Source: World Bank, The Economist.
This list of variables was in The Economist in February 2013. Notice the dominance of the Nordic countries – they have largely escaped the fallout from the Financial crisis. New Zealand tops the “Corruption Perceptions Index” and overall is lying 6th. Also note Switzerland being top in Competitiveness and Global Innovation.
Here is a graph from the BNZ which paints a rosy picture for the NZ economy – looking at a 3% increase in GDP this year followed by 3.7% in 2014. Investment is probably the reason for the forecasted growth – with the construction industry especially in Christchurch. However trade will most likely be subdued as demand for imports has been on the increase at the same time the dry summer has affected primary exports. Nevertheless by international standards New Zealand is in reasonably good shape when you consider the problems in Europe and the USA.
One of the first topics in the Behavioural Economics course that I am teaching is Prospect Theory. Of critical importance to behavioural economists is the fact that people are frequently subject to cognitive illusions (errors in understanding reality based on how information is presented or framed and how our brain processes information) causing errors and biases in decision making. Moreover these events are typically not one-time occurrences: People fail to learn appropriately from their mistakes, which is a product of not abiding by conventional economics behaviour norms. Nobel Laureate Daniel Kahneman and Amos Tversky referred to this as errors and biases approach. Prospect theory was developed as descriptive theory of certain aspects of average decision-making behaviour. Conventional economics can’t describe, explain, or predict choice behaviour. Emotions are a key driver of a person’s behaviour. People have been shown to be loss averse, generally appearing to dislike losing something roughly twice as much as they like gaining it. Such a phenomenon has been shown in a number of experimental studies in a broad range of contexts. Loss aversion can be explained by prospect theory , which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude.
This is illustrated in the graph. The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained.
Many people pay special attention to reference points when income or wealth increases or decreases. What counts isn’t total income or wealth but the relative changes in income and wealth – this is why the negative and positive dimensions of the value function are drawn from a reference point. In conventional economics, what people are most concerned about is the endpoint or total amount of income or wealth. But from the perspective of prospect theory, many people are happier if their income increase by 10% from a lower level of income than 2% from a much higher level of income. If my income goes up by 10% from $1,000 to $1,100, I’ll be happier than if my income goes up 2% from $10,000 to $10,200. Of course in conventional economics, your emotions don’t introduce concerns about reference points that may override your desire to increase your absolute level of income.
Here is yet another graphic from The Economist showing the change in stock markets since the peak before the financial crisis in 2007/8. Although Dow Jones Industrial Average surpassed its previous peak (though it is still around 7% off once inflation is taken into account) – see previous post. As you can see some stockmarkets are still struggling and Greece is more than 80% below its peak in 2007.
Here is a very good video graphic from The Economist. It looks at youth unemployment rates in the main economies of Europe and discusses the reasons why some countries have had much higher rates. Notice German’s low rate which was falling during the GFC which was mainly due to labour reforms which allowed small businesses to fire employees more easily and liberalised work for part-time and temporary work.
Just published on their website, the Reserve Bank of New Zealand has prepared a short video explaining inflation. The video, featuring the Bank’s Head of Economics, John McDermott, explains how inflation is measured and how it manifests itself in everyday life. It also explains the importance of maintaining price stability. Well worth a look.
Time magazine ran an interesting article on the tomato market in the Holland and Greece. The Greeks produces twice as many tomatoes than the Dutch but very little of it is sold in export markets. This is a concern in that it is a missed opportunity for the Greeks to earn income. What is more ironic is the fact that in the summer imports of tomatoes come in from Holland because the Greek farmers are still struggling to grow a crop during the hottest time of the year – Holland employs high-tech green houses and is able to produce significantly more during the summer months than Greece.
However, Greece has the potential to produce tomatoes for domestic consumption as well as for export but only has two harvests a year and is at the mercy of the elements – poor weather = poor harvest. The Dutch in contrast have temperature controlled greenhouses helping to create ideal growing conditions and they can produce 70kg of tomatoes in a square metre of his greenhouse whilst the Mediterranean grower gets approximately 7kg. They can also produce all year round.
Single Currency and Productivity
With the introduction of the euro in 2002 Greece could no longer devalue its currency to control the price of its products. With a weaker currency their exports were much more competitive but this had the effect of making the Dutch work even harder to achieve more efficiency and greater economies of scale. Therefore the only way that the Greeks can now compete is by cutting costs and embracing technology.
But it is not just the tomato market that has been hard hit. Greece’s agricultural sector’s productivity levels are 44% below the European average and labour costs have increased by approximately 90% and this is in contrast to Germany where unions agreed to a 3% rise. What is more concerning is that the acreage given over to growing tomatoes in Greece is 10 times that in Holland but they hardly export any of them. The Dutch have seen their exports increase by 30% since 2005. Some economists have laid the blame on the oligopoly market structure that controls the distribution. These middlemen pay farmers low prices and take a big mark-up on tomatoes even as they have failed to put in place a more efficient distribution system, including for exports.
