Archive for the 'Economics' Category

Have you looked behind the couch?

January 22nd, 2008

A particularly annoying species of headline writer has been out and about lately. That’s the one who likes to write headlines like:

Stock market loses $10 billion.


It’s silly, lazy journalism. The economy hasn’t ‘lost’ any money. Any losses are either purely theoretical (gains that were never realised), or are offset by the gains of some other party. Sure, some people may have a share portfolio worth a bit less today, but it still owns the same share of the same companies, with the same capital and assets. The market has just decided it’s worth a little bit less now.

No money has gone missing – bank accounts are just the same, other than the people who had to cover their margin calls. But all that money just went straight back into someone else’s bank account.

The reason this is bad journalism is that it distracts us from the real story. People think ‘oh no, a lot of money has been lost’. But really there’s nothing bad about that in itself. The real question is why the stock market went down.

And because the answer for that is mainly ‘fears of a US recession’, that’s bad news for everyone. Telling a story about the massive losses on the stock market creates an illusion that it’s just a problem for ‘rich people’. But the underlying causes of the fall might be a problem for everyone.

Why can’t we all just get along.

January 6th, 2008

In case you hadn’t noticed, the TV and film writers in the US are on strike. It’s been about 9 weeks now since they went on strike in November.

The economics side of this is the question of ‘why’? The standard theory suggests that you should never see strikes, because the simple threat of one should be all that the unions need in order to achieve the best outcome they could. What this ignores is the problem of asymmetric information – not everyone knows the same pieces of information, and some (like how committed the membership of the union is to the strike) are very hard for any side to know perfectly.

But even given that history, strikes in Hollywood tend to be long and vicious. I think that’s probably because the studios can stockpile a lot of finished product, especially in film, and that protects them from the immediate economic consequences. It’s probably also because the personality factors are going to be exaggerated in the environment they all live and work in.

So what are they fighting for?

They’re ultimately fighting over who gets a piece of the pie, and who gets to be treated as a hired player. There’s a strange line drawn in business between the people who are entitled to a share of the profits they create (authors, hedge fund managers), and those who are simple employees who have no rights to a share of profits.

Writers are currently in the first group, getting a (small) share of the profits that come from DVD, video and TV screenings of the things they write. The studios would like to put them into the first group.

Who’s right? It’s hard to say.

The best economic answer to the question of whether you should get a share comes down to bargaining power, and in particular of whether your characteristics (be they creative or simple marquee value) will boost the project more than the next available worker. In Hollywood some writers clearly have that cachet, and some do not. But they all bargain together, and so the value of the top writers gets pushed down to the whole pool to some extent.

So the pure answer would be ‘if they’ll give it to you, then you deserve it’.

Hence the strike.

I just wish they’d get back to it. I’m starting to miss TV, and I’ve finished half my computer game pile…

The scariest thing in economics

November 22nd, 2007

You know what phrase is most likely to scare an economist? “I’m an engineer, and have some thoughts about economics”. Something in the training of engineers seems to make them think that they can apply their knowledge to a completely different field.

A prime example from the National Review talking about the falling dollar.

After constructing a lovely straw man (go marvel at the craftsmanship!) this engineer starts in:

Economic transactions involve the exchange of “something” for “money.” The “something” is specified in terms of number (1, 2, 3, etc.); length/area/volume (“the foot”); weight (“the pound”); and/or time (“the second”). “Money” is specified in terms of “the dollar.”

This is quite simply completely and utterly wrong. There is nothing in all of economics that requires money to be part of a transaction. Economics says that two parties will engage in a transaction when they both receive something of value to them. Back in the days before currency, perhaps I’d trade two pigs to you for a cow. I’m only willing to accept the cow in exchange for the pigs because it has value. So the setup is wrong here from the start: it’s not “something” and “money”, it’s “value” and “value” – the trade is symmetrical.

The problem with this scheme is that the magnitude of our fundamental unit of market value, “the dollar,” is not defined. Being undefined, the value of the dollar can change. This fact gives rise to huge economic costs and risks for which there are no offsetting benefits.

This is true. But I don’t trade money with you because I have an intrinsic value of money. I trade money for goods because I value money. Why value money? Because other people also value money and will trade me goods for it in return.

