperfect economic systems with idealised models of laissez-faire capitalism. Both viewpoints compare the real with the hypothetical and both lack realism.

More realistically we now face the definite prospect of a more regulated financial system. No-one can plausibly deny that their have been regulatory failures and shortcomings even if some of the failed regulations were initially well-motivated. Moreover, it must be acknowledged that the increased complexity of operating in a global environment where there are a significant number of large players can increase the returns to more coercive and intrusive regulation.

Is permanent nationalisation of the banking system a likely longer-term prospect? Clearly the significant stakes that European and US governments will or have taken in the banks do indicate a drift toward socialism (on any reasonable definition) and there will be the likelihood of greater regulation of the direction of lending and such things as executive compensation. It is difficult however to determine how long such interventions will be sustained. In the case of the US and the UK there is the likelihood of eventual substantial divestments of publicly-purchased equity for budgetary as well as efficiency-based reasons.

Government controlled banks may remove some capitalistic excesses but will impose problems of their own because of incentive issues endemic to public ownership. Politicians typically face short-term political constraints that are inconsistent with economic logic and which can be both headline driven and overly conservative. If politicians rule over capital markets a new type of systematic inefficiency will plausibly develop that reflects, at core, the reason that most economists reject socialism. Looking at the current Australian scene, for example, it seems to me that disastrously inept and wasteful government investments in 'green car' technologies and 'Food Bowl' projects offer no encouragement that government run banks would outperform private enterprise in minimising wasteful social investments.

It is true that - even apart from the current problems - there is a general rethink of the role of government in economies such as the US. US wages have stagnated over recent decades while the concentration of income going to the highest income earners has grown strongly. Even conservatives such as Alan Greenspan have criticised this trend. But the US is an outlier in its respect for FMF that has justified increasing income inequality via regressive tax cuts. This is a bias that will plausibly be soon removed by a very plausible and likely change in US political leadership.

The move by the US government to provide $25 billion handouts to the US automobile industry represents a very clear trend towards increased government involvement in the economy. These grants are conditional on meeting government objectives of more 'fuel efficient' cars. This is probably a poor move given the long-term pressures that work against mass manufacturing of automobiles in the US. More fundamentally it is wrong to foster an economy that rewards and saves poor performers.

The fear is that the current intervention with respect to the banks will be seen as a precedent for blind acceptance of increased government involvement in broader sections of the economy such as health, education, transport along with possible greater restrictions on free international trade and investment. Such restrictions would endanger living standards and would help to keep millions of people in developing countries poor by denying them access to foreign markets. It also denies residents in developed countries to inexpensive products. We need to learn from the current crisis and adapt our regulatory settings not 'shoot ourselves in the foot' with pointless restrictions that reduce our freedom and which cripple the economy by building inefficiencies into it.

Society will change as a consequence of the current crisis and hopefully the incentives for 'get-rich-quick' schemes through debt-funded investment in housing will be diminished. There may be some sort of return to old-fashioned values of 'living within means' and therefore not being excessively leveraged. There will also be less of the economic complacency that has been induced by the long-term boom that operated up to the current crisis. Currently an Australian aged 30 has lived all his or her teenage and adult life in an economy that has steadily expanded. That has now changed and it is natural to suppose that, as a consequence, we will become more fearful and cautious. This increased caution may have costs in terms of excessive risk aversion as well as obvious individual benefits.

Finally, I think the discipline of economics will change in response to current events just as it did so dramatically after the Great Depression and the period of high inflation in the 1970s/1980s. Specific changes will include a reassessment of the view that derivative contracts can reduce risk . More generally there will need to be a broader rethink of financial regulation policies. One issue of prominence will be international regulatory regulation. Part of the reason for the current financial problems is the competitive pressures not to regulate domestic monetary sectors intensively because of the prospects of operating in a less regulated international financial economy. The need for rethinking the regulation of international financial markets will be heightened by the expanded role that China will be expected to play in the global economy.

These are issues that deserve greater attention than I can give them now but which will increasingly play a part in unfolding debates.

Update: Gary Becker and Richard Posner elaborate these issues.  One of their main points is to link likely changes in the structure of capitalism to the extent of the damage it causes.

