Whilst away on hockey tour in Malaysia I was able to avail myself of the ‘The Straits Times’ newspaper which is published in Singapore. One article that particularly caught my attention was that concerning the creativity of algorithms. Most are oblivious to their creativity yet highly sophisticated algorithms have created music based on the works of great artists but in a style that is personalised and therefore indicative of you the individual. They are also replacing writers – Professor Phil Parker of the Insead Business School in Paris has published more than a million reports on Amazon in just a couple of years. Using a proprietary algorithm that produces a report in 10 – 20 minutes instead of about 4 weeks. The algorithm pulls information from the web, performs econometric analyses, creates tables, formats the report and publishes it as a Word document. Professor Parker has also developed algorithms to produce poems, videos and video games.
Although we could question the efficacy of algorithms on intangible dimensions such as “soul’ and “depth”, one area where they trounce human beings is stock trading. With up to 75% of trades on Wall Street done using computer programmes it is no wonder that algorithms execute trade at lightening speed and carry out numerous transactions every second. On the NYSE the average round-trip transaction time is 600 microseconds. To put into perspective if you blinked it takes you 300 milliseconds to complete the action – during that time NYSE executed 500 trades. This desire to improve efficiency in the market has led to extremely low costs of trading and very high stock liquidity. However it has also produced huge swings in stock prices. On 6th May 2010 – know as the ‘Flash Crash’ – the DJIA fell 9% in minutes but then recovered most of that loss in the subsequent few minutes.
The landscape of society was always made up by this uneasy relationship between nature and man. But now there is this third co-evolutionary force – Algorithms – and we will have to understand them as nature and in a way they are. Kevin Slavin Ted Talk
Another satirical clip from Clarke and Dawe of ABC in Australia, this time on the crisis in Cyprus. I like the idea of the spin cycle with this new model and the impact the crisis is having on Russian investment. Well worth a look
This is something that I have been covering with my Behavioural Economics students.
Behvaioural economists pay special attention to the causes of financial bubbles. Many explanations are offered, but key among them are herding, relative positioning and overconfidence. These psychological factors are sometimes referred to ‘Animal Spirits’ (from economist John Maynard Keynes) or ‘Irrational Exuberance’ (Alan Greenspan former US Fed Chairman) not only create bubbles but also greater volatility in the booms and busts.
1. Following the herd: Decision making in a world of uncertainty
People tend to follow the herd, especially information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets.
2. The role of relative positioning in investor behaviour.
Another cause of financial bubbles is relative positioning, which is a concern people have regrading their own economic and social status relative to other people. Any deterioration is a person’s relative positioning should reduce a person’s well-being. Many people will invest more as share prices increase for fear that otherwise their economic status will fall relative to those who are currently investing and making a lot of money, at least on paper (shares that they own). This fuels further increases in share values, but not on the basis of changes in the fundamental values of the assets. Relative positioning is similar to herding, but people aren’t following the leader. Instead they’re trying to protect their relative economic and social status by keeping up with others in their reference group who are already investing.
3. Overconfidence and underconfidence
Overconfidence is a belief, fed by emotions, that you can predict movements better than you actually can. When you’re overconfident, you’re not as smart as you think you are. Overconfidence tends to lead to great investment in financial assets that you would otherwise. Some economists argue that people invest in assets that they wouldn’t invest in if they considered more objective criteria and weren’t ruled by emotions.
Underconfidence is also emotionally driven. It’s a belief that you have a less capacity to understand and predict asset prices than you actually have. It tends to lead in panic-driven selling of financial assets, causing many people to dump assets they should keep, based on objective criteria.
Confidence is affected by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.
4. Institutional failure
After the recent Global Financial Crisis (started in 2007) economists have emphasised the role of institutions in affecting decision making. Investment decisions that can be bad for society but good for the individual can be a product of the institutional environment. If decision makers face little or no downside risk when making very risky decisions, they’ll take those risks. The recent GFC showed that eventhough corporate decision makers and brokers often bear little or no cost for potentially bad financial decisions or for providing poor financial advice, they still earn significant salaries/bonuses. Why not engage in these behaviours if you come out with a lot of cash. Some people will refrain from behaving this way for moral reasons. But history has shown that plenty of people will make decisions that harm society if those decisions benefit them personally.
This is a classic moral hazard problem where the individual or institution doesn’t bear the costs of the decision. Nothing irrational is happening here, but such behaviour can fuel bubbles and busts and can cause bankruptcies and liquidity crises. Also, if regulations are not well designed, rational decision makers can provide misleading information to clients. Credit rating agencies (Moody’s, Standard & Poor’s, Fitch) were giving AAA ratings (very safe) to financial assets when they were more like BB (junk status). The quality of regulation and its enforcement play an important role in influencing investment behaviour therefore it is imperative that there is more accurate information about investments.