There’s a kind of collective illusion going on here. It only works because we all sit down and agree that it will work. There’s no guarantee that it will, but somehow our collective delusion holds. We could go back to exchanging everything in barter, but that would cost us a lot of time and effort.

Can the value of the dollar change? Sure, it might. And in the past it has. That’s why we need a system to stabilise inflation.

Rather than being rigorously defined like all other units of measurement, the value of the dollar is left to the market. This is an extraordinarily strange way to determine the magnitude of a basic unit. For one thing, the absolute magnitude of a fundamental unit doesn’t matter — what matters is that it be precisely defined and unchanging. The market also has absolutely no way of determining what the value of a unit “should” be, whether that unit is the foot or the dollar.

Here’s where we see the logical fallacy at full flight. There’s a desire for a nice, absolute resting point – some central value that is determined. But it can’t ever happen. We trade things because we value them. But we’re also human and unique – why should I value anything the same amount as you? And if money is simply a medium ultimately used for buying goods of value, then why on earth should money have any kind of intrinsic value at all?

(Economists who’ve dealt with engineers of this ilk already know where this one’s going at this point).

Having had the job of determining the value of the dollar thrust upon it, the market does the best it can. Moment by moment it equilibrates the supply of dollars and the demand for dollars at some market value. This market value is reflected in the price of gold.

Ah ha! And here we are, another gold bug. Told you the economists could read this play a mile off.

This is really simple to answer: why on earth would gold hold any kind of intrinsic value at all? It’s not that useful a metal, really. It’s not clear how much there is, but there certainly isn’t a fixed supply yet because we haven’t finished digging it all out of the ground. Sure it’s shiny, but plenty of things are shiny. So why gold?

What’s that you say?

Because other people value it too?

Simply put, there is almost no difference between so called ‘fiat’ currency and gold backed currency. There are a few technical points relating mainly to international trade and monetary policy, but in terms of day to day use nothing at all.

And what about the mighty Federal Reserve? Well, the Fed could exercise absolute control over the value of the dollar since it controls the supply of dollars. The Fed has the power to vary the size of the monetary base from zero to infinity. Given this, the Fed has the power to fix the dollar’s value (in terms of gold or anything else) at any level it chooses.

However, the Fed doesn’t do this. Instead, it exerts a vague influence over the size of the monetary base by targeting the federal funds rate.

Now isn’t the time to explain about open market operations, and the way monetary policy works. It’s pretty technical, and not for the non-specialist really. But this is exactly wrong: by changing the interest rate the bank is changing the money supply. It’s just doing it in a fashion that more directly controls the reaction.

A simple analogy might explain: if you wanted to increase the price of some good by 10 per cent, what would you do? Would you reduce the supply of that good until the price went up, or would you just increase the price?

That is, the Fed creates money in response to demand for short-term capital. Given that one use for short-term capital is commodity speculation, and given that commodity speculation is one way to profit from inflation, the Fed is operating a system that is designed to respond to inflation by creating more money.

Such a system exhibits “positive feedback” (like a nuclear reactor) and is dangerous.

We’re now reaching the territory where the lack of knowledge of economics and financial markets is making this very very difficult to understand. While I’m prepared to be corrected by someone with better knowledge of financial markets than me, this appears to be pure gibberish. The federal reserve isn’t doing anything in response to demand for short-term capital – it’s acting in response to unemployment and inflation rates.

Nonetheless, the real problem is the confusion about the fed’s role: the fed does not just reduce inflation, sometimes it wants to increase it. A bit of inflation is a good thing in an economy (just look at what happened in Japan with some deflation).

I think he might be referring to the recent credit crunch, in which case what the Fed was doing wasn’t really increasing the money supply per se, so much as replacing some of the money supply that had disappeared off to non-liquid sources. If they hadn’t acted the money supply would have shrunk, raising interest rates and reducing economic activity. They were just trying to keep things as they were, more or less.

Why would the Fed employ a monetary-control approach that is both indeterminate and dangerous? I believe the underlying problem is an intellectual confusion between “money” and “capital.”

The irony of accusing the Fed of “intellectual confusion” here had me laughing for about five minutes.

Anyway, I’ll skip a few more paragraphs of deep confusion to get to the funniest bits of this article.

