What are the implications of declining productivity growth in high-income countries?

The graph shown above indicates that productivity growth rates in high-income countries have declined. That decline seems evident even if we disregard the low productivity growth in the years immediately following the global financial crisis. (Selection of high-income countries for inclusion in the graph was based largely on aggregate GDP.)

The productivity indicator used in the graph - multifactor productivity (MFP) – is that part of GDP growth that cannot be explained by changes in labour and capital inputs. It reflects the influence of technological progress and production efficiency.

The most obvious implication of a decline in MFP growth rates is a lower rate of growth in per capita incomes. Declines in MFP growth are sometimes offset by more rapid growth of employment, through higher immigration, or more rapid growth of capital stock, through higher investment levels. However, such offsetting factors are not sustainable over the longer term.

In most instances, and in the longer term, it seems reasonable to expect a ½ percent lower rate of growth in MPF to be reflected in a ½ percent lower rate of growth in average incomes. Over 10 years, a decline in average income growth from, say, 2 percent per annum to 1.5 percent per annum would amount to the difference between a 22 percent and 16 percent increase in income.

That is not negligible, but it doesn’t cause me a great deal of angst. As noted previously on this blog (in a post written when I was more sceptical about the number of countries experiencing a decline in productivity growth) the slow-down in measured productivity growth in the U.S. and some other countries may be attributable, in part, to difficulty in measuring the outputs of the information and communications technologies (ICT) industries. When consumers can download more stuff that they do not have to pay for, the quality of their lives improves, even though that isn’t reflected in average income and consumption measurements.

It is also likely that some part of the decline in measured productivity growth may be attributable to environmental and social regulation. I am sceptical about the merits of much of that regulation, but I acknowledge that some of it provides benefits to humans that should be offset against associated income losses.

However, there is an implication of declining productivity growth that governments and their dependents should be thinking more seriously about. That is the potential for revenue growth to decline. Unless the revenue to GDP ratio is raised, a lower rate of growth of MFP is likely to translate to lower growth of government revenue. (Note that the same difficulty in measuring the outputs of the ITC industries for productivity estimation also applies to measuring income, sales and value added for tax purposes.)

Lower revenue growth has interesting implications in the context of expected ongoing increases in government spending. As previously discussed on this blog, under existing programs, substantial increases in government spending seem likely to occur as the proportion of elderly people in the populations of many countries continues to rise.

So, why not raise the revenue to GDP ratio by changing the tax mix in favour of more efficient taxes that have less adverse effects on economic incentives? The political obstacles to tax reforms have not always been insuperable, but revenue-raising reform proposals are less likely to be supported than revenue-neutral proposals.

Another option is to raise the revenue to GDP ratio by raising tax rates. That is also likely to encounter political obstacles but, more importantly, the adverse effects on incentives seem likely to further reduce productivity growth. The marginal excess burden of taxes tends to rise as the tax rate is increased (see discussion here).

Yet another option is to let public debt continue to rise and hope debt servicing doesn’t become too much of a problem. We may actually see some problems emerging with that strategy over the next few years with increased public debt incurred in response to COVID-19. Perhaps central banks will succumb to government urging to over-stimulate economies to allow the “inflation tax” to reduce debt to GDP ratios. However, that would make ongoing debt accumulation a more costly strategy because it would result in high interest rates and thus higher costs of debt servicing over the longer term.

We haven’t considered debt default, but you have to be desperate to consider that!

My point is that governments and their dependents do not have any easy options available to adjust to an ongoing decline in productivity growth.

Economists advising governments will likely suggest that the best way forward is adoption of a package of reforms (including tax reforms) to raise productivity growth, combined with action to prune government spending. What governments will do, however, will depend to a large extent on the relative political power of different interest groups. In most countries, that seems to me likely to point more toward spending cuts than toward productivity-increasing reforms.

So, it seems reasonable to speculate that declining growth in productivity will be ongoing and result in cuts in government spending in policy areas where political resistance is likely to be weakest. Which policy areas are likely to be most affected?

Which of the western democracies will be able to cope with future growth in government health spending?