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 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.
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.
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 $147/barrel
10. QE might mean the end of conventional monetary policy. Some countries have discarded inflationary targets and there is no cornerstone for price expectations.
There has been numerous mentions in the media about the need to reduce the strength of the NZ$. 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.
No doubt most of you will be heading to the beach for part of the summer holidays. Here are a couple of books that look like a good read. I will be back on the blog in the middle of January.
Paper Promises: Money, Debt and the New World Order [Paperback] by Phillip Coggan
In today’s financial climate, we are all, naturally, obsessed by debt. In almost every aspect of our life we experience it – on our credit cards, mortgages, bank loans and student loans. But where has this debt come from? How does it work? What is any money really worth? And what promises do we need to believe to keep the whole system afloat?
In this fascinating look at money through the ages – including our own unstable future – award-winning financial journalist Philip Coggan examines the flawed structure of the global finance systems as they exist today, and asks, with deeper imbalances that the world is currently facing, what’s actually at stake. Amazon.co.uk
Winner Take All: China’s Race for Resources and What It Means for the World [Hardcover] by Dambisa Moyo.
Commodities permeate virtually every aspect of modern daily living, but for all their importance—their breadth, their depth, their intricacies, and their central role in daily life—few people who are not economists or traders know how commodity markets work. Almost every day, newspaper headlines and media commentators scream warnings of impending doom–shortages of arable land, clashes over water, and political conflict as global demand for fossil fuels outstrips supply. The picture is bleak, but our grasp of the details and the macro shifts in commodities markets remain blurry.
Winner Take All is about the commodity dynamics that the world will face over the next several decades. In particular, it is about the implications of China’s rush for resources across all regions of the world. The scale of China’s resource campaign for hard commodities (metals and minerals) and soft commodities (timber and food) is among the largest in history. To be sure, China is not the first country to launch a global crusade to secure resources. From Britain’s transcontinental operations dating back to the end of the 16th century, to the rise of modern European and American transnational corporations between the mid 1860’s and 1870’s, the industrial revolution that powered these economies created a voracious demand for raw materials and created the need to go far beyond their native countries. Amazon.com
How Do We Fix This Mess?: The Economic Price of Having it All, and the Route to Lasting Prosperity [Hardcover] by Robert Preston
In Robert Peston’s new book he explains in his characteristically straightforward way how the world got itself into the current economic mess – and how we might get out of it.
‘How do we fix this mess? I don’t know. But don’t stop reading now. Perhaps if we have a clearer understanding of what went wrong, we’ll have a better idea of what needs to be done. This book is a map of what needs to be fixed.’
The record-breaking unbroken growth between 1992 and 2008 wasn’t the economic miracle that it seemed. It was based on a number of dangerous illusions – most notably that it didn’t matter that the UK and US year after year consumed more than they earned.
But we couldn’t go on increasing our indebtedness forever. The financial crash of 2007/8 and the subsequent economic slump in much of the west was the moment when we realised we had borrowed more than we could afford to repay. Amazon.co.uk
2008 – 2010 – approx 10-14 new cases of HIV infections per year among drug users.
2011 – 206 new cases
2012 Jan – Oct – 487 new cases
With the current state of the Greek economy there are more people who are vulnerable and use drugs. Some turn to cheaper drugs and inject them instead of smoking in order to get the same high from a smaller quantity. One of the main methods of controlling the spread of the virus is by the distribution of free, clean needles but the demand for more needles has increased from 50 per addict to approximately 200. However the spending cuts by the Greek government has meant that there is a shortage of basic materials.
Here is a very funny video from Paddy Cullivan who first performed this at Kilkenomics 2011. Worth a look.
Here is a very good TED talk from Shlomo Benartzi. It’s easy to imagine saving money next week, but how about right now? Generally, we want to spend it. Economist Shlomo Benartzi says this is one of the biggest obstacles to saving enough for retirement, and asks: How do we turn this behavioural challenge into a behavioural solution?
Shlomo Benartzi uses behavioural economics to study how and why we plan well for the future (or fail to), and uses that to develop new programs to encourage saving for retirement.
I like this Election Indicator from the NYT which suggests that a healthy performing Dow Jones Industrial Average (DJIA) usually means victory for the incumbent party in the US election. Their chart ranks 28 presidential terms since 1900 – part of the chart is below – complete chart can be found at “US Presidential Stock Markets”.
When the DJIA has risen more than 5% a year the incumbent party has won the election on 11 occasions to losing on 3. When the market fell below a 5% growth rate the incumbent party has lost 8 out of 13 elections.
