A2 Economics – Economic Rent and Transfer Earnings

Economic Rent and Transfer Earnings To most of us “rent” is defined as a periodical payment made for the use of a particular asset – usually a residential or commercial property. However, the concept is not limited to land or buildings because it can also be applied to the other factors of production. When a factor is earning more than its supply price, it is receiving a part of its income in the form of economic rent. This situation arises when demand increases and supply cannot fully respond to the increases in demand. For example, labour already employed will experience an increase in income so that they must be earning more than their supply prices.

Present Wages – Wages when initially employed = Economic Rent

The minimum payment required to prevent a person transferring to another employer or another occupation is know as transfer earnings. It is determined by what the factor could earn in its next best paid employment. Transfer earnings may be regarded as the opportunity cost of keeping an employee in their present job or it may be regarded as the employee’s supply price in their present occupation. For example, if the minimum weekly wage that would persuade someone to work as a shop attendant is $200 but he or she actually receives a wage of $250, then the transfer earnings amount is $200 and he or she is receiving $50 in the form of economic rent. Therefore, economic rent can be defined as any payment to a factor of production that is in excess of transfer earnings.

The graph below shows the demand and supply for labour. The equilibrium wage is $120 with a quantity of 50 units. Total earnings is equal to $120 x 50 units of labour = $6,000 and employees receive the same wage of $120. However, all workers except the last one taken into employment were prepared to offer their services at wages less than $120. Therefore, provided the supply of labour slopes upwards (i.e. it is less than perfectly inelastic) an increase in demand will give rise to rent payments to those factors that were already employed at the original wage of $120. The area of economic rent and transfer earnings is shown in the graph below. Only the last labour unit employed earns no economic rent because the wage of $120 is the supply price to that particular labour unit.

Inelastic and Elastic labour supply

The amount of economic rent and transfer earnings in the return to labour depends upon the elasticity of supply and the level of demand. The greater the occupational mobility of labour, the smaller the element of economic rent. If labour can do a variety of occupations then quite small changes in the wage rate will cause large movements of labour into an industry when wages rise, and out of that industry when wages fall.

Very specialised labour has an inelastic supply curve. This includes surgeons, top CEOs, scientists and jobs that require high skill levels or involve significant danger and skill, eg, deep sea divers. The relatively high rewards to this labour are due to the fact that they are in very scarce supply relative to the demands for their services. Their transfer earnings will be much less than their salary because the market values outside their own specialised professions are probably very low. A frequently quoted example of earnings that contain a large amount of economic rent are those of top sports people. Today these people can earn significant amounts of money in a short period of time. A footballer such as Christiano Ronaldo earns €326 923 per week because of his ability to attract big crowds, merchandise sales and sponsorship deals when he was at Real Madrid Football Club. His skill levels are unique and in very limited supply when considering other players. This reflects a very high marginal productivity leading to a higher wage.

Some other occupations that are held in high regard by society do not command such high salaries because of their low marginal productivity. This includes nurses, firefighters, teachers, etc. Furthermore, the supply of labour for these jobs tends to be elastic because there are many people to choose from, unlike their footballing counterparts who have unique skills.

Quasi rent

Where the supply of labour is less than perfectly elastic an increase in demand will lead to some workers receiving economic rent. This rent may be of a temporary nature, however, because the higher wage may lead to an increase in supply, which in turn, lowers the wage. Increased wages might entice other workers to undertake the necessary training. The economic rent that is earned during the period before supply can be increased is referred to as quasi rent. True economic rent refers to the remuneration of factors that are fixed in supply.

Read more at: elearn Economics – https://www.elearneconomics.com/

Making economics relevant to students

Although a few years old now the mini-documentary below is very good and features many notable economists and economic thinkers. They basically look at the issue of financial stability, or the lack thereof, and discuss what is at the core of the problem. It includes Joseph Stiglitz, Gillian Tett, David Tuckett, Stephen Kinsella, John Kay, David Weinstein, Steve Keen and Dirk Bezemer. I have used this post to try and bring some reality to a lot of prescribed economics courses at high school level.

