Saturday, November 29, 2008

Unemployment and the Bumpy Ride Ahead

The Australian Skilled Vacancies Index (SVI) is a monthly indicator updated by the Department of Education, Employment and Workplace Relations. It is based on a job vacancy report from various industries and occupations including the trades. It can be treated as a leading indicator for unemployment.

The chart below depicts the inverse relationship of the index with the unemployment rate. Note SVI is lagged six months, meaning the levels indicated for unemployment, say in the last observation, October 2008 is actually matched with the value for SVI back in April (hence the predictive potential of the indicator).

Source: ABS Trend Unemployment Rate, Australia, October, 2008 (Cat. 6202) and DEEWR Vacancy Report November, 2008

The reason for this sequential relationship? Labour economics tells us that the costs of acquiring skilled labour cause employers to smooth their hiring decisions during peaks and troughs in the economic cycle (see Walter Oi's article, Labor as a Quasi-fixed Factor, in the Journal of Political Economy, Chicago Press, 1962). In a down cycle, they will maintain their skilled workers for as long as possible instead of laying them off. During upswings they do not necessarily start hiring as a certain amount of "slack" has been pent up from the low season. So the skilled vacancy reports can be used as an early warning device for predicting future employment conditions.

The problem? The most recent reports show the index diving to its lowest levels in recent times. The early November report has SVI at 65.6 where dipping below the base (of 100) signals a decline. This is a bad omen especially since the downward trend has yet to hit a bottom. Even if we are to assume fiscal stimulus and monetary easing occurs this December, the sheer momentum of the current mood will see unemployment inching back up from 4.3 per cent in October to about 6 in May next year (according to our estimates).

There are of course other factors such as interest rates and industrial relations policy that need to be considered, but all other things being equal, we are in for a bumpy ride ahead. (For those who would like to read a more detailed forecast of where it is headed, please send me an email, and I can provide you with a more technical presentation of the model that underpins the analysis).

Saturday, November 22, 2008

New Expectations in Monetary Policy

The ridiculous entries in and reactions it receives (from Paul Krugman no less) demonstrate the decline in confidence that Americans have come to regard both the US Fed Chairman Ben Bernanke and Treasury Sec. Hank Paulson with. So much so that the unexpected announcement by the Obama transition team of the appointment of a new treasury chief in the person of current NY Reserve President Timothy Geithner was all that was needed to generate a much needed lift late Friday after a near disastrous week on Wall Street.

Here in Australia, the monetary and fiscal authorities have been keen to do a similar two step as the Americans with the same limited effect. Back in May of this year, the RBA was put under scrutiny over its decision to raise interest rates. Having shown its audacity in doing so during the election season that toppled the Howard government, it was given the imprimatur by Treasurer Wayne Swan who in declaring a war against inflation since taking office set the tone for monetary and fiscal policy to be on coordinated footing.

It didn't matter that Joseph Stiglitz, a Nobel Prize winning economist had been appearing on local TV regarding the Australian situation on inflation and the policy on inflation targeting which he predicted would be abandoned within five years because of its inefficacy to deal with the importation of inflation through petrol and food prices.

The defense that it was the commodities driven terms of trade boom generating price inflation notwithstanding, the oracle of Stiglitz has been proven true in less than six months with the higher than anticipated RBA cut of 100 basis points and further cuts in the offing, despite inflation exceeding the upper band of the 2 to 3 percent range. Why is it then that macroeconomic policy makers often fail to get their settings right?

Could it be that they are still operating under a misguided view of the world that sees agents as purely rational? To what extent do adaptive rather than rational expectations play a role in resolving the problem?

Saturday, November 15, 2008

The triumph of Krugman’s Economic Geography over Porter’s Industry Clusters

(WARNING: Readers of the following may experience minor bouts of dizziness resulting from a re-balancing of mental perceptions of what governments can and cannot do. These symptoms should ease after a day or two. Should they persist, consult any handbook on new international trade theory for relief.)