The Greeks could become a thriving exporter of tomatoes once again but will need to embrace the Dutch technology and make use of its natural conditions – sunshine.
If you look at the labour market in Spain you would think that it resembles the German economy 10 years ago when Gerhard Schroder was its leader. Schroder was responsible for labour reforms that ignited the German economy into one of the strongest in Europe.
Spain is relaxing labour laws and cutting public spending and there are some positive signs here in that labour unit costs are falling as result of greater productivity. However German’s vocational education sector was a significant factor in its improved performance as the education and training system is more job orientated. Furthermore, with austerity measures in place and more to follow – pressure from the EU to introduce yet another sales-tax rise – Spain will find it hard to generate any sort of growth. But if it does grow will it generate any reduction in unemployment? Because of labour reforms some economists now believe that only 1.5% growth is required to bring about net job creation rather than 2.5% as previous.
The 10bn-euro (US$13bn) bailout of Cyprus’ economy, agreed by the EU and IMF, demands that all bank customers pay a one-off levy and has led to heavy cash withdrawals.
Under the currently agreed terms, depositors with:
* Less than 100,000 euros in Cyprus accounts would have to pay a one-time tax of 6.75%.
* More than 100,000 euros would pay 9.9%.
The BBC says the president may want to lower the former rate to 3%, while raising the levy on the larger depositors to 12.5%. Some EU source told Agence France-Presse there could be a three-way split on the level of levy, grouped into accounts holding less than 100,000 euros, between 100,000 and 500,000 and more than 500,000. The clip below is from Al Jazeera – it shows at one bank in the Limassol district, a frustrated man parked his bulldozer outside and threatened to break in.
The media last week were championing the fact that America most-cited benchmark, the Dow Jones Industrial Average (consists of the biggest 30 companies on Wall Street), had surpassed the peak that it reached prior to the Global Financial Crisis in 2008. Although the DJIA has doubled since March 2009 the American economy has only grown over the same period by 7% in real terms. Ultimately there is no real correlation between GDP growth and stock market returns The Economist stated main reason for this is that central banks worldwide have been forcing down the returns on Government bonds hoping to get investors to put money into more risky assets and therefore restore confidence amongst businesses and consumers.
Do the figures stack up?
Although the DIJA has hit a record high numerically, has inflation been factored into the calculation? If you look at the real figures (adjusted for inflation) the Dow Jones is approximately 9% below where it was in October 2007. Therefore the purchasing power of your shares in October 2007 is greater than that of today.
In real terms DIJA would be around 12,900 instead of the peak of 14,253.77 on Tuesday 5th March.
Justin Lahart in the Wall Street Journal stated last week that when you included the dividends earned (with investments in the DIJA) over the past five and half years and if they were reinvested the DIJA would be at 16,000. Adjusting for both inflation and dividends would put the DIJA around 15,000 – up approximately 5%.
Another consideration that he alluded to was that the DIJA doesn’t really reflect how well the average stock is doing. Companies with high market capitalisations like Apple are worth more than others also stocks like International Business Machines are worth more than others. Therefore stocks with the largest weightings have tended to weigh on the DIJA. If you put all stocks on the same footing since DIJA’s old record, and the index would have performed much better. The equal-weighted DIJA now stands at 16,683.44 which is 2,518.91 points higher than its 2007 high of 14,164.53 – see graph below.
A lot of behavioural economics textbooks look at the role of anchoring in our decision making processes. The anchoring effect is a type of framing where the appraisal of options is affected by an original starting value (or anchor). This is despite the anchor being arbitrarily chosen. For example, when asked to value the same property after being given different anchor values, real estate agents gave valuations that were significantly correlated with the arbitrary anchors provided.
With regards to the seizures of ships by Somali pirates, economists have had a particular interest in the negotiations that have taken place especially as the market has been generally free of government intervention. Research has shown that by sending consistent (cheap-talk) signals about their type (“sophisticated pirate” / “poor owner”), each side hopes to negotiate a better outcome but have reason to speed up the negotiation process:
Pirate - the hostages (and themselves) need to be fed
Crew – cargo might be perishable and the vessel is not in use therefore not making money.
However higher past ransoms are positively associated with subsequent ransom amounts – higher ransom amounts pass on a negative externality on future victims. This finding has policy implications for governments considering becoming involved in ransom negotiations. For instance, under political pressure to recover hostages, the Spanish government paid 1.2 million USD in 2008 for release of the Playa del Bakio, more than twice the previous record amount for a fishing vessel – source: Barrgh-gaining with Somali Pirates, 2012 by Olaf J. de Groot, Matthew D. Rablen and Anja Shortland. Therefore a floor price (see graph) has been set for future negotiations and it is a point of anchoring for the the pirates. Also from this paper is a graph (see below) that shows the duration of hijack and the ransom paid in US$m – there is a lack of correlation although the authors suggest that there is insufficient observations in this analysis.