With the COVID crisis economists have got in wrong in many of their predictions. In New Zealand they stated that house prices would fall by 30%, unemployment would rise to between 15% to 30% and the downturn in NZ would be a lot worse than the GFC in 2008. Auckland house prices have risen by 17% since the outbreak, Unemployment is only at 4.7% and GDP growth expanded 1.6% in the March quarter. There is a very good podcast from Radio New Zealand’s Media Watch programme in which they discuss the problems of economists’ forecasts. Furthermore economists have long proven to be bad at predicting recessions. 

  • A study by the IMF in 2018 looked at 153 recessions in 63 countries between 1992 and 2014 and found the vast bulk of them came as a surprise to economists.
  • The Queen famously asked why nobody noticed the 2008 Global Economic Crisis coming.  
  • In his acceptance speech for the Nobel prize for economics, Friedrich Hayek said economists’ tendency to predict things with the certainty and language of science was misleading and “may have deplorable effects”.

The economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.

According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:

  • confidence in ones’ abilities,
  • moral self-esteem,
  • hope and anxiety reduction,
  • social identity,
  • political ideology
  • religious faith.

Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”

Overconfidence
Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.

If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if 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. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.

The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.

Strategic ignorance is when a believer avoids information offering conflicting evidence.

Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.

Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.

Final thought

People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.

Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted 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.

Sources:

“To err is human; so is the failure to admit it” – The Economist June 10th 2017

“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16

Will China’s dominance be more regional than global?

Below is a very good video with FT’s global China editor James Kynge and FT economics commentator Martin Sandbu. They discuss whether China will dominate global commerce or whether the world economy could split along regional lines. They also give a good account of the growth of China since the 1970’s. The main points from the video follow.:

  • China – major player in the global economy forever more but not the centre of a global economy, partly because other parts of the world will not be keen to let it and global economy starting to become more regionalised rather than globalised.
  • China growth – 1979 to 2018, GDP growth averaged 9.5 per cent a year.
  • Global centre of gravity – last 40 years has moved towards China
  • How did China grow? – late ‘70s market reforms and attracting foreign direct investment. Significant reason was in mid ‘90s, when the sons and daughters of farmers were allowed to migrate from the village to big factory towns. Western countries were pursuing globalisation at the time so China’s cheap production costs were a popular option
  • China still a poor country – ranks 61st and the world in terms of countries by their average per-capita incomes. China is still very much a developing nation. But it’s a very different type of economy, from the type of developed country that we can see elsewhere in the world. China’s middle class – 400m people. But there are a billion Chinese that are much less well-off.
  • China and the middle income trap – getting from poor to middle income is a very different process from getting to middle income to high income.
  • Chinese consumers last year spent about $7.3tn – greater than the entire GDP of the Japanese economy. But now I think we’re entering a very different phase. And that one is characterised by China’s emergence as a technological power.
  • China leads the world in many technologies. – wind and solar power, online payment systems, digital currencies, aspects of artificial intelligence, 5G telecoms, ultra-high-voltage power transmission.
  • Within the world trading system there are three hubs – Germany – China – USA. However trade relationships seem to be more regional within these hubs and it is suggested that China will become more dominant on a regional basis rather than global.

Can low inflation and financial stability reduce inequality?

Martin Wolf of the Financial Times wrote a piece on ‘Monetary Policy is not the solution to inequality’. In it he mentioned that as well as the traditional means of taxation and government welfare spending, can central banks also assist with reducing the level of inequality in an economy? In maintaining aggregate demand (C+I+G+(X-M)) and stimulating economic growth there runs the risk of higher prices and a business cycle that becomes a volatile series of booms and busts – see previous post.

With the housing sector coming under close scrutiny by central banks higher interest rates to reduce house prices would also impact AD and raise unemployment. With some lower income groups living from pay check to pay check this would make matters worse. The graph below shows the impact of taxation and welfare spending has on inequality levels – note China and India. You can see those economies that have a more left wing government policy objective.

Source: FT – Monetary Policy is not the solution to inequality.

Rising inequality had led government’s to choose between higher unemployment or increasing levels of debt by expansionary monetary policy from the central bank. Either you allow people to borrow excessive amounts of money to boost AD or the economy slows and unemployment rises. A better solution could be to reduce the incentive to fund housing etc by the accumulation of debt but with equity financing

Inconspicuous Consumption is the way ahead

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status. Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth.