Obama has been doing well with a compound annual gain of 8.8%.
Michael O’Sullivan wrote an interesting chapter in “Understanding Ireland’s Economic Crisis” about Ireland’s bubble. He talked about the anatomy of a bubble and went through various examples from history. There are 3 stages of the bubble which he describes:
Stage 1 – Favourable shock
The Favourable Shock – in many cases this a change in economic policy or a technological shift. Examples:
The Mississippi bubble – the creation of paper money
Railways booms in the US and UK during the 19th Century
Dot.com bubble – 1990’s
Foreign Direct Investment – Ireland 1990’s
The above events enhance expectations of future economic growth and earning potential. What helps turn the boom into a bubble is the ease of credit – expansionary monetary policy (low interest rates), relaxed lending conditions etc. This then leads to rising asset values which allows corporate and the household sector the ability to take on more debt (leverage). In Ireland real interest rates (Interest rate – CPI) was 0% in 1998-2001 and was approximately -4% in 2000.
Stage 2 – Speculative growth
The Speculative Stage is one where the ecstatic enthusiasm for risk chases high returns and investment becomes speculation. A quote from J.M.Keynes describes the change in mood:
As the bubble gains momentum some people come to believe there is a greater fool who would buy their inflated assets. With this aura of confidence and supporting arguments from the periphery – e.g. “the world has changed” or “this time it’s different” – a mood of speculative optimism becomes rampant. An example of this positive rhetoric was from former Irish Taoiseach (Prime Minister) Bertie Ahern. He stated that those warning of the property bubble should “commit suicide”.
Stage 3 – Irrational Exuberance
Irrational Exuberance starts to dominate the “herd” and often this stage sees the sharpest and most bewildering rise in asset prices. However, there comes a time when this sort of frenzied activity cannot be maintained and eventually the bubble bursts. Most bubbles end with a tightening of monetary policy – higher interest rates – credit controls – limited borrowing potential. For Ireland, as was the case with other economies, the global financial crisis was the “lighting of the fuse”
The Irish Credit Bubble
Morgan Kelly wrote a paper on this and below is a chart from the book “Understanding Ireland’s Economic Crisis” which shows how bank lending assisted the bubble. In 1997 Irish bank lending to the non-financial private sector was only 60% of GNP compared with 80% in most eurozone economies and the UK. By 2008 bank lending grew to 200% of national income. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more as mortgages.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
Nobel Laureate Joseph Stiglitz came out strongly against the recent QE3 by the US Fed and the ECB’s announcement that it would buy government bonds of indebted eurozone member countries. With this announcement stock prices in the US reached post-recession highs although some worried about future inflation and significant government spending. According to Stiglitz these concerns are unwarranted as there is so much underutilisation and no serious risk of inflation. But the US Fed and the ECB sent three clear messages:
1. Previous actions didn’t work – ie QE1 and 2
2. The US Fed announcement that it will keep rates low until 2015 and buy $40bn worth of mortgage backed securities suggested the recovery is not going to take place soon.
3. The Fed and the ECB are saying that the markets won’t restore full employment soon – fiscal stimulus is needed.
In textbook economics increased liquidity means more lending, mostly to investors thereby shifting the AD curve to the right and thereby increasing demand and employment. But if you consider Spain an increase in liquidity will be cancelled out by an austerity package.
For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending. Joseph Stiglitz
Here is a cool graphic from the WSJ that looks at the impact of the US Fed’s monetary policy of dumping trillions of dollars into the economy in order to stimulate economic activity – it covers the period from September 2008 through to today. The graphic shows the impact on the following:
* 10 year treasury yields
* DJIA – Dow Jones Industrial Average
* WSJ US dollar index
Click WSJ Interactive Graphic to go to the page.
The New Zealand Herald last Saturday had a useful article on the importance of the rural sector to the growth of the economy. Brian Gaynor talked of the confidence of the rural environment compared to that of their urban counterparts who are struggling in a very competitive environment. New Zealand’s exports have increased from $7.9bn in 1983 to $46.7 bn today whilst the contribution of meat, dairy and wool have decreased from 53.8% to 37.5%. Although this gives the impression that the rural economy is not holding its own one has to remember that:
Meat, dairy and wool’s contribution has increased from 34.5% to 37.5% during the last 10 years.
If logs, oil, fruit, wine, fish, casein and Tiwai Point’s aluminium are added then exports from the non-urban sector accounts for around 60% of total exports.
The rural sector has a trade surplus with the rest of the world but the urban sector runs a substantial deficit. The increase is residential house prices has been 8 fold but the problem here is that in borrowing to buy a house they are accessing overseas banks. This means that we need to export more and more rural products just to pay the interest on these overseas loans.