A logical definition of the dollar might be “equal in market value to one five-hundredths of an ounce of gold.” The value of all the dollars in the U.S. monetary base would then be maintained by having the Fed’s open-market operations target the price of gold to keep it near $500 per ounce. Because the real market value of gold cannot run away to zero or infinity, the new monetary control system would be determinate and stable.

What I am describing is not a classic “gold standard.” Back then, gold was the monetary base. Instead, the monetary base would be the same “fiat” currency that we have now. Banks would maintain the value of their dollars the way they do now — by redeeming them with the dollars of the monetary base upon demand.

Oh boy.

OK, firstly: “not a classic gold standard”? Rubbish. This is the gold standard with a silly hat. If your dollar is worth 1/500th of an ounce of gold, then it doesn’t really matter if you go to a jeweller rather than a bank to get the 1/500th of an ounce, it’s still a fixed currency. Sure it’s not backed by gold, but the economic effect is exactly the same.

But what’s wrong with this solution? Well, the same problem any fixed currency has, it’s vulnerable to speculative attack. So what would you do? Well, you might continually buy gold to try and force the price up. The Fed would have to sell to you in order to meet its mandate. But the Fed doesn’t have an infinite amount of gold – sooner or later they’ll run out, the price of gold will go up, and confidence in the currency will collapse.

This relates to the earlier suggestion that ‘money supply would be irrelevant’: if there’s more money than gold, then the currency will collapse. So no free banking, no infinite money supply. Too much money and the economy could collapse.

That’s not going to help keep interest rates low, by the way.

This new system would not be concerned with the federal deficit or the U.S. trade deficit. These relate to capital, and capital is not money. Similarly, the system would not be concerned with interest rates, which represent the cost of capital, not money. (As an aside, if the dollar were as stable as the foot, interest rates would be very low.) There would still be a role for the Fed as “lender of last resort,” but this would be a “banking” function separate from monetary control.

Interest rates are the cost of capital, not money???

Just in case you had any lingering thoughts this guy knew what he was talking about, there’s this gem.

Of course interest rates are the cost of money. If I spend money, I’m foregoing the interest on it. There is no definition of cost that can possibly mean that interest rates are not the cost of money.

The distinction between “money” and “capital” here isn’t that silly – but the idea of a ‘cost of capital’ is. There’s a cost for how much money you had to borrow to build the capital. And there’s a return on the capital. In an equilibrium, both of those are equal to the interest rate. The ‘cost of capital’ in economics normally means the cost of building an office block, or making an assembly line.

So, to summarise: this guy is a complete idiot with no understanding of economics whatsoever, or the role of monetary policy. His proposed solution would create massive problems and remove one of the most important arms of economic policy.

That conclusion would be obvious to anyone with first year training in economics. And even if it wasn’t, you might think twice when you realise that everyone with a background disagrees with you (including, by the way, many engineers with actual training in economics).

But for some reason a few engineers seem immune to the kind of self analysis required to actually think that it’s possibly that they’re wrong, and maybe the experts are right. And I don’t know why, but it’s only engineers.

Wait, he’s not done?

Fixed exchange rates between the dollar and (say) the euro are just as desirable as between the foot and the meter. The belief that “floating” exchange rates are needed to deal with trade imbalances between nations represents more intellectual confusion between money and capital.


Wow. Now I need to explain international trade, capital accounts, and the role of the exchange rate?

Nah, too tired for that. This article is already over two thousand words long.

If you want real prosperity, give monetary control to the engineers.

Or, rather, if you’d like to screw the economy, create a massive recession and destroy large parts of the economy, let an engineer look after things. Alternatively, stick with the remarkably effective monetary policy system that has created almost two decades of prosperity and stability in the developed world unmatched in all of history.

To Index or not to Index

July 5th, 2007

As the new financial year rolls around, I’m giving some thought as to how invest my money. I’ve got a mortgage, which means that my investment portfolio (such as it is) is pretty heavily weighted towards property. So I’d ideally like to put some money into the stock market.

As I see it, I’ve got three options:

  1. Put my money into shares directly.

  2. Put my money into a mutual fund.

  3. Put my money into an index fund.

The first option isn’t that attractive for a couple of reasons. Firstly, I don’t have that much to invest, so I won’t be able to get many stocks. So I’d have to be lucky (DJS, I’m looking at you here) to get decent returns at all.