The chart shows that those OECD countries with the greatest burden of debt servicing a decade ago have subsequently had the lowest growth in government spending. It isn’t hard to understand how that might happen when we think about the consequences of accumulating debt in our personal lives. If we go heavily into debt, a higher proportion of our income must be devoted to servicing debt and less is available for other spending. Our creditors are likely to be reluctant to extend further credit if they become concerned about our ability to service existing debt.

At a national level, there are additional complications including the potential for governments to inflate away the real value of debt denominated in local currency and possible ‘bailouts’ by the IMF and ECU. Nevertheless, governments that become poor credit risks must pay a higher risk premium than is normal for government bonds, in order to obtain access to additional credit.

There is evidence that rising government debt to GDP ratios are associated with lower economic growth, which in turn, leads to lower growth in government revenue. That obviously has potential to further squeeze non-interest government spending. The results of a recent study published by the Dallas Fed (‘Rising Public Debt to GDP Can Harm Economic Growth’, by Alexander Chudik, Kamiar Mohaddes, M. Hashem Pesaran and Mehdi Raissi) suggest that over the longer term persistent accumulation in debt as a percentage of GDP at an annual rate of 3 percent is eventually associated with annual GDP growth outcomes that are 0.2 to 0.3 percentage points lower on average. To put that in perspective, the average growth rate of OECD countries has been about 1.5 percent per annum over the last decade. Causality could run both ways. Lower GDP growth can lead to higher debt levels, which, in turn, can lead to lower economic growth.

You might be wondering why I think the chart shown above has much relevance for western democracies other than Greece, Italy and Portugal, which had high government debt servicing burdens a decade ago. The relevance stems partly from the continued increase in government debt as a percentage of GDP in most OECD countries over the last decade. On average, net financial liabilities of those countries have risen by around 23 percentage points of GDP over the last decade to around 67% of GDP in 2018.

Those looking for reasons to be complacent can obtain some reassurance from low world interest rates. With interest rates paid by governments lower than the rate of economic growth in most OECD countries, debt servicing is not yet a widespread problem. At current interest rates, it would be possible for the debt to GDP ratio to decline in most OECD countries, even if governments pay interest on their debts by borrowing additional funds.

How likely is it that world interest rates will remain at low levels over the next few decades? In their recent OECD paper, The Long View: Scenarios for the World Economy to 2060, Yvan Guillemette and David Turner suggest that relatively low growth in investment is likely to keep downward pressure on world interest rates, even though population ageing is likely to reduce savings rates. Nevertheless, they note evidence that reversals of the relationship between world interest rates and economic growth rates have been “fairly common” in the past. They warn that a sustained rise in interest rates relative to growth “could eventually make large debt stocks costly to service and unsustainable”.  Their projections suggest that some decline in economic growth rates is likely to occur in most parts of the world over the next 40 years.

My concerns about the potential for debt stocks to become costly to service in many more OECD countries are related to the implications for government spending of the ongoing increase in the proportion of elderly people in the populations of these countries. The implications of demographic change have been much talked about over the last few years, but the magnitude of the likely impact on government spending doesn’t yet seem to be widely appreciated. The study by Guillemette and Turner projects an increase in annual public health and pension spending of about 5 percentage points of GDP for the median OECD country between 2018 and 2060. The bulk of that increase is for public health spending, which is projected to continue to be pushed up by technological change and government health policies, as well as demographic factors.

The methodology used by Guillemette and Turner produces estimates of the increase in the revenue to GDP ratio needed to pay for projected government spending increases without any further increase in debt to GDP ratios. An increase in revenue as a percentage of GDP of 6.5 percentage points of GDP is projected to be required for the median OECD country over the period to 2060. A much larger increase is projected to be required in some countries. For example, the required increase in revenue for the U.S. is projected to be 10 percentage points of GDP.

I think the baseline scenario presented by Guillemette and Turner is too optimistic because their modelling takes no account of the disincentive effects of higher taxation on GDP growth. The possible magnitude of this excess burden of taxation is discussed in an Australian context in an article posted on this blog a few years ago.

Leaving that aside, it seems to me that ongoing increases in debt to GDP ratios - and hence substantial increases in government interest payments as a percentage of GDP - are a much more likely outcome in most OECD countries than tax increases in the years ahead. In those countries where debt servicing isn’t yet a problem, there seems likely to be much less political opposition to further increases in public debt than to tax increases. That suggests to me that over the next few decades most OECD countries are likely to increase their debt to GDP ratios until debt servicing does become a more widespread problem.

