Thursday, April 30, 2009

Is child-rearing a luxury for the rich?

Should the baby bonus be income or means tested? The answer may not be so straight-forward.

If we use the lense of a redistributive social democrat, then any bonus paid to the rich is a form of fiscal leakage and middle class welfare. They are misallocations of resources better spent elsewhere particularly in this season of budget shortfalls, when the government will have to borrow to fund social programs.

There is an apparent logic to this which nobody with a shred of common sense can deny. However, before we throw the baby (bonus) out with bathwater, it would behoove us as policy advisers to look at the empirical evidence first.

The baby bonus first introduced in 2004 was a means to lift the birth rate of Australia. It was a bold social experiment which lends itself to evaluation four years down the track. This is what researchers at the University of Sydney at Royal North Shore Hospital have done with respect to the rise of birth rates in New South Wales. Their findings have been featured in the Medical Journal of Australia. As reported in the media, these findings reveal that
Women who showed a "significant increase in first births" after the baby bonus were teenagers of average socio-economic status, but also those in rural areas in their teens or early 20s, and "average or advantaged" women aged 30-44 who lived in city areas.

For women who already had one child but then had another the increase "occurred predominantly among younger women of low and average socio-economic status", the authors write. The increase in third or subsequent births occurred across all ages.

Contrary to popular criticism of the baby bonus scheme, the authors "did not find ... the increase in births only occurred in low socio-economic or disadvantaged groups (emphasis mine)".
Based on this analysis, it would seem that even the income-rich are sensitive to the bonus in deciding to have kids. Why is this so, and how do we put it all into perspective?

Enter Gary S Becker. The famous Nobel Laureate economist who literally wrote the book (on) Human Capital is generally regarded as the first of the “economic imperialists”, whose work extended beyond the traditional confines of economics (to demography in this case). Becker introduced the whole notion of time as a commodity. Edward P Lazear explains how Becker’s analysis has affected the discourse on fertility as follows:
Since child services (the commodity produced with children) is a time intensive commodity, high wage women face a higher price of children than do low wage women (emphasis mine). Also, as labor force opportunities improve for women, in part because of more equal distribution of education, women find it more costly to have children.
This explains why fertility rates in poor countries are higher and why rich countries are ageing as a result of low birth rates to begin with. If we are to take Becker’s principles to heart, this would mean that the baby bonus, rather than being “capped” should actually be set as a proportion of the woman’s wages for it to deliver the biggest (fertility) boom for each buck spent. Politically of course this would be a non-starter, but perhaps there is a workable alternative.

For example, the rise in teenage pregnancies particularly from disadvantaged youth lies on the opposite side of the continuum to career women. The evidence supports the theory that child-rearing would be more attractive to them particularly with the bonus. What is at stake here is not just the well-being of these mothers but of their children, since future educational and health conditions of children have been found to correlate well with the educational levels of parents, particularly that of moms.

A pragmatic Solomonic solution to the policy dilemma would be to provide an age, as well as incomes/means test for the bonus. This way, the government can say it has been both fiscally and socially responsible by correcting some of the unintended consequences of the previous government’s policy of encouraging teenage pregnancy while attending to the wishes of those who believe that the rich can fend for themselves in these troubled economic times.

Saturday, April 25, 2009

A Con at BrisCon

If you were faced with two investment opportunities:
  • one involving the purchase of a stock at 1/1000th of the asking price, and
  • the other involving the purchase of a stock with a possible future obligation to pay 2000 times the original unit value of your investment, which one would you take?
Obviously, the first one would be almost irresistible; the second would seem quite dubious to anyone. It came as a shock to many mom and pop investors that, in the case of their BrisConnections holdings, the two options were identical. As reported in the Sydney Morning Herald this week,
BrisConnections stapled units were sold in a initial public offering last July, with investors paying the first of three $1 instalments at the time.
They were then required to pay two further instalments, one this month and another in January 2010.
But many shareholders sold out of the stock after it was listed, with the units closing at 41 cents on the first day of trading.
They had plunged to 0.1 cent by October and have remained around that level ever since.
Many retail investors bought the units thinking they were getting a bargain, without realising that they would be required to pay a further $2 on each unit, making themselves liable for further payments up to 2000 times the value of their investment.
To borrow the words of Richard Thaler and Cass Sunstein, authors of the book Nudge, this is a case of poor “choice architecture”. One of the main points found in the book is that although many of us would like to think of ourselves as rational decision-makers, we are often primed to make foolish choices by of the way solutions are framed.
As behavioural economists point out we are (aside from being rational beings) subject to human frailties that our reasoning often gets confounded by complexity. What a layperson perceives as a perfectly reasonable choice upon closer scrutiny often turns out to be misinformed. Discounting this very nature of our thought processes may lead to a poor design of “nudges” or the prompts that are aligned to the way our brains are wired preventing us from perceiving a situation correctly.
In the case of BrisConnections, investors thought they were buying into a project which had a compelling business case with an implicit state guarantee at a huge discount. They failed to assess the risk of contingent liabilities. Yes there were public disclosures but most do not read the fine print when accepting an offer is only a mouse click away. Following Nudge principles, a simple prompt after the person has pressed “accept” warning them of the possible value of their contingent obligations would have alerted many to the dangers of proceeding.