The mutual fund option looks a bit better. There are a lot of options, and I’d be able to invest only a small amount of money at first. But there are two big draw backs:

  • Decent ‘actively managed’ funds charge very high fees, and even then often require large entrance costs. Which means I’d be stuck with the lower tier of funds.

  • Even the good managed funds can’t beat the market: the evidence suggests that pretty much no firms are able to consistently provide higher returns than the market index (e.g. S&P ASX 200). For instance, see Malkiel (1995).

(The other smaller problem is that almost all of them invest in property to some degree, and I don’t want more property investment in my portfolio)

So that pretty much leaves me inexorably with an index fund. An index fund takes shares that give the same return as an index like the ASX200 (usually a pretty substantial subset o the whole index). So by definition the return on the fund is the same as the market. And as an added bonus, index funds tend to be really cheap: about 1% cost of management, compared to over 4% for some mutual funds.

This is pretty much the advice of experienced market analyst Henry Blodget too, who’s written a great book on share investing. I just need to get a copy rather than just reading the free excerpts…

Free Parking

June 25th, 2007

From RiotACT I found this web page calling for action on parking:

The purpose of this website is to channel our frustration with the parking situation into change. Let’s stop whinging to our co-workers and tell someone who has to care – the Government. What we propose is not unreasonable, but the recommendations are designed to fix an unreasonable system.

Specifically, the site mentions or complains about:

Excessive and unfair fines

Limits and No Parking zones

It’s not “just $70”.

The first big problem I have with the site is that it talks about a set of recommendations they want to make to Government, without ever showing these anywhere. I’m not keen on signing a petition without any details of what I’m signing.

But, more broadly, what’s the problem here, and how will the things they seem to be proposing help?

The main complaint is about lack of parking. Now most non-economists probably think this is just a supply issue. But economic tells us that there are two halves to every market: supply and demand. If there aren’t enough spaces to park in, then that’s a result of supply being greater than demand.

The simplest answer is to build more carparks, but there are a couple of arguments against that. Firstly, it’s not always easy to build the carpark near where people want to go. Think about the CBD of any city: where would you put the extra car parks? Cars take up a lot of space, especially the 4WD behemoths. Secondly (and reluctantly), maybe it’s not the greatest idea in the world to encourage more people to drive everywhere. There are congestion and environmental arguments in favour of rationing car parking.

If increasing supply isn’t the answer, then you can address demand. The simplest way to reduce demand for parking is to charge more for it. Anyone from Sydney or Melbourne knows how cheap Canberra parking is, even in Civic.

Fair Parking Canberra notes the government is building more sites, but calls for a few things. Firstly, different fines depending on how long you’ve overstayed your parking. Secondly, change some existing no parking zones and one hour zones into four hour zones (presumably so you can go move your car at lunchtime…). And thirdly, lower prices for parking and parking fines.

So what will these do?

What about making some one hour spaces into four hour spaces? (I’m going to ignore the stupid idea of getting rid of no parking areas. Those lines are normally drawn with regard to public safety or access) Think about a one hour space. In a normal day, 8 cars can park there. Change it to a four hour space, and only 2 can. Even if you argue that the majority of people are looking for 8 hours worth, so long as there are substantial numbers of people who don’t you’ve just reduced the supply of parking. Good for people who get there early, terrible for everyone else. Bad, bad idea.

What about changing the fines? A little bit of law and economics will come in handy here. Say you park illegally, how much do you expect to pay?

E(F) = p * F

WHere p is the probability of being caught, and F is the fine. In order to ensure people follow the law, we need to make:

E(F) > L

Where L is the price of legal parking. The fine is $70, and the probability of being caught appears to be around 1 in 7 (based on the experience of people around work who accidentally stay in a 2-hour space too long). So the expected fine is about $10. Probably enough to discourage people from parking illegally.

But if we lower the fine, then more people are going to park illegally. We’ve effectively reduced the ‘price’ of overstaying in a parking spot. Which means that the supply of available parking is going to shrink.