Sunday, October 19, 2008

Financial crisis, Australia & unknown unknowns

One of the refreshing incidental features of the current financial crisis is that many economists are displaying uncharacteristic humility. They don't know what is happening and they know that they don't know. Humble pie is also being eaten by supporters of theories that our real savings performance has been boosted by capital gains on the stock market and in house prices. I have even gone a bit quiet myself on the irrelevancy of current account deficits - I am a long-term supporter of the Corden/Pitchford thesis - although still thinking about this one.

A few strident Keenly-alert alarmists are 'predicting' a doomsday as a consequence of the financial collapses but this seems to be media-tartism as much as 'prediction'. A few have predicted a deep U or even L-shaped rather than V-shaped recession in the Australian economy with median estimated duration of about two years. When pressed to back up their judgements these 'experts' appeal to past recession characteristics (which seem irrelevant now) or to the need to make an educated guess - in other words they are guessing but giving their naked guesses a modest cloak.

We can easily gawk and gasp at the startling financial shocks that are occurring around the world but no-one really understands how these shocks will feed into the real economy. How will employment and incomes change? Of course these are the substantive issues.

What are my guesses? I think it is likely Australia will experience a sharp contraction in economic activity over the next few years that is a recession. The share price collapses of the mining giants Rio Tinto and BHP-Billiton - along with a collapse of the Australian dollar - jointly don't make a lot of sense in themselves since the falling dollar should largely offset lower resource prices. But the implication is that more than 50% of Australia's exports are destined to be severely impacted on by the recession. The market is implicitly forecasting much more bad news not less. The 'big end' of town is forecasting a quite severe slowdown. Unfavourable movements in the terms-of-trade and reduced investment activity will end or severely slow down the mineral boom and reduce our living standards just as the boom enhanced them.

The destruction by about 40% of stock market wealth savings - more if you value assets in US dollars - and the fear that the housing market is subject to a threat of near collapse will put a dampener on private sector spending and encourage community-wide efforts at deleveraging. While these are individually rational for households (I have already done it!) and firms these moves will put a dampener on demand and economic activity.

Much of the growth in borrowing in recent years has been in business investment and this will inevitably slow, even if interest rates fall dramatically, as retail sales and other indices fall off.

Could we have a dramatic recession that leaves more than say 10% unemployment? I would not rule out this possibility partly because of the high probability that further adverse financial shocks will occur in response to real shocks engendered by the first round financial shocks.

More specifically however Australian real estate prices have not tumbled as they have in Europe and the US and Australian private debt levels remain high. The claim that there is a housing shortage due to high immigration is fine but a deteriorating economy, and rising unemployment, will raise severe solvency issues among those who took on huge mortgages on the assumption that the economy and their incomes would grow at a rapid rates forever. It is a substantial threat that could ultimately threaten thebanks and lending institutions and call into play the Government's deposit guarantee.

Thursday, October 16, 2008

George Soros on free market fundamentalism

This is an amazing interview with Soros.  A fan of markets he nevertheless sees deregulated financial markets as delivering a biased reflection of reality that generates booms, busts and bubbles.  The reason - too much credit, too much leveraging.  Free market fundamentalism is just as misguided an ideology as socialism.

Soros sees the current crisis as the end of an era and the beginning of a potentially catastrophic shock. His solution - minimise foreclosures on mortgages by resetting mortgages below the market value of homes and using public and private capital to replenish the equity base of the banks.

His major fear for the world longer-term is not financial it is climate change. His medium term solution to the current catastrophe - create a global investment boom designed to address the effects of climate change so that the world can live sustainably rather than basing its global prosperity on excessive and destructive levels of US consumption that are driven by grossly excessive debt and agency problems.

I subscribe to his emails here.  Great value and always of interest.

Thursday bloodbath

I glanced at the All Ordinaries at 10-25 am today and the index had fallen just under 6% in 25 minutes. This is fearful stuff.  Last night the S&P on Wall Street fell 9% the biggest decline since 1987.  Oil prices have hit a low of $75-90.

The fear is that the US is now in recession. Although this can probably taken for granted given the events of the last few weeks - the assesssment that the US is in recession is based on data covering the time period before the current upheaval.  Thus expectations are for a deep and probably prolonged recession.