Friday, April 24, 2009

Did the Oil Price Boom of 2008 Cause Crisis?

This is the question posed by James Hamilton of USC San Diego in a paper for the Brookings Institution. He concludes that

Eventually, the declines in income (due to higher oil prices) and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession. (Causes and Consequences of the Oil Shock of 2007-08)

As Justin Lahart of the Wall Street Journal comments:

A more controversial argument on energy’s role in the credit crunch could go like this. Housing prices kept on climbing, but the Federal Reserve – laboring on the idea that it couldn’t identify bubbles and that even if it could, it shouldn’t pop them — didn’t do anything about them. But then rising oil prices started adding to inflationary pressures, so the Fed kept pushing rates higher, left them high even as housing prices collapsed, and was to slow to lower them when the credit crisis got rolling.

This phenomenon is arguably what took place in Australia with the caveat that we are an oil exporting country. So for non-resource rich states like NSW the parallelism should hold.

Saturday, April 18, 2009

China and the Long March to (Global) Recovery

The unfolding bi-polar global economy emerged this week with talk of “green shoots” in the US being mimicked by “bamboo shoots” in China. Several leading indicators from stocks, housing and credit markets had some hoping that these were early signs of recovery. This was then dashed with reports of poorer than expected retail spending in the US and weaker GDP growth in China later in the week. Closer inspection of China's data however show that there were genuine signs of recovery burried in the figures.

The Economist rightly points out that the slowdown in China is a result of purposeful policy back in 2007 when authorities were worried of overheating and restricted the flow of credit. The recent data shows that lending and investments have been restored, and that consumer spending has remained robust (read Jim O'Neill from Goldman Sachs referring to China as the new shopping superpower here). What has been impeding growth overall is the slowdown in exports resulting from weak demand from abroad. Contrary to perception though, employment in the tradable sectors accounts for only 10% of the labour force and much of the content of their exports is imported from abroad (only about 18% is locally value added, which translates to 7.2% of GDP).

Andrew Peaple of Dow Jones writes in the Wall Street Journal that:

the debate among economists is becoming more alphabetical. Is this recovery V-shaped, with China set to return quickly to the high-level growth of recent years? Or is it more W-shaped, as a government spending-led recovery this year peters out and China's longer term structural issues resurface?

Manoj Pradhan of Morgan Stanley forecasts that:

(G)lobal output will probably start growing in 3Q09 (3rd quarter of 2009), with G10 output growth turning positive in 4Q (4th quarter). However, growth for 2009 as a whole will stay firmly in negative territory for all regions except AXJ (Asia excluding Japan) ... We expect AXJ’s outperformance to be sustained next year with a 6.4% increase in output, compared to 2.1% for CEEMEA (Central and Eastern Europe and Middle East and Africa), 1.1% for the G10 and 0.3% for Latam (Latin America).

That developing Asia will lead the world to recovery is evident from this forecast as well as by consulting this year-to-date chart of stock market performance around the world assembled by Bespoke Investments. Apparently, there could still be something to the BRICs and decoupling argument after all.

The Impact of China's Stimulus

Markets cheered when the leaders of the G20 emerged from their summit in London with little more than an agreement to infuse the IMF with additional capital through issuing SDRs (special drawing rights) intended for distribution among member countries. Dani Rodrik points out the significance of these measures.

To produce greater bang for each buck from a fiscal stimulus plan, countries have to increase their Keynesian multiplier. One of the things that reduces the multiplier effect is the marginal propensity to import. To prevent leakage of such spending on foreign goods (the effect of the marginal propensity to import), it is essential for other countries to "pull their weight" and engage in similar levels of spending. In developing markets, credit and liquidity was drying up, limiting their capacity for fiscal spending .