And what about charging based on how long you’ve overstayed? Well, firstly you can’t do that for any of the free car spots, because you never know how long you’ve been there. The way the parking inspectors work, they often can’t tell if you’ve overstayed one minute, or four hours. So this only works for pay-and-display car parks (as pay-on-exit obviously doesn’t apply). It’s not a terrible idea in that context, but the extra complexity (both legal and administrative) would make it hard to implement.

‘Fixing’ parking isn’t hard. Charge more for it. People won’t like it, especially those who would prefer to always park for free (the subtext I read into the Fair Parking site). But it will fix the problem.

By way of disclaimer, I should note that my workplace has free parking. And I hate it! It’s impossible to get a park after around 9:30am, which makes it very hard to sleep in, or to run out for an errand during the day. I really wish that we could introduce pay parking, because it would reduce the demand.

Investment strategy and the PSS

May 17th, 2007

As a Commonwealth Public Servant I’m lucky enough to be in the Public Service Superannuation defined benefit scheme. Back when I joined the Public Service this was a really nice scheme. You get a (generous) defined benefit linked to your final salary in the public service, and you get a big contribution from your employer. On the downside, it’s not very flexible and it’s really only for pension (rather than lump sum) benefits. You can get a lump sum, but it’s a bad deal compared to the pension. And the big deal is there’s a maximum benefit limit.

In the past I would have liked to put a lot of money into the PSS, but the maximum benefit limit meant (assuming I have a full career in the APS) that I would reach the maximum benefit while putting in close to the minimum contribution.

Then, last Budget, the Government announced some changes to the way that private superannuation is taxed. In short, while earnings still get taxed at a 15% rate, contributions and payments do not. So now other superannuation (especially Self-Managed Super Funds) look more attractive. How much more attractive than the PSS? Well, I never really worked it out because I any increase in super would have to go into another fund.

Which brings us to this Budget, and the announcement that the Maximum Benefit Limit for the PSS would be raised. Not massively, but enough that I can make some additional contributions now. Which brings me to today’s question – if I have some money to contribute, should I put it into the PSS or a self-mananged fund?

To start with, let’s suppose that I’m going to contribute an amount equal to 2% of my salary extra to the PSS. Under the rules, this means that the Government will match that, increasing my benefits by 4% of my salary. Why am I talking in terms of a percentage of my salary? Because that’s how PSS benefits are set, based on a percentage of your final salary. And ‘buying’ one per cent of my final salary costs one per cent of your current salary. This contribution comes out of my after-tax salary, so I need to gross this up for the before-tax cost.

To work out what this is worth in 35 years when I retire, I need to assume a rate of wages growth, we’ll say 4%. And inflation of 2.5%. Put this all together, and the real average annual return is 1.9 per cent per annum. But the PSS also lets you buy an actuarially “cheap” pension, so this needs to be grossed up by 15% to get a fair value, to give you a real average annual return of 2.3%.

So what about putting the money into a self-managed fund?

Firstly, you can salary-package your contribution, allowing you to contribute out of before-tax income. We’ll assume the contribution is the same amount as the PSS in terms of before-tax cost. This contribution then gets taxed at 15% as income of the Super fund. From then on, the earnings of the super fund are taxed at 15%, and you’ll also pay some management cost (let’s assume 1% of funds under management). If you assume that the return on funds invested is 7%, then you’ll get a real average annual return of 1.9%.

So it looks like the PSS is the better bet. BUT – you’ll pay tax on the pension from the PSS, but not on the payment from the self-managed fund. There’s a rebate of 10%, but you’ll still pay income tax. Put all this together, and what do you get? Well, I think the self-managed fund gives you about a 20% higher return than the PSS. But if the stock market had returned 6 per cent rather than 7 per cent, then the PSS would be about 5% better. And if your wages grew at 5% rather than 4% (say you expected a few promotions between now and then), then the PSS would be 10% better with a 7% stock market return, and 32% better with a 6% stock market return. Here’s a summary table, showing the self-managed fund return compared to the PSS:

Stock market 7%Stock market 6%
Wages 4%+20%-5%
Wages 5%-10%-32%

So the conclusion is that I’m going to need a more sophisticated model, because it sounds like this is a decision that depends pretty dramatically on the assumptions that you make.

(Disclaimer: This does not constitute financial advice. Individual circumstances vary. Consult a financial advisor. If you believe me without getting this checked you’re on your own!)