Update: By 2-30 am the index had fallen 6.4%. BHP-Billiton had fallen $4 to around $26. At about this time I received the following clip from The Times Online - 'the world prepares for a long recession'.

Tuesday, October 14, 2008

Obama supporter by default

I find it hard to support war hero John McCain and his dud Vice Presidential candidate Palin.  But Obama is no shining angel either. 100 prominent US economists get stuck into Obama's policies on tax and trade (a longer list is here):

'Barack Obama argues that his proposals to raise tax rates and halt international trade agreements would benefit the American economy. They would do nothing of the sort. Economic analysis and historical experience show that they would do the opposite. They would reduce economic growth and decrease the number of jobs in America. Moreover, with the credit crunch, the housing slump, and high energy prices weakening the U.S. economy, his proposals run a high risk of throwing the economy into a deep recession. It was exactly such misguided tax hikes and protectionism, enacted when the U.S. economy was weak in the early 1930s, that greatly increased the severity of the Great Depression'.

What a clown Obama is and McCain at least supports free trade. If I had the chance would I ever think about voting for McCain? Probably 'no'.  Don't ask me to explain my reasons in detail. What a choice!


This is stunning, grotesque, entertaining.
Thanks Bernd I think

Rudd's fiscal stimulus

Kevin Rudd's $10 billion fiscal expansion package makes some degree of sense as a preemptive way of offsetting the impending effects of a (likely) impending international recession on the Australian economy. This move will complement the recent interest rate cut and the dramatic decline of the Australian dollar as a means of stimulating the economy.

Under flexible exchange rates the main tool for stabilising the economy is monetary policy not fiscal policy.  Part of the effect of a fiscal expansion will be to drive up local interest rates which will to some extent undo the welcome monetary relaxation.

The major effect of fiscal policy, in general, is to determine the allocation of resources across the public and private sectors of the economy. But the current expansion is mainly to increase spending by pensioners and families with children which will primarily drive demand which is probably welcome.  The doubling of the first home buyer's grant will mainly drive up real estate prices and have a negligble effect benefitting new home buyers.

The search by Labor Party yokels for viable infrastructure projects is deeply troubling. It is partly a search by disgruntled socialists for an alternative to to private enterprise. It is also partly a search by third-rate Labor politicians for opportunities to grand-stand. Governments around Australia are retreating from a past commitment towards thinking rationally about public investments. The $1 billion the Victorian Government is wasting on the Northern Dog - the central Victorian attempt to resolve water resource problems by promoting dubious 'water efficiency improvements' - is an early instance of fiscal stupidity.  My fear is that many more stupid projects are in the pipeline.

Monday, October 13, 2008

Nationalising banks or boosting their liquidity & restoring trust

John Quiggin seems enthusiastic about the prospects for more 'utopian' society with government-controlled major banks.  As much as I am deeply concerned with the very recent claims of imminent global financial peril I do not share his enthusiasm for this at all. Governments might well wish shore up the capital base of large banks in Europe or the US by subscribing to equity (voting or non-voting) but this should be sold down ASAP. 

By the way the mad Green Left have launched their own campaign to nationalise the Australian banks.  It is a confused proposal that fails to see the lack of competition between the Australian banks as the reason for their high profits and poor performance.   While I agree with some of these criticisms it must be acknowledged that they are at present solvent! No small issue in current dangerous times.

Gary Becker has useful things to say on the public ownership issue.  The issue is to provide liquidity and to bolster trust. The idea of pollies - of the Kevin Rudd type - having a management say on which major private sector projects get funded in our type of society (green cars, water efficiency schemes) is not something we should think about for a minute.

By the way, Willem Buiter is scathing on the verbiage coming out of the IMF. He has to my mind a more down-to-earth and sensible approach to resolving the crisis of confidence that is currently threatened to bring the world financial system completely to its knees :
(1) Public guarantees of interbank lending between banks in different national jurisdictions. This could be implemented by national central banks acting as counterparty of last resort in the (unsecured) interbank markets.

(2) International agreement on limits on public guarantees for other bank liabilies and for liabilities of other highly leveraged institutions. This includes agreements on terms and conditions attached to such guarantees.

(3) International agreement on recapitalisation of banks with significant cross-border activities.

(4) Fiscal bail-outs of countries whose systemically important banks have a solvency gap that exceed the government’s fiscal capacity.