He is probably the foremost economics blogger to win the Nobel Prize for his theoretical work on international trade and economic geography. Princeton Professor, Dr Paul Krugman in a succinct, yet elegant manner, explains both the sectoral and spatial implications of global production, something that Porter attempts with 800+ pages but fails at achieving the same level of clarity.

Both men began their work at relatively the same period in the late 70s. Of the two, it was Porter who gained prominence and notoriety in the speaker’s circuit for his depiction of competitive forces, which can be regarded as industrial organization for dummies.

While Krugman sought to explain the specialization of regions in producing certain goods deductively through mathematical reasoning, Porter used induction, studying specific cases of concentrated clusters of industry activity. The result is that Krugman provides a policy tool that is easily wielded unlike Porter’s bulky analysis.

Mercantilist Revival

Applied to the firm, Porter’s notion of strategic competition has its use. But when public policy tries to appropriate the same approach to cities, regions and countries, it loses validity according to Krugman. In fact, he calls those who seek to improve the competitiveness of a place to the detriment of all others Mercantilists.

The notion that we can drive up exports by competing as firms do through Strategic Trade Policy is beset with all the pitfalls of selective government intervention. Although it may have had a few instances of success, when applied more broadly the impacts are too minute, while the chances of getting it wrong and the costs associated with failure are too big to ignore.

Porter takes us through several hundred years of history in which nothing is guaranteed to reiterate even if conditions could somehow be duplicated today. Around the world, there are thousands of government supported science parks and export processing zones intended for cluster development, but a few successful ones truly produce value creating innovation. They are usually informal networks that came about more from benign neglect than through selective intervention, i.e. the software hubs of Bangalore India did not have a decent ICT infrastructure during its genesis.

Monday, November 10, 2008

The death of BRICs and decoupling?

The announcement by China of a 4 trillion yuan stimulus package (approaching the size of the entire Australian economy) has provided the clearest signal that the BRICs theory could be coming to an end and with it the idea of decoupling.

The BRICs Dream

It was in the wake of events in Septemeber of 2001 that investors searched for ways to spread risk and rebalance their portfolios heavily weighted towards advanced markets. Jim O’Neill, an economist at Goldman Sachs, in a paper entitled Dreaming with BRICs coined the now ubiquitous term and created with it the theory of decoupling: the notion that European and emerging economies, such as Brazil, Russia, India and China (BRICs), have diversified and deepened enough to sustain growth during economic downturns in the US.

From 2003 to 2007 the idea was holding up pretty well. The rapid climb of the BRICs was breathtaking. The world economic tables compiled by Angus Maddison gave a stunning picture of the “arc” that China in particular was following in its industrialization. Germany and Japan were notching up respectable growth figures at last. The US economy was well on its way to full recovery with a series of tax cuts and low interest rates. Things were looking pretty solid.


Then as the first wave of repricing of sub-prime mortgages began in late 2007, things began to unravel quickly. Global fund managers and banks in a synchronized manner started to re-examine, declare and write-down their exposures linked to these mortgages.

At the annual World Economic Forum in Davos, Switzerland, CNN’s Richard Quest began polling participants on their views regarding the possible contagion effect the US housing crisis would have on the rest of the world. Those who projected a slowdown edged out the doom sayers who saw a prolonged recession.

At the conclusion of the forum, the International Herald Tribune ran a piece called Decoupling: Theory vs. Reality. The message was that only a partial decoupling had occurred. As America sneezed, Europe would not catch a fever, just a mild cold, neither would Asia contract pneumonia, just the flu. This prognosis rested on the case that China could not substitute fully domestic consumption for lost exports and that investors had oversubscribed Chinese shares in the five years since the BRICs Dream came out.

The IMF as late as June of this year, released a study called Convergence or Decoupling supporting the notion that decoupling and integration could actually occur simultaneously. From 1985, globalization has brought about greater integration and increasing finance and trade flows among countries. This has led to the coupling of business cycles among countries with similar levels of per capita income, but evidence of decoupling for groups of countries at various stages of development was also found.