Claremont Review of Books

Most developed countries cannot be dependent on private domestic consumption in excess of 60% of its GDP. Not only is the planet running out of resources to produce these goods/services but also the impact on climate change is very significant. The essay that won the 2021 Financial Times ‘Political Economy Club prize’ by Krzysztof Pelc outlines that there is a shift in attitudes of today’s consumer. He states that much of the material wealth that people generate is an expression of signalling to others ‘look at me’. In each case this signalling demands some sort of ‘conspicuous waste’ – a highly visible expenditure of resources that brings no material benefit but simply signals the purchaser’s ability and willingness to waste those resources. As there are more things to buy the greater the pressure on people to buy them and thereby increasing the waste and diluting the means of social distinction. The conspicuous consumer could be a thing of the past as loud labels become a shallow human signal with show-off status being gradually replaced by natural-face-to-face interaction and an emphasis on a sustainable planet.

Owning material things from expensive homes to luxurious cars turn out to provide less happiness than holidays, concerts and special occasions. In the long run it doesn’t matter so much about the USA, European economies and their consumption habits but those that are fast growing and with vast populations – China and India. They have a good chance to shift their trait-display systems before conspicuous consumption becomes locked in as a cultural norm.

The recent global downturn with Coivd-19 has sent out a few mixed messages. Firstly there has been the reduction in consumption as people’s credit lines have dried up but there are those that believe that you should spend more to maintain growth and employment in the economy. With household budgets being very tight smarter consumption rather than less consumption has been advocated by Geoffrey Miller in his book ‘Spent’. He refers to this as more ethical consumption where the production of produce does not involve the abuse of natural resources or the exploitation of people or animals. Furthermore a need to switch from an income tax that promotes short-term runaway consumption to a consumption tax that promotes longer-term ethical investment, charity, social capital, and neighbourly warmth.

“affluent economies such as Britain’s have already reached a point at which further advances in wellbeing are not likely to come from a single-minded focus on growth.” Krzysztof Pelc

Euro 2020 action bias and penalty kicks – is it best if the goalkeeper does nothing?

With the Euro 2020 now over and games including the final decided on penalties I thought it would be appropriate to look at the psychology of penalty kicks. Would goalkeepers be better not moving when facing a penalty?

Action bias is a situation where we would rather be seen doing something than doing nothing. This has been the case in numerous government elections as the voting population like to see some action from politicians when in some cases the best option is to let the economy run its course. President Nixon (US President 1969-74) was a great one for doing something even though it would have been better to do nothing – I refer to the wage and price controls introduced in 1971 – the controls produced food shortages, as meat disappeared from supermarket shelves and farmers drowned chickens rather than sell them at a loss. So when the economy is doing badly the government maybe tempted to intervene, even if the risks associated with the changes not necessarily outweigh the possible benefits. Furthermore if an economy is doing well policy makers may feel that they shouldn’t do anything even though the changes could improve the economy further.

According to classical assumptions in economics, when people face decision problems involving uncertainty, they should choose what to do according to their utility from the possible outcomes and the probability distribution of outcomes that follows each possible action. Bar-Eli, Azar, Ritov, Keidar-Levin, & Schein, 2007

In a 2007 study, Michael Bari-Eli at the Ben Gurion University of the Negev, Israel, analyzed 286 professional soccer penalty kicks. They discovered that goalkeepers almost always jump right or left because the norm is to jump — a preference for action (”action bias”). The goalkeepers jumped to the left 49.3% of the time, to the right 44.4% of the time, but stayed in the centre only 6.3% of the time. Analysis revealed that the kicks went to the left 32.2%, to the right 39.2% and to the centre 28.7% of the time. This means that the goalkeepers were much more likely to stop a kick if they had just stayed put – see table below.

The table above suggests that the decisions taken by the kicker and goalkeeper are made roughly simultaneously. The fact that the directions of the kick and the jump match in 43% of kicks rather than in 0% or 100% of the kicks suggests that neither kicker nor goalkeeper can clearly observe what the other chose when choosing their action.

A goalkeepers’ decision making.