(5) International agreement on mandatory debt-to-equity conversions for banks and other highly leveraged institutions.

(6) International agreement on avoiding a moral hazard race to the bottom for deposit insurance through limits on deposit insurance (this is really as special case of (2)).

(7) International agreement on common access rules and common methods for valuing illiquid assets in different national TARP-like structures.

(8) International agreement to adhere rigorously to mark-to-market accounting and reporting principles and on common rules for relaxing regulatory requirements attached to marked-to-market valuations.
John Quiggin is also keen on 100% deposit insurance schemes of the type just announced by Kevin Rudd.  My presumption is that this is primarily directed at stopping runs on small non-bank lenders in Australia should there be a 'rush to quality'.  Of course for the moral hazard reasons mentioned by Buiter this should - at best - be a short-term measure.  It has the negative feature of drawing attention to the fact that deposits are not in fact guaranteed - many Australians do not know this - and raises explicitly the prospect that perhaps these institutions are threatened. Note that, significantly the Rudd scheme also apparently includes a guarantee on interbank lending which is one of the sensible points on Buiter's list. This will restore trust and encourage lending that will free up paralysed capital markets.

Saturday, October 11, 2008

A comment on Aussie equity markets

Equity markets around the world have fallen dramatically over the past week as fear of the next financial disaster or just fear of the pure unknown has taken hold.  I have no idea what will happen or how long the current crisis will prevail - indeed I am unconvinced anyone does - but I have a few tentative ideas about the current situation at least with respect to equity markets.

The collapse of the Australian dollar and the collapse of Australian export-oriented resource stocks do not make a lot of sense taken together.  The Australian economy seems in much better shape than most other developed economies and, at the present time, our financial system seems sound.  It is difficult to believe that the main sources of demand for our coal, iron ore and food exports will dry up and there has been some relief from the drought.

Consider a stock like BHP-Billion which at $27-74 is now priced at 9.7 times earnings.  Its share price high for the year was just on $50.  It is true that its export prospects have dimmed somewhat with the likely future global recession but the destination of most of its exports remains in the high growth parts of Asia where recession is unlikely.  The price in US dollars of these exports would need to decline by a little less than 1/3 to match the improvement in returns in Aussie dollars that will result from the vastly devalued Australian dollar which has fallen from 98 to about 65 cents US.  And if this reduction in 1/3 did occur that would restore the Australian dollar earnings of this exporter. There would be no further implied need for a fall in the Australian dollar price of the stock of the type that has occurred. I cannot help thinking that (further financial disasters excluded) this stock is massively oversold.

Indeed, looking through the industrial and mining stocks I see a fair bit of apparent value in many places.  Rio Tinto is selling at 8 times earnings and looks even cheaper than BHP-Billiton - an additional bonus is that, if BHP-Billiton's takeover of Rio Tinto does go ahead, it is a cheap way of getting into BHP-Billiton since the target is currently trading at a discount to the takeover offer.

Much the same sorts of observations can be made about the prospects of listed beef and food exporters. They look very cheap at current prices and would seem to have tremendous medium to long-term prospects.

Boring though hopefully safe income yielding stocks like Telstra (13X earnings) at $3-90 and AMP (12X earnings) at $5-89 are yielding around 8% when interest rates look like falling to around 5% over the next few months.  There are plenty of other stocks in similar situations.  Again very cheap.

I am not suggesting anyone hops in and starts buying - I'd definitely at least wait until the market heads out of its current nosedive before doing this.  But I wonder if because I can see real value emerging in the market at present that others might be doing the same. Barring further financial shocks and disasters - OK these do seem reasonably prospective - greed and self-interest should start to drive a recovery in what seem to be very undervalued Australian stocks.

Thursday, October 09, 2008

Immigration & Labor

One of the most despicable anti-Australian policies of the Hawke-Keating era was the devotion to bring many unskilled immigrants into Australia under the guise of the 'Family Migration' Program to bolster Labor's standing with the ethnic lobbies.  Whenever the global economy faltered the Labor Party pursued high immigration targets based on the 'family' program to bolster its re-election objectives. This earned the undying gratitude of the narrow range of families concerned (and those who spend much of their lives at CentreLink) but irritated the rest of the community who had to pay the taxes and got no immigration spinoffs. It undermined support for a legitimate immigration program based on securing well-educated immigrants who could get well-paid jobs and who could contribute intellectual and cultural talent to Australia.  Hawke - not conservative politicians - created the problem of Pauline Hanson.