Then the September surprise on Wall Street hit beginning with Merrill Lynch, Lehman Brothers, and AIG. Synchronous market gyrations, recession stalking a number of EU members followed by the slowing of Chinese and Indian growth prospects have all but eclipsed the decoupling thesis. A briefing paper entitled Synchronised Dive into Recession prepared by the International Economics Programme of the UK-based think tank Chatham House in October has said:
(u)p to mid-2008, the emerging markets remained strong – ‘decoupling’ did work. Now the crisis has deepened, no region will remain immune to shock waves.
In other words, all bets are off!

Saturday, November 8, 2008

Mapping Happiness

This intriguing diagram was taken from a publication of the World Values Survey Association, a global network of social scientists committed to cross-cultural mapping of societies in all of the inhabited continents of the world.

What is striking about it is that after conducting interviews with representatives of 80 societies from 1981 to 2007, each national sample consisting of 1,000 participants, covering 85 percent of the world's population, the results remain stable over this time (i.e. movements have been slow).

You can conclude that the results confirm the importance of two things:

Institutions. The new institutional economics (NIE) school tells us that individuals and groups in society structure and organize their dealings in a manner that reduces costs to them (the so called transaction cost approach). Social norms and expectations (a.k.a instituions) are a way of enforcing stability and regularity. Because these arrangements suit the interests of both parties transacting, they are expected to endure much longer than any formal legal or political dispensation.

Inertia or status quo bias. Behavioral science tells us that much as we would like to think of ourselves as rational agents, our behavior is affected by what we perceive others think and expect of us. Thus, we might persist in customary practices even when the original incentive for it has gone. This makes the case for institutional change even more difficult to make.

Difficult perhaps, but not impossible nor uncommon. One key finding of the WVS is that

since 1981, economic development, democratization, and rising social tolerance have increased the extent to which people perceive that they have free choice, which in turn has led to higher levels of happiness around the world, as the "human development" model suggests.

The new discipline of lists and scorekeeping

Alas, five hundred years since Europeans circled the globe, we are told anew and for a different reason that “the world is flat”. Cities, countries and regions are in competition with each other to attract people, money, knowledge and know-how in a manner that enhances their quality of life without detracting from their sense of place or unique vibrancy. Enter the new discipline of lists and scorekeeping to provide the metrics that help us decide where we should locate our careers, our money, and our lives on this planet.

Most Prominent Types of Scorecards

We compiled a list of some of the most widely used world indexes around. We found a great deal of variety in the types and categories available. Here it is (and if you are aware of any more, do add them to the list):

Human development Index

Creativity Index

Subjective Well-being Index

World Competitiveness Scorecard

Entrepreneurial Activity Rates

Logistics Performance Index

Growth Environment Score

Index of Economic Freedom

Global Peace Index

Freedom in the World Index

Global Hunger Index

Happy Planet Index

Global Competitiveness Index

Global Gender Gap Index

Global Enabling Trade Index

Travel and Tourism Competitiveness Index

Global Information Technology Index

Financial Development Index

Worldwide Governance Indicators

Ease of Doing Business

Environmental Sustainability Index

World Health System Ranking

Impunity Index

Climate Risk Index

Global Integrity Index

Press Freedom Index

Foreign Direct Investment Performance Index

Friday, November 7, 2008

Smart Intervention

With the conclusion of the American electoral cycle conducted amidst one of the most severe economic storms the globe has seen since the Great Depression, many are suggesting that the repudiation of the GOP at the polls in both the presidential and congressional races means that the era of bigger government intervention is back.

It was a combination of imprudent deregulation of financial markets on the one hand coupled with unwarranted government intervention in the housing market on the other that led to the collapse of such Wall Street icons as Lehman Brothers placing great clouds of uncertainty over the major economies of the world.