In order to suggest a best option for goalkeepers it is necessary to examine the probability of stopping the ball following each combination of kick and jump directions. The table below presents the average saving chances using the formula

Number of penalty kicks saved ÷ Number of penalty kicks x 100

Jumping left = 20 ÷ 141 x 100 = 14.2%
Staying Centre = 6 ÷ 18 x 100 = 33.3%
Jumping right = 16 ÷ 127 x 100 = 12.6%

The research conclusions state that goalkeepers jump to the right or the left during penalty kicks more than they should. In analysing the 286 kicks Bar-Eli et al show that while the utility-maximising behaviour for goalkeepers is to stay in the goal’s centre during the kick, in 93.7% of the kicks the goalkeepers chose to jump to their right or left. This non-optimal behaviour suggests that a bias in goalkeeper’ decision making might be present. The reason that they suggest is ‘action bias’. However you also need to look at the psychological aspects of a goalkeeper. Former Arsenal and Chelsea goalkeeper Petr Cech said that he never liked to stay in the centre as it might look to the fans that he wasn’t trying. Although he would be in a good position to save a penalty that was kicked down the centre, he would feel a lot worse if he stayed in the centre and the ball went into the goal either side of him.

Sources:

Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks. Journal of Economic Psychology, 28(5), 606-621.

Why has global inflation been on the rise?

Global inflation has been on the rise over the last year and there are various factors behind this increase:

  • Global supply chain problems – empty containers being located in the wrong ports as a result of COVID-19 and issues like a shortage of microchips impacting the supply of cars. Add to that the increase in oil prices and freight charges as many ports closed down. The Chinese port of Yantian (the world’s third busiest port behind Shanghai and Singapore) was closed for a period of time. This alludes to a huge backlog in freight which won’t be cleared until well into 2022. According to the Baltic Dry Index the cost of moving raw materials by sea has risen by 194% since December 2020.
  • Boom for consumer goods in lockdown – in order to make life more bearable there was big increase in demand for cars, furniture, household appliances and other items. This boom in durable goods coincided with a constraint in supply
  • Labour supply constraints – with the borders being closed countries found that the normal inflow of labour was not available. This was especially prevalent in the low income service sector and amongst primary industries – fruit pickers etc in New Zealand.

Central bankers have wondered why inflation has remained so low and if they can reach their targets – 1-3% RBNZ. However as America has discovered even with record low interest rates an expansionary fiscal policy (lower taxes and increased government spending) will have a desired effect on prices. The challenge is to ensure that prices don’t spiral out of control. The question now is whether the higher levels of inflation will remain when the supply chains return to normal and supply can keep up with demand. Or will we see higher inflation as the norm within the global economy.

Business cycle or volatile booms and busts? The four stages of the bubble.

I picked up this graphic and explanation from The Geography of Transport Systems by Jean-Paul Rodrigue (2020)

It is apparent that business cycles aren’t those smooth ups and downs as depicted in a lot of textbooks but more volatile with booms and busts. Central banks appear to play their part in this process with the low cost of borrowing feeding the boom phase of the cycle. Instead of economic stability regulated by market forces, monetary intervention creates long-term instability for the sake of short-term stability.

Bubbles (financial manias) unfold in several stages, an observation that is backed up by 500 years of economic history. Each mania is obviously different, but there are always similarities; simplistically, four phases can be identified:

  • Stealth – emerging opportunity for future prize appreciations of investments. Investors have better access to information and understand the wider economic context that would trigger asset inflation. Prices tend to increase but are unnoticed by the general public.
  • Awareness – many investors start to notice the momentum so money starts to push prices higher. There can be sell-offs but the smart money takes this opportunity to reinforce its existing positions. The media start to notice that this boom benefits the economy.
  • Mania – the public see prices going up and see this a great opportunity to invest with the expectations about future appreciation. This stage is not so much about reasoning but psychology as money pours into the market creating greater expectations and pushing prices up. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going. At some point, statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.
  • Blow-off – everyone roughly at the same time realises that the situation has changed. Confidence and expectations encounter a paradigm shift, not without a phase of denial where many try to reassure the public that this is just a temporary setback. Many try to unload their assets, but takers are few; everyone is expecting further price declines. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged asset owners go bankrupt, triggering additional waves of sales. This is the time when the smart money starts acquiring assets at low prices.

Cost-Benefit Analysis of the Auckland Harbour cycle bridge

Reading Michael Cameron’s blog this morning I was intrigued to read that New Zealand’s Transport Minister Michael Wood did not provide the cost-benefit data when he announced the new $785m Auckland harbour cycle bridge earlier this month. However it has now been revealed the initial assessment by Waka Kotahi is only 0.4 to 0.6. That meant for every dollar spent on the bridge, there would effectively be a 40 to 60 cent loss. If a project is less than 1.0, the project’s costs outweigh the benefits, and it should not be considered.