Bringing migrants to Australia who convey skill externalities, who at least speak basic English and who do not despise the democratic values of a civilised society makes a lot more sense than turning Australia into an irreversible social experiment.  John Howard did a tremendous job of enlarging and reorienting the immigration program towards accepting those with skills.

Andrew Bolt makes some sensible criticisms of the current direction of Rudd-style migration policies.  I share his concern with Labor's apparent commitment to maintaining high levels of immigration as the economy looks likely to weaken.  This can only be done by expanding the import of unskilled workers and 'Family' migrants in the migration program. Rudd started off endorsing the skill orientation of the Howard immigration policies - although he lied his head off about the refugee program - which the Liberals had already expanded.

Bolt's observations remind us that, along with economic management, Labor cannot be trusted on immigration.  Their record is appalling.

If the families of unskilled immigrants living in Australia wish to be reunited with their loved ones CentreLink might well consider funding their tickets home.  Australia has zero obligation to accept family-based chain migration of the unskilled. None. In addition, seeking unskilled immigrants to meet short-term shortages is about as stupid and short-sighted a labor market program as you can imagine. Australia is an attractive destination and can insist on the best imnmigrant applicants available. Unfortunately admitting the riff-raff is just the sort of policy that will appeal to Labor since it expands a fair slab of their core constituency.

Grim news & a cheer-up

This quote from the Times Online just about says it all:
'Interest rates across the world were slashed yesterday as central banks took unprecedented emergency action in an effort to contain the worst economic threat since the Great Depression.....
....The extraordinary level of coordination was designed to demonstrate resolve in the face of financial panic but failed to restore confidence in the stock market. Share prices rallied briefly in London but the FTSE 100 index closed down 239 points at 4,367, its lowest point for four years.
 In its bleakest forecast for years, the International Monetary Fund said that the world was entering a major downturn in the face of “the most dangerous shock . . . since the 1930s”. The US and Europe were either on the brink of or already in recession'.
The IMF's Global Financial Stability Report on the crisis is here. The executive summary of the report is here.  The 'Fund is mainly arguing the case for a much more regulated international financial system and offering its services.

I have been so busy the last few days that I have been unable to focus on the extent of the current disaster, the loss of personal wealth and so on.  The prospects for a prolongued, severe global recession are real.  How things change so quickly!

Amidst the gloom I came across this refreshingly vulgar musical piece at FXH's Lan Downunder by The Saw Doctors.  I've been playing it between meetings and teaching today. Rob Waschik provided me with this delightful insight into the source of the affection displayed by the Saw Doctors towards the Bangles displayed in the FXH clip.  I thought they were pretty good too.

What does this have to do with the possible collapse of capitalism? Nothing at all. Nothing. That's why I link to it.

Tuesday, October 07, 2008

Financial arithmetic

Since May the all Ordinaries index of Australian stock prices has declined from 6000 to about 4400 which is a decline of about 25%.  The value of the Australian dollar has over the same period fallen from about 0.98 US cents to a low today of just under 70 cents.  This is a decline of a bit more than 25%.  To be more precise one US dollar's worth of Australian equity four months ago in May was worth about 52 cents today.

Update: (Wednesday): The Aussie dollar collapsed to a bit over 64 cents last night.  This is perplexing.

Monday, October 06, 2008

Did climate change cause the drought?

I've said my piece on this issue before. I am happy to concede that the current drought might prove to be a manifestation of climate change but my claim has been that this is not implied by the evidence. My impression is based in part on the following rainfall graph:

which seems to me trendless at least until the mid-1990s. Other graphs for particular parts of Australia - not the far South West of Western Australia - show a similar absence of trends.

The CSIRO have recently completed a study of the case for worsening drought frequency and intensity and for tightening the 'exceptional circumstances' motivation for paying 'drought relief' to farmers. They provide evidence of increasing temperature - we knew that anyway - but argue that evidence of decreased rainfall depends on what period you choose. Selecting data post 1950 it looks like drought frequency has increased provided that the current drought is included. This study has been criticised by David Stockwell who finds that the climate models used wrongly predicted increased drought in areas where it had not occurred. This is of interest becauyse it is these models which predict iuncreasing drought frequencies and intensities. But ignoring this point this study does not provide historical evidence of increasing drought frequency.