This is why the Chinese fiscal stimulus which is roughly equivalent to 90% of Australia's entire GDP was significant for advanced economies. Some estimates put the multiplier in China at 1.1, meaning $1 spent by the government leads to $1.1 of additional spending elsewhere. Picture the output of Australia for two years being disbursed in less than a year. Much of this multiplier is due to the public investment nature of the spending on roads and basic infrastructure. For this reason, resource rich countries like Australia will have much to cheer about in the coming months.

Saturday, April 11, 2009

Credit Rationing by Australia's Big Four(?)

The week following the announced mortgage freeze for “victims” of the Global Financial Crisis, the "four pillars" of Australian banking said they would not be passing on in full the reduction of 25 basis points made by the Reserve Bank to the cash rate. They were of course villfied for the latter, while hardly any praise was given for the former. Some would say that in both cases, the banks were simply looking out for their own interests. Could these two decisions be interrelated? Are these banks undermining monetary policy?

A freeze on payments for the unemployed is of course welcome news to those who are at risk of being laid off. It is a voluntary rewriting of contracts to prevent the swelling of non-performing assets in the books of these banks. Missed payments will be capitalised and recovered down the track. Meanwhile, delinquent borrowers will remain in their homes. Of course implementing such an arrangement does not come without costs. How will the banks recover them?

Unfortunately, the only way to pay for the sour loans would be by keeping rates steady on the remaining ones. It would not surprise me if this were the case. As Stiglitz noted in his pathbreaking article, the pricing of loans is not based purely on the law of supply and demand as one might expect. This is because of imperfect information and risk. Setting loan rates is a way to screen out certain types of borrowers and signals to them the type of projects to seek financing for.

An equilibrium rate is one that maximises returns for the banks. This implies that if rates are set too high, loans would suffer an adverse selection problem where borrowers would veer more towards high risk, high return projects in order to make a decent return. Setting them too low would sacrifice profits unnecessarily. Competition amongst the banks would essentially discipline those that did not adhere to this optimal rate.

So even if the rate consistent with supply and demand were lower than the optimal rate, credit rationing would ensue where the banks would require greater collateral or create quotas for certain types of loans, which would in turn bid the rates up to the optimal level.

It is not hard to see how this could be taking place in the banking sector now. Given the cocktail of 50 year historically low rates courtesy of the RBA, generous home owner grants courtesy of the government and the impending growth in unemployment over the horizon courtesy of the global financial crisis, would it be inconceivable for the banks to start rationing credit to slow the inflation of yet another unsustainable asset bubble?

Information Costs and Bank Deposit Guarantees

Another plausible explanation for the big-four's imperviousness to public backlash is the fact that they have had easy access to credit courtesy of the government's AAA-rated bank deposit guarantee, and as a result can park their funds elsewhere at higher yields and contract their lending activities during this economic downturn.

The bank deposit guarantee was enacted at the height of the financial meltdown in 2008. It was a case of policy plagiarism of action taken by the Republic of Ireland, a country that has suffered heavily from the piercing of their local asset bubble. The question is, given the disparate situations faced by Ireland and Australia, was it appropriate to transfer the policy from one to the other?

Perhaps, yes, no and maybe would be the best answer. Yes - it might have been necessary to raise the deposit guarantee simply to promote confidence amongst the depositing community to prevent capital flight. No - it was not necessary to raise the guarantee to a million dollars, as the type of depositor who would have such large cash holdings also has access to informal social networks that have information about the relative quality of certain deposit taking institutions. Maybe - given that a majority of analysts see economic growth returning by the latter part of this year, the three year guarantee period was a case of overkill.

As for the question posed at the beginning of this discussion, whether the banks are distorting the market for capital, it should be noted that the deposit bank guarantee will have by far a greater distortionary effect in the medium term.

Saturday, April 4, 2009

Dishonest or Incompetent?

The broad contours of two competing narratives on the origins of the GFC are what David Brooks brilliantly outlines in his op-ed piece for the New York Times. Dubbed as"Greed and Stupidity" or alternatively as I have framed it, dishonesty and incompetence. In any principal-agent relationship, there are always two problems to look out for: dishonesty, in which case the need is for the principal to motivate the agent to take his view of things; and incompetence, in which case greater monitoring is required. Policy, to be on the mark, has to address these agency costs.