You wonder about the rationale for this amount of expenditure when there is an opportunity cost – money that could be spent on the areas that seemed to be constantly deprived of government funds e.g. Health (especially with the vaccine rollout), Education etc.

Evaluation of Cost-Benefit Analysis
It is clearly more efficient for public spending to be subject to rigorous analysis, rather than based on the whims of politicians. However, there are a number of criticisms of CBA when projects are given the green light

1. It is often very costly to undertake, though usually this forms a very small proportion of total project spending.
2. Assessing the monetary value of external costs and benefits is often very difficult. What precisely is the value of the congestion that would be reduced if a new bi-pass were built around a busy town? How much extra tourist revenue will actually be gained from a new airport? How long will the building be used as a venue, as in the case of the Viaduct area in Auckland for the 2020/21 America’s Cup. One solution to this problem is shadow pricing, where analysts attempt to place a value on the costs and benefits of a decision or a project where an actual market price does not exist.
3. Changing circumstances can make initial projections appear grossly inaccurate. The Wembley Stadium project in London went considerably over-budget, and the majority Olympic Games are far more costly than originally estimated. For instance the Montreal Olympics in 1976 was eventually paid off in December 2006. Higher interest and inflation rates, and falling exchange rates can all dramatically affect costs.
4. Actual costs can also rise above planned costs as a result of moral hazard, where project managers go over budget because they expect that those who fund the project will make extra funds available, providing an insurance against their over-spending.
5. Ultimately, decisions to go ahead with projects are only guided by CBA, leaving politicians to make the final decision. Politicians are free, of course, to ignore the results of an appraisal. It looks like they have with the cycle bridge.

Black Caps Test Champions and positive externalities

In 2019 I stayed up all night to watch the Back Caps lose the World Cup One-Day final in England in what was such a bizarre finish and one felt for Kane Williamson and the side. However two years later and all has been forgotten as the Back Caps become the first ever World Test Champions. Captain Williamson like Richie McCaw, a humble character, has led from the front and just goes about his work in a quiet manner.

Black Cap supporters will take great pleasure in talking about such a result but what all this alludes to is the fact that as part of this entertainment comes without the public paying for it, the public benefits from an externality.

Those who were able to travel to Southampton for the game and will have no doubt spent a significant amount of British pounds tonight in the bars and restaurants around town. Nevertheless the satisfaction (utility) derived in pounds from the game would have been much greater than the price they paid for the ticket. This suggest that there is a lot of consumer surplus present – the difference between the price that a consumer WOULD BE WILLING TO PAY, and the price that he or she actually HAS TO PAY. Furthermore the lead up to the game brings about a sense of delayed gratification (Behavioural Economics) especially after the disappointment in 2019 World Cup. Research (Smarter Spending – see previous post) shows that owning material things from expensive homes to luxurious cars turn out to provide less pleasure than holidays, concerts or even witnessing the Back Caps winning the first ever Test World Cup – where were you when the Black Caps beat India in Southampton? With New Zealand’s win national pride increases, along with patriotism and people feeling better about themselves. This in turn brings people together and boosts well-being of the nation.

Could there be Demand-Pull inflation in New Zealand?

The recent GDP figures the March Quarter 2021 and the Annual figure were significantly different from those predicted by the Reserve Bank. The key component of GDP is Private Consumer Expenditure which increased way above the 0.5% of the RBNZ – see table.

This no doubt encouraged more investment which saw an increase by 15.5%. This suggests that the economy is creeping towards the threat of demand-pull inflation – i.e. the economy is running hot and demand is outstripping supply – see graph.

Source: BNZ Markets Outlook.

While New Zealand’s GDP growth might pale against global comparisons this year, it’s already strong enough to be telling of rapidly diminishing economic slack and rising core inflation. Indeed, that excess demand is now arguably the order of the day in NZ, partly as the ability to supply goods and services is compromised in many ways, compared to pre-COVID times.

Furthermore the weakening NZ$ – has made exports cheaper. This is also part of the overall aggregate demand in the economy. So with C+I+G+(X-M) all increasing there is pressure on the supply-side. The NZ trade-weighted exchange is at 73.2 this morning whilst the RBNZ forecasted 75.3. However predicting anything in an economy today is very difficult considering what we have experienced with COVID 19.