The heading in today's The Age - 'What Victorians are living through now is not just a drought, it's climate change' suggests what it says. Moreover, it is written by the head of climate analysis - Dr David Jones - at the Bureau of Meterology so I must stop and carefully read the analysis. But again this analysis does not quite make the claim of increased droughts being associated with climate change. What it says is that rainfall has been below normal for 11 years and this is unlikely to be something generated by chance - it is double the previous record run of dry spells from 1979-1984 and the data base drawn on goes back to 1855. It would be nice to have this data. In the final paragraphs Jones writes:

'Climate change caused by humans is now acting to make droughts more severe and ncreasingly likely, while substantial warming of our climate is inevitable as a result of greenhouse gases already emitted and those that will be emitted in the decades to come.

Regardless of the underlying cause, the drought provides Victorians with a snapshot of a hot and dry future that we all will collectively face'. (my bold).
My inference from the bolded bit is that he has taken a guess that, on the balance of probabilities, the current drought is likely to be caused by climate change. To emphasise the point, Jones may well be right. He writes:
'A notable feature of this drought is the long series of failed autumn rains. Victoria, and indeed most of southern Australia, has experienced a substantial decline in its autumn rainfall since the 1970s. This is important because autumn rainfall "wets up" the soil in catchments, allowing winter rain and snow to flow into rivers. Decent autumn rain also gives crops and pastures a start after the heat and dry of summer. Victoria has now experienced eight dry autumns in a row, and indeed 16 of the past 19 autumns have received below-average rainfall.

The autumn drying trend was first noticed in south-west Western Australia in the mid-1970s, and has subsequently spread to the south-eastern states. This rainfall decline is driven by a rise in atmospheric pressures, and a weakening of cold fronts and low-pressure systems that once reliably brought rainfall to southern Australia. This shift in weather systems and rainfall has been linked by scientists to human-induced climate change, be it through greenhouse gases or changes in the ozone layer over Antarctica.

While we will continue to see the occasional wet autumn in the future, the chances are that we will not see a return to the wet autumns that were once commonplace. Over the past few years we have also seen a repeated failure of spring rains, which is a projected response to global warming across southern Australia'.
Thus Jones is also confirming the causal claim by drawing a link between predictions of climate change effects and what has happened. I am not well up enough on specific predictions to confirm this claimed coincidence. The IPPC forecasts I have seen suggest different rainfall trends in different parts of the country.

It seems plausible to suggest that longer-term temperature increases will be associated with increased drought frequency. Eventually there will then be the ex post judgement that climate change has driven drought. I remain unconvinced that this judgement can be drawn now but I will pursue this matter and if I find convincing evidence to the contrary will publicly retract my views.

Sunday, October 05, 2008

The bigots are at it again - Henson seeking photographic subjects

The artist Bill Henson's visit to a school to find young children he could potentially photograph is entirely innocent and the hysteria being generated by all sides of politics about it should stop.  What is happening is a Salem-type witch-hunt cloaked by claims of 'protecting children'. Now the unfortunate school master who apparently approved the visit is being persecuted.  There is no connection between the attractive art work produced by Henson and pornography and no link between  artistic interest in photographing children and pedophilia - the association being suggested by the bigots.  Henson is an artist who makes us aware of the ambiguous beauty of sexually immature children.  This is not something to suppress but something that, as a community, we should seek to understand.

It is unambiguously wrong to treat young children as sexual play-things but this is no argument for promoting hysteria about images of less than fully mature human forms who are of artistic interest. Moreover, to condemn an artist for openly seeking potential models - with both individual and parental approval - is unbalanced hysteria.

Liz Conor made perceptive remarks about the previous bout of Henson hysteria.

Bigots such as the anonymous Currency Lad make their usual sorts of claims. They apparently see the issue as one of 'children's welfare'. I think it is really their own narrow view of the world and possibly their upbringing.  What creates their fears? Tim Blair in an astonishing piece seems pleased that the principal concerned has apparently been sacked.