This is how the greed narrative is broken down. It is essentially an amplified version of the situation faced by most emerging markets where the dominance of a certain class of moneyed elites, or oligarchs, holds sway over political or ruling elites. With their entrenched interests in keeping things the way they are, any attempt at reform will simply wither at the vine. The most coherent expression of this is encapsulated in "The Quiet Coup" by Simon Johnson in The Atlantic. In essence, it is a moral hazard problem, one of "keeping the bastards honest."

Johnson uses statistics covering the last three decades to illustrate the growth of the finance industry in the US. From a low of 16 per cent at the outset, its share of corporate profits rose to 41 per cent in the last decade, and with this came a rapid wage disparity between average workers in the finance industry and other sectors. With increased wealth and prestige came influence and power. The revolving door between Wall Street and Washington produced an incestuous relationship which spawned lax regulation and increased risk-taking.

A nuanced and slightly more convincing explanation is offered by the incompetence argument. Its takeoff point is the increased diversity and complexity of bank operations and the ignorance of senior bank executives with regard to the nature of assets they were handling. It is essentially an information problem. The mutation of investment banks from partnerships to publicly listed companies and their subsequent merger with commecial banks bred a lack of transparency and accountability. Yet with all this centralisation of authority, why were the captains of industry asleep at the wheel?

The basic answer is complacency. They thought that they had figured out a way to manage and diversify away systemic risk. As Felix Salmon points out in his riveting article for Wired Magazine, they were enamoured and gradually seduced by the elegance of a mathematical formula, known as the Gaussian copula developed by an actuarian by the name of David X. Li working at the time for JP Morgan Chase, which was published in The Journal of Fixed Income back in 2000. The fact that this theoretical model was not subjected to more scrutiny and empirical evaluation really says something about "group think" and herd mentality in the so-called Information Age.

The analysis of Li sought to simplify the manner by which to estimate the corelation of undesireable events like defaults occurring in two separate loan contracts. He used the prices of an instrument known as a credit default swap in lieu of actual default histories to determine the coefficient of corelation. Using this approach, it was possible to bundle junk bonds together and still come up with triple-A rated instruments known as collateralised debt obligations or CDOs.

Nevermind that the coefficients actually may change as circumstances on the ground become fluid. Though elegant, the brittleness of the solution became evident once it was tested by the hard reality of unforeseen external circumstances such as the rise of China and the flooding of the financial sector with fresh capital seeking safe yet solid returns.

Financial innovations based on the Li formula spawned complex instruments too opaque to comprehend or monitor since doing so required intimate knowledge held by the mathematicians closely linked to the models used for underwriting such contracts. On top of that was a system based on the "cult of accountability", the search for standardised measues of achievement with which to rate the performance of financial executives who were paid according to the amount of such contracts they had floated and not on how well the instruments performed thereafter.

In other words, these numerical methods did not square with real performance on the ground, and they could be "gamed" by the executives whose activities they were meant to control. This created a pseudo-objectivity which as Jerry Z Muller writes makes this the first epistemologically driven recession the world has seen (epistemology being the study of the limits of knowledge, or how we know what we think we know).

Policy Prescriptions
If the greed narrative is to be followed, then the obvious solutions to the crisis have to do with curbing dishonesty among the bankers. How do you reduce the power of entrenched interests? Well, to take an extreme case, Vladimir Putin's approach was to prosecute the dishonest crooks, takeover their operations, break-up their monopoly. Curb their excesses by putting a tight rein on the level of compensation they are allowed to have. A softer version would be that held by McCain. Say "no" to government bailouts. Let them have the "freedom to fail" as the recent White House announcement over General Motors tried to signal.

If on the other hand the incompetence narrative is to be followed, then the solution would entail simplifying contracts, making them easier to subject to regulatory supervision and managerial control, not substituting due diligence for diversification, gaining a better handle on what it is that forms the underlying value of assets. In other words, improve the quality of information being transmitted.

Finally, whatever narrative you subscribe to, there is one conclusion that both will support. This is the need to reinstate rules that prevent banks from getting "too big to fail", "too complex to manage" which was what the Glass-Steagall Act of 1934 was designed to do following the (last?) Great Depression. Unfortunately, the opposite has happened with Goldman Sachs and Morgan Stanley becoming bank-holding companies like the bailed-out Citicorp to be monitored by some supervisory body yet to be named. The question now is whether the authorities will be sophisticated enough to stay on top of these large complex organisations, or will we be substituting market failure with government failure in the not too distant future.