TWI – An index that measures the value of $NZ in relationship to a group (or “basket”) of other currencies. The currencies included are from NZ’s major export markets i.e. Australia, USA, Japan, Euro area, UK, China. – $A, $US, ¥, €,  £, Yuan.

With this, there are cracks appearing amongst central banks around the world, as to how long they can reasonably continue with their extreme monetary policy settings. Interest rate markets have been asking the question and at least some central bankers have now given a bit of ground –notably the US Federal Reserve last week. Yes, there is still the debate about how much of the ramp-up in headline CPI inflation, globally,is transitory. However, there is also the fundamental question of whether underlying inflation is firm enough, and labour markets recovered enough, to recommend policy rates to start to normalise, whatever that means. It’s a different question, with more important implications.

Source: BNZ Markets Outlook

New Zealand looks to UK and EU for export markets

Concerned with a dependence on the Chinese market for its exports, New Zealand has agreed to the implementation of trade deals with the UK and the EU. Negotiations have been going in the background of rising tensions in the Pacific especially between China and Australia. However being too reliant on one market is a risky business as is depending on one resource to generate export income – the resource curse.

Background to New Zealand’s trade with China
On 7th April 2008 New Zealand became the first OECD country to sign a free trade deal with China. However this is not the only first with regard to the relationship between the two countries. New Zealand was the first to negotiate a WTO accession agreement with China as well as the first to recognise China as a “market economy”. With this in mind, the Chinese government have acknowledged the support of New Zealand by granting them the first bi-lateral agreement with a western nation.

Today China is New Zealand’s largest trade partner, accounting for NZ$19bn (US$13.5bn) exports in the year to the end of March, a quarter of its total exports. The deal with the UK would involve tariff cuts on New Zealand farm exports including dairy, lamb and beef but this would be a concern for UK farmers especially as they have now left the protectionist EU subsidies.

New Zealand trade destinations – March 2020 – March 2021

Source: FT

The Pound, the Exchange Rate Mechanism (ERM) and George Soros pockets $1bn

Teaching  exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM). The video below explains the drama that unfolded very well.

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in relation to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Impact of an appreciating currency

Currently looking at exchange rates with my AS class. Below is a mindmap showing the causes and effects of a rise in the value of a currency. Also looks at how a rise in the currency may reduce inflationary pressure. Good for revision purposes when dealing with exchange rates and trade. Also gives a structure for essay questions / long answers in CIE and NCEA respectively.

Adapted from CIE A Level Revision by Susan Grant.

The New Corporation – Documentary

Following on from the very successful documentary ‘The Corporation’ comes ‘The New Corporation’. The Corporation​ examined an institution within society. THE NEW CORPORATION reveals a society now fully remade in the corporation’s image, tracking devastating consequences and also inspiring movements for change. Click on the link below to view screening options – The New Corporation

The Supercycle and MMT

I listened to a very good interview on the David McWilliams podcast in which he talks with Dario Perkins the super cycle and the end of neoliberalism. A lot of the discussion was around the paper that Dario Perkins had written – A New Supercycle Running on MMT – in which he sees MMT as delivering a superior fiscal-monetary mix.
The fact that fiscal policy must take over from monetary policy has been the apparent with the range of policies that were implemented after the GFC. Since the late-19th century the super cycle can be placed into three phases of Capitalism influenced by macro-financial-political regimes – see chart below. MMT could provide the intellectual rationale for a new form of capitalism – Capitalism 4.0. Over the last century the pendulum has swung between extreme fiscal and extreme monetary policy with the global economy primed for another change.

1920’s – Monetary policy dominated but ineffective during the Great Depression
1930’s – Fiscal policy dominated as there was a need for government intervention to get the economy moving after the Great Depression
1940’s – 1960’s – Fiscal Policy – with the 2nd World War and the recovery process post-war.
1970’s – Stagflation and fiscal policy is no longer effective and Keynesian economics as government spending just causes higher inflation and higher unemployment.
1980’s – Monetary policy gains traction and inflation is brought under control. Central Banks become independent and fiscal policy and government intervention is seen as a restriction to growth. With Reagan and Thatcher Neoliberalism was the ideology of the day

Source: A New Supercycle Running on MMT

Have we reached a new regime – Capitalism 4.0?
The GFC was a warning that capitalism in its present form was not working and there was potential for a new regime change. However governments adopted austerity and QE which made inequality worse. The issue was that there was no alternative to the neoliberalism Capitalism 3.0 but with the arrival of COVID-19 governments have been forced to spend up large and there is a belief that the old system doesn’t work and that maintaining Capitalism 3.0 will not make the situation any better. Stephanie Kelton, author of The Deficit Myth, argues that we need to rethink our attitudes towards government spending.