The authors of the paper conclude by saying:
ransoms might be lowered by making rich ship-owners more patient by, for instance, by governments providing emergency loan guarantees to cover the running cost of the hijack, or compensating ship-owners for loss of hire, while offering
significant financial compensation to the crew.
Recently the minimum wage in New Zealand increased from $13.50 to $13.75 per hour. What are the arguments for an increase in this and what affect does it have?
An argument for the minimum wage is the fact that sometimes in labour markets there isn’t enough competition between employers and a monopsony situation occurs – see graph below. Here the minimum wage would protect the employee. However, is raising the minimum wage based more on reducing inequality as people are still struggling with the purchasing power of their incomes. In the US President Obama spoke in his State of the Union address about increasing the minimum wage from US$7.25 to US$9 – seems to be well targeted with regard to its impact. But ultimately how many people are affected by the increase in the minimum wage?
With the increase in minimum wage there is the belief that employers will lay-off workers. Evidence suggests the following:
1. Employment doesn’t fall much as the increase in wages lowers labour turnover, which raises productivity and the demand for labour.
2. The increase in costs for the employer will be passed onto the consumer in higher prices for goods and services
There is also the argument that wage increases will boost aggregate demand and therefore growth and employment. But in the USA this is estimated to increase consumer purchases by approximately US$15bn and when you think that the US economy is worth US$15 trillion is quite small in the scheme of things.
Economist Christina Romer stated in The New York Times that a more generous earned-income tax credit would provide more support for the working poor and would be more pro business at the same time.
Monopsony Labour Market
A monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. Unlike other examples we have looked at, in this situation we are now dealing with an imperfect rather than a perfectly competitive market. The monopsonist will hire workers where:
Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)
In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.
In this situation the power of the employer in the labour market is of overriding importance and the employer can set a low wage because of this buying power.
Nouriel Roubini wrote a piece on the Project Syndicate site focusing on the costs of QE. After three rounds of QE one wonders about its effectiveness. Roubini came up with 10 potential costs.
1. QE policies just postpones the necessary private and public sector deleveraging and if this is left too long it can create a zombie economy – institutions, firms, governments etc lose their ability to function.
2. Economic activity in the circular flow may become clogged with bond yields being so low and banks hoarding liquidity. Therefore the velocity of money circulation grinds to a halt.
3. With more money in the economy this implies a weakening of the currency but this is ineffective if other economies use QE at the same time. QE becomes a zero-sum game as not all currencies can fall simultaneously. QE = Currency Wars
4. QE leads to excessive capital to emerging markets. This can lead to a lot of extra liquidity and feed into domestic inflation creating asset bubbles. Furthermore an appreciation of the domestic currency in emerging markets makes their exports less competitive.
5. QE can lead to asset bubbles in an economy where it is implemented. It is especially prevalent when you’ve had an aggressive expansionary monetary policy (1% in USA after 9/11) already present in the economy for many years prior.
6. QE encourages Moral Hazard – governments put off major economic reforms and resort to a band aid policy. May delay fiscal austerity and ill discipline in the market.
7. Exiting QE is important – too slow an exit could mean higher inflation and assets and credit bubbles are created.
8. Long periods of negative real interest rates implies a redistribution of income and wealth – creditors and savers to debtors and borrowers. QE damages pensioners and pension funds.
9. With QE excessive inflation accompanied by slow credit growth, banks are faced with very low net interest-rate margins. Therefore, they might put money into riskier investments – remember the sub-prime crisis, oil prices up $147/barrel
10. QE might mean the end of conventional monetary policy. Some countries have discarded inflationary targets and there is no cornerstone for price expectations.
From reading the McKinsey report on the mismatch between the skills of the unemployed and the jobs available – Structural Unemployment – here is an interesting graph which I have put together from their data. The lack of skills is a common reason for entry-level vacancies in the nine economies below. It seems that employers and those in education don’t communicate much as to the future requirements of labour.
Here is a clip I got from the Tutor2u A level economics blog. From Channel 4 news in the UK it takes you through what some of the 10 million residents in Shinjiazhuang live through – China’s most polluted city. Forced to wear masks every day there are some real concerns especially for the owner of an upmarket apartment block which is situated beside a coal-fired power station.
Here is a great documentary on behavioural economics from PBS – features Richard Thaler – University of Chicago and co-author of Nudge, Gary Becker Univerisity of Chicago, Jennifer Lerner – Harvard – social psychologist. The main model of consumer behaviour assumes that we never buy anything until we’ve calculated the impact on, for example, our retirement fund, and we’re so good at maths we use interest rates to compute our pleasure, over time, after buying something.