What children have been harmed by Henson in any way?  What harm is there in openly seeking subjects for photography?

Is it not true that children are beautiful and their bodies worthy of artistic interpretation and portrayal? Is the only response to Henson's art that which might be suggested by a police force or a criminal prosecutor? People who see things in this way should examine their own visions and guilts. Even if their desire is to protect children they do more harm than good by suggesting that merely portraying the human form is something wicked and to be eradicated. These bigots diminish us all.

Update: Peter Craven gets it right - Zealots rule.  Julia Gillard is more stupid than usual - it sends a shudder up her spine to think that people might visit a school to look at children.

Saturday, October 04, 2008

It's a man's world

This is little old but it is a performance worth noting. James Brown and Luciano Pavarotti in concert.


The bailout approved by the US House of Representatives.  In this second attempt to pass the bill - ansd after more than a usual amount of pork - many Republicans shifted their vote in favour of the bill. Still a majority of Republicans did not. Wall Street soars (Update: Subsequently falls heavily).  America is happy (Update: Subsequently unhappy) again.

It is interesting to glance at the first few pages of this enormous (400+ page) "Assets Relief Program" bill. Here is a negative assessment - to be clear I don't agree with this line but it does reflect what about half of America thinks.

Saul Eslake over at Troppo will no doubt be happy with this legislative outcome. The deal plus a few extras only costs 6% of GDP according to Saul the banker which he claims is cheap in the history of such matters. Saul urges politicians to protect Australian bank profitability by not insisting that any forthcoming RBA interest cut be passed onto borrowers.  Yes he does work for a bank and obviously sees no humour in the self-interest that seems to underlie such claims. What's good for bank shareholders is apparently self-evidently good for Australia. Why have the Australian Banks done so well in difficult times? Partly I guess it is a sound regulatory setting and maybe efficiency - is this the same thing as lousy customer service - but also it reflects the cosy security of a tight quadropoly. Where is Caesar's wife?

Friday, October 03, 2008

Palin winning in the giggle stakes

Sarah Palin went to a debate camp in Arizona to sharpen her skills in preparation for the big debate. David Letterman sent in a spy to discern the 10 most important things they focused on. Meanwhile a pastor in Alaska has broadcast a video seeking to protect Sarah from witchcraft during the debate. An industry has developed poking fun at Palin.

Update: Here is a brief discussion of the actual debate.  Palin seemed, to me, to lose - she is surprisingly inarticulate -  though did much better than expected.  It was not a debacle for Palin and a few commentators gave it to her.  Biden was fearful of appearing to be the 'bully'.

Thursday, October 02, 2008

Pessimistic thoughts on the financial crisis

The US Senate have passed the bailout plan and sent it back to the House of Representatives for the second time. I have pointed out before the tax and public finance implications of the US economy moving towards an $11.3 trillion dollar debt with the $700 billion rescue package. This debt amounts to $37,098 per US citizen.

Some have said that the US will recoup the $700 billion eventually by selling off real estate when things have settled down but that claim seems dubious given that the package targets specifically bad debts. Moreover, it is by no means clear that the package together with earlier measures (about $1.3 trillion in all) will resolve the underlying crisis. The US has overspent for a decade and is now faced with the prospect of borrowing more to forestall disaster. If the US were not such an important part of the global economy the answer would be easy - let the US experience an intense recession and let it begin to repay its debts both through increased personal savings and significantly higher taxes. I emphasise that this is an impractical immediate response but longer-term it must happen. The Senate, in fact, has only agreed to pass the bill with some further tax breaks.

The global implications of the US problems are being dramatically illustrated by events in Europe which some see as facing the prospects of a more intense recession than that anticipated in the US. France is seeking a 300 billion Euro rescue package for European Banks. It is already on the verge of recession. In an interesting twist Ireland has guaranteed all the bank deposits in its banks. This should boost confidence in Ireland - despite the fact that this vibrant Celtic economy is already in recession - but other European countries are complaining about the banking move because it is undermining confidence in their less than their fully guaranteed banks - customers are apparently shifting their deposits to Ireland!

The possibility of a really severe global contraction seems plausible and a global recession inevitable. Australia is exposed to these developments because of our open economy and our high levels of private debt.

The current situation is dire and I don't see straightforward solutions.