Modern Monetary Theory (MMT)
MMT states that a government that can create its own money therefore:Cannot default on debt denominated in its own currency;

  • Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
  • Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
  • Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
  • Does not need to compete with the private sector for scarce savings by issuing bonds.
  • Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

It will be interesting to see if MMT can enjoy the same presence in economic policy that monetarism and Milton Friedman experienced in the post-stagflation time period. Back then there was a political revolution primed to embrace monetarism and neoliberal ideas and an electorate that had experienced a serious economic crisis – stagflation. Subsequently the influence of MMT will come down to politics.

Joe Biden seems to have embarked on a more radical macro-economic policy which has various instruments that are found in MMT. Will there be other political leaders who embrace this paradigm like Reagan and Thatcher in the 1980’s with Friedman and monetarism?

Source: A New Supercycle Running on MMT

Behavioural Economics course for school students

At various stages of my teaching I have delved into the area of Behavioural Economics as it is part of the CIE A2 course and from a personal interest perspective. I have attached a course booklet that consists of lesson plans on various topics and resources that are required to supplement the course. Click below to download the course notes and workbook. If you would like the PowerPoints that complement the course please email me – m.johnston@kingscollege.school.nz – and I will forward them on. Ideal for those Friday afternoon classes.

Behavioural economics is about bringing reality into economic analysis. It borrows from psychology, sociology, politics, and institutional economics (which focuses on the rules of the economic game) to describe and explain human behaviour and economic phenomena. Behavioural economics builds upon conventional economics, offering more tools for understanding why people behave the way they do when it comes to income, wealth, ethics, and fairness. It uses prospect theory to describe the choices that the typical person makes. The course is split up into 4 topics and is designed for approximately 12 periods in length.

1. Understanding Choice

Free choice in Economic Decision Making – Nudging – Anchoring and Framing – Free – Placebo Effect – Paradox of Choice – Loss Aversion and Endowment Effect – Conventional v Behavioural Economics

2. Ethics and Economic Growth

Ethical Behaviour – definition – Milton Friedman and ethical behavior – The Conventional – Perspective on Ethical Behaviour and the Economy – A Good Company – Ethics / – Happiness – Examples of Companies with socially responsible norms – Ethics and Profits
Ethical consumers

3. Behavioural Finance

Definition – what is it? – Efficient Market Hypothesis – Random Walk Hypothesis – Irrational Exuberance – Bubbles and Busts – Tulip – Great Crash – Dot.com – 2008 Global – Financial Crisis – Causes of Bubbles

4. Game Theory

Introduction to Game Theory – Football – Penalty Shoot outs – Golden Balls Game Show

5. Money and Happiness

Conventional Theory – Money = Happiness – Measuring Happiness – Gross Domestic Product v Gross National Happiness – Diminishing Returns for Income and Wealth
Easterlin Paradox: Money doesn’t buy happiness
– The Hedonic Treadmill – Money leads to more happiness but not for too long – Differences in happiness between countries – Government Policy and Happiness- Smarter Spending

Sources:

Behavioural Economics for Dummies – Morris Altman
Thinking, Fast and Slow – Daniel Kahneman
Economic Naturalist – Robert Frank
Nudge – Richard Thaler & Cass Sunstein
Inside Job – DVD
Black Gold – DVD
The Corporation – DVD
How Algorithms Shape our World – TED Talk

Degrowth – is life better with less?

Most economics courses will include the topic of limitations of Gross Domestic Product as an indicator of standard of living. US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile. Increasing GDP has been the indicator of a healthy economy but is it time for degrowth? This CNBC video looks at whether degrowth is the way forward and should we priorities social and ecological well-being? Scotland, Iceland and New Zealand have focused on well-being rather than economic growth. New Zealand’s recent ‘well-being’ budget indicated this. Good video for the future direction of macro policies and where we are going as a society.