At the centre of all the rational models lies an unflinching belief in free markets. The idea is to keep regulation and government interference to a minimum, in both the every day consumer market and in the giant money markets of Wall Street. Rational economists believe that the increase in wealth, worldwide, over the last 30 years, is a triumph for free markets.
With the GFC, the rift in economics widens between the rationalists and the behaviouralists. So which side is right? Are we rational about money, or do our emotions and psychology play a much bigger role than previously realized?
The programme features loads of experiments:
$20 auction. People bid for the $20 but the second highest bidder receives nothing and pays the amount of the losing bid. See what happens.
Answer this question
a) Would you prefer $100 in a year’s time or $102 in a year one day?
b) Would you prefer $100 right now or $102 tomorrow?
Here is a very good website that has leading economists discussing the issues that face the world economy. Articles are short and concise. It is well worth a look.
The Economists’ Club is the consummate forum for the world’s most prominent economists, business leaders, and policymakers to discuss and debate today’s most hotly contested economic issues – from China’s mercantilism and the pursuit of fiscal austerity to the intricacies of financial markets and the future of the dollar and the euro – in a non-technical way.
There has been numerous mentions in the media about the need to reduce the strength of the NZ$. RBNZ Governor Graeme Wheeler outlined some of these in a recent speech. He identified the following policy responses:
1. Lowering Interest Rates
By lower interest rates you may reduce pressure on the exchange rate as long as the new rate is uncompetitive to those in other countries. However a one-off reduction in the interest rate which conflicts wtih the policy of the central bank’s inflation target could lead to expectations of a subsequent reversal. Examples of when it hasn’t work:
Australia – since the end of 2010 RBA cut its official cash rate by 1.75% – no significant impact on the AUS$.
Japan – on the other hand the Yen actually appreicated by over 30% between February 2007 and November 2012 when the interest rates was lowered to 0 – 0.1%.
Switzerland – The Swiss Franc appreciated by 20% between Jan 2010 – July 2011 despite interest rates being lowered between 0 – 0.75%
2. Intervening in the Foreign Exchange Market
The RBNZ have 4 criteria it uses to decide whether to intervene in the foreign exchange market.
1. Is the exchange rate at an exceptional level?
2. Is its value justified?
3. Is intervention justified with current monetary policy?
4. Are market conditions conducive to achieving the desired outcome?
Global exchange rate turnover is between US$4 -5 trillion per day and it is estimated that the NZ$ is the 10th most traded currency in the world. The RBNZ has indicated that it is prepared to intervene but can only attempt to smooth the peaks of the US$ – NZ$ exchange rate.
3. Quantitative Easing – printing money.
This has been adopted by the US central bank in response to teh global financial crisis. However New Zealand was not exposed to risky investments to the extent that other countries were. New Zealand’s challenges are different from those in the US, Euro zone etc. The printing of more money would put upward pressure on inflation, especially asset prices, and ultimately lead to higher interest rates.
4. Cap the exchange rate – the Swiss experience
The Swiss National Bank spent had some success in capping the Swiss franc to the Euro – SFr 1.2 – 1 euro. This woud be very risky for New Zealand – Swiss lost approximately
NZ$35bn in the process. New Zealand would need to intervene to the same extent and the interest rates would need to drop to 0% also. The capping would amount to quantitative easing which with 0% interest rates would be inflationary.
Graeme Wheeler finished up by saying:
The New Zealand economy currently faces an overvalued exchange rate and overheating house prices in parts of the country, especially Auckland. The Reserve Bank will be consulting with the financial sector next month on macro-prudential instruments. These instruments are designed to make the financial system more resilient and to reduce systemic risk by constraining excesses in the financial cycle. They can help to reduce volatile credit cycles and asset bubbles, including overheating housing markets, and support the stance of monetary policy, which could be helpful in alleviating pressure on the exchange rate at the margin.
I picked some interesting statistics from Reserve Bank Governor Graeme Wheeler’s recent talk to the NZ Manufacturers and Exporters Association.
Importance of manufacturing
* share of global GDP fell from 27% in 1970 to 16% in 2010.
* USA 26% in 1970 – 9% in 2008
* Manufacturing employment 62m in 2000 as compared to 45m in 2010
Reasons for the above:
* Global transfer of capital, investment, and technologies
* Competition from Developing Economies – export processing zones with lower taxes and cheap labour.
This trend of relative decline has been common despite differences in economic structures, size and geography, commodity endowments, and exchange rate arrangements and behaviour. For example, since 2000 the real effective exchange rate of the United States has depreciated by 14 percent and manufacturing employment fell by 31 percent.
In New Zealand manufacturing’s share of GDP has trended down:
1980’s = 25%
2012 = 12%