The most tired bit of analysis floating around with the ascension of the Democrats in Washington is that a new dawn has come heralding the end of economic fundamentalism (a term used by Warren Buffet), the neoliberal agenda with the ‘magic of the markets’ at its core. The economic philosophy espoused by Reagan and Thatcher has been the cornerstone of fiscal and economic policies of both Conservative and New Democrat/New Labor governments over the last thirty odd years. It is time to dust up John Maynard Keynes and consign Milton Friedman back into storage, so they say.

Joseph Stiglitz, a Nobel Prize recipient in economics for his work on the 'economics of information', former Chief Economist of the World Bank and former Chairman of the Council of Economic Advisors under Pres. Bill Clinton, has rightly pointed to the laxity of financial regulation in credit and derivatives markets under the Bush White House, coupled with monetary easing by the Federal Reserve in response to the post-911 and dot com collapse in the early part of the decade as foundations for the present sub-prime mortgage crisis.

This is only half the picture, which deflects a fair share of the blame that should be laid at the feet of the Democrats. The other half comes from the unintended consequences of well-meaning government policies in the housing market ratcheted up significantly by the Clinton administration but initiated as far back in Carter’s to promote greater home ownership by mandating the Federally-supported Fannie Mae and Freddie Mac to allocate a greater share of their lending to lower income groups, the so-called ninjas (no income, no job, and no assets).

The home mortgage meltdown was made up of two failures: a false-negative on the one hand (government failing to act when it should have) and a false-positive on the other (government acting when it should not have). This was a calamity caused not for a lack of public intervention, but by the inappropriate (non-)use of it.

Of course, in the heat of the campaign, a smart candidate like Barack Obama who has reportedly read his fellow University of Chicago professors’, Thaler and Sunstein’s book, Nudge (Yale, April 2008- see left) on this very issue (just as British Opposition Leader, David Cameron has) probably believes that government’s role is not necessarily to mandate things to individuals, but to ensure that they are primed to make intelligent choices, knew that to pose such a nuanced stance would only be self-defeating.

Yet, in his advocacy of tort reform as well as in his healthcare policy which had been opposed by constituents of his own party, trial lawyers in the case of the former, and rival Hillary Clinton in the case of the latter (for being too libertarian) he demonstrated the essence of what is being termed the ‘real third way’, paternal libertarianism: not quite the Keynesian model; one might think of it as the Chicago School of Law and Economics. This new school of thought is in essence a heterodox economic paradigm sprouting from the discoveries made in the budding fields of behavioral and neural economics.

By conducting experiments and studying the mental processes involved in decision-making, this new branch of economics has demonstrated how even highly rational individuals make foolish moves when facing complex, unfamiliar terrain. It demonstrates how our minds often get tricked by the manner in which problems are presented to us.

In order to optimize social benefits in these circumstances, it is not sufficient for policies to merely maximize choice by increasing competition through deregulation. Governments also need to ensure that choices made by consumers are more likely to serve their interests by creating regular feedback mechanisms with which they can evaluate their choices vis-à-vis other options in a timely fashion. This would counteract the inertia of sticking to a current yet less beneficial position or being swayed unnecessarily by the mentality of the herd into making a foolish one.

When laid out in plain English, as Obama did by calling it a policy based on common sense, he contrasted it with the prevailing dogma of neoliberalism. This presented a perfect counterfoil to the seeming blind adherence of the incumbent party to unbridled free markets as a way to allocate resources optimally in society. This soothed the wounded psyche suffered by the American electorate under the current adverse economic climate and appealed to their characteristic sense of pragmatism.

In contrast to the prognostics of most analysts appearing in the news media, the new dispensation is not necessarily going to mean greater intervention by the collective in the sphere of the individual, but smarter intervention. These sorts of intervention do not set out to limit choice, but are designed with better “choice architecture” in which options can be posed in a manner that intelligently spots and corrects for natural, irrational biases present in most humans (read: homo sapiens, not homo economicus).

Of course it remains to be seen whether this new principle can be put into practice by the incoming administration amid the euphoria and stratospheric expectations raised by ambivalent promises made during the campaign, but the kernel of a new idea has been planted, and given time its diffusion is going to be inevitable.