The New Inflation Threat – Cost Push and Demand Pull – should we be worried?

If you are teaching macro policy this podcast from the BBC Business Daily programme is excellent. They debate whether inflation will be a short-term phenomenon or have a longer lasting impact on the global economy. It features Mohamed El-Erian, economic adviser and president of Queens’ College, Cambridge, who thinks central banks are already behind the curve when it comes to keeping inflation in check. Dana Peterson of the US Conference Board takes the view that it will be temporary. They also interview a restaurant owner Luke Garnsworthy. Now that England’s third lockdown has mostly lifted, customers are itching to spend and he can’t find enough staff for his kitchens. But, he says raising prices and wages isn’t an option for him. The key points from the podcast are below:

Demand Pressures
A year ago the global economy was in shutdown mode with no demand as consumers had nowhere to go. However with significant spending by governments to support those who have lost their job and the fact that people can’t spend has meant that there is a lot of pent up demand waiting to unleash itself on the market. Now that a lot of countries have opened up their economies, aggregate demand is surging and making up for lost time. This has been a surprise to many but something that is likely to continue especially in those countries that are able to contain the virus and vaccinate their citizens.

Supply constraints
Many supply chains have been slow to return to their pre-covid volume. Problems with containers, availability of container ships have made it very difficult for producers to access component parts, raw materials etc. Commodity prices, eg oil, are on the rise accompanied by semiconductor chip shortages and the Suez Canal tanker incident have caused both businesses and consumers to worry about rising prices.

Countries like Bangladesh, India and Vietnam are central to the global supply chain but the severe nature of the pandemic in these countries has added another bottleneck.

A further problem is the lack of available labour which has resulted in some firms increasing their wages in order to attract workers – Amazon and McDonald’s have done this. But higher wages are unlikely to compensate for structural unemployment – mismatch of skills – which has been very prevalent. In order to compensate for these increasing costs companies will be tempted to put up their prices.

But should we be worried?
Dana Paterson, chief economist at The US Conference Board, believes that the long-term threat of inflation is exaggerated. She suggests that prices are rising in areas that were very popular during the pandemic but as it subsides consumers will switch their spending to other areas that wasn’t possible during the pandemic – eg. bars, restaurants, movies, theatre etc.

The emergence of working from home should offset some of the minimum wages increases in some economies as employees can save on commuting costs and move to cheaper accommodation. Businesses can also save on office space and hire more workers from low-cost areas.

The rise of e-commerce has generated more competition and has helped to keep prices lower. International supply chains, outsourcing and the likely continued relative strength of the US dollar will work to keep prices down. The US Fed view higher prices as a healthy economy and want to see it rise above its 2% target before increasing interest rates. Also tolerating more inflation gives the Fed time to meet its full-employment mandate. There should be more concern about the type of inflation that becomes prevalent – asset price inflation. This is especially true in New Zealand.

New Zealand benefiting from high commodity prices.

New Zealand’s commodity prices have increased by 17% this year and is expected to increase by 22% by December 2021. What has caused this increase in prices? With Covid restrictions lifted in many countries this has seen an increase in demand especially from China and South East Asian countries. Dairy, horticulture and forestry commodity prices have been the big winners. Kiwi fruit returns are expected to be the highest on record and log prices have increase over 20% in the last 6 months. Furthermore with the opening up of restaurants in the northern hemisphere the demand for meat will undoubtedly increase which is a good omen for sheep and beef farmers. At this time of year lamb prices normally fall but prices have actually increased over April and May.

Shipping costs have been very high of late but as they start to come down with more supply this will be a further boost to exporters especially bulky exports like forestry. It is expected that wood export volumes will be approaching record high levels over 2021 and 2022. The strong return from commodity prices will mean higher national incomes and will support the strength of the NZ$ and interest rates.

This could be a honeymoon period for New Zealand exporters as supply will eventually catch-up with demand and bring down prices. From a longer-term perspective, environmental constraints are biting on global food production. New Zealand’s dairy sector is at the coal face and the demands by government for fencing and other environmental restrictions means that there is less land being used and lower stock numbers. Other dairy exporters in Europe are also experiencing the same restrictions and it is the consumer who is likely to bear the increase in costs with higher retail prices.

Source: Economic Overview. Reshaping the world. May 2021