Guillemette and Turner present scenarios that would require smaller increases in government revenues than in the baseline (no-change) policy scenario, but those scenarios involve health policy and labour market reforms that have been difficult to achieve in the past. I don’t think we can expect voters to be any more supportive of reforms that could damage their short-term interests than they have been in the past. The best we can hope for is that when they see the writing on the wall, a sufficient proportion of voters in most countries will be supportive of political parties proposing economic reforms, rather than waiting until they are imposed by creditors (or institutions such as the ECB and IMF). In 2013 I wrote something here contrasting the responses of Sweden and Greece to fiscal crises, that illustrates the choices available.

The transition may be traumatic, but it seems likely that technological advances will provide options superior to government provision of many services in coming decades. What I have in mind particularly is the potential for blockchain to enhance opportunities to seek mutual benefit in voluntary cooperative enterprises, as previously discussed on this blog. That may create potential for functions to be transferred from the public sector to cooperative enterprises that can perform the functions more efficiently.

During the next few decades most of the western democracies seem likely to experience ongoing difficulty in coping with the additional government spending required to meet the health needs of the elderly.  The most likely outcome seems to me to be an increase in debt to GDP ratios that will result in more widespread debt servicing problems. It seems inevitable that debt servicing problems will lead to a lower rate of growth in government spending in many OECD countries, possibly accompanied by the transfer of some functions to voluntary cooperative enterprises.

That leaves the difficult question of identifying which of the western democracies are more likely to be able to implement those reforms through normal democratic processes in order to avoid having austerity imposed upon them by creditors and international agencies.

Is Bitcoin better than gold?

When suggestions have been made to me in the past that I should write about Bitcoin, I have expressed reluctance on the grounds that I don’t know much about it. Some would say, however, that is also true of some other things I write about on this blog.

Time seems to be running out for me to write about Bitcoin while the topic is still interesting. I keep reading news reports suggesting that Bitcoin is rapidly becoming respectable. Apparently New York State’s top financial regulator has just granted the first license to a Bitcoin exchange. A couple of weeks ago it was reported that Goldman Sachs is making a significant investment in a Bitcoin-focused company.

Anyone looking for a simple explanation of what Bitcoin is and how it works can find a fair amount of information online without much difficulty. The Economist attempted to provide an explanation a couple of years ago, but I found an explanation aimed at five year olds to be more helpful. A couple of months ago Nicolas Dorier referred me to the excellent explanation which Andreas Antonopoulos provided to a committee of the Canadian Senate in October 2014. Mr Antonopoulos also appeared before a committee of the Australian Senate and responded admirably to concerns about use of Bitcoin for nefarious purposes such as funding of drug trafficking and terrorism. He also argued strongly that incumbents in the finance industry should not be allowed to dictate government regulations applying to Bitcoin.

Should we view Bitcoin as money? In order to look at this question it is necessary to consider three functions of money: a unit of account; medium of exchange and store of value. Some economists, including Scott Sumner, argue that the unit of account function is the distinguishing characteristic of money from an economic perspective, and I am inclined to agree. Bitcoin is not widely accepted as a unit of account at the moment - it certainly does not seem likely to displace national currencies in that role in the near future.

However, Bitcoin seems to be proving itself to be very useful as a medium of exchange in international transactions. It is particularly pleasing to see reports of Bitcoin being used to enable guest workers from countries such as the Philippines to send remittances home to their families for a much lower price than is charged by firms such as Western Union. Further innovations are occurring in this area. For example, it has been recently reported that an Australian company, Digital CC, has set out to become the Uber of international transfers by developing a peer-to-peer transacting technology to allow remittance payments to be made via a mobile app.

There is no question that Bitcoin is much better than gold as a medium of exchange, because gold is expensive to store and transport.

It is when we consider the potential for Bitcoin as a store of value that the question of whether Bitcoin is superior to gold becomes harder to decide. A glance at the charts below might suggest that investors in Bitcoin are being optimistic if they think it will soon be accepted as a reliable store of value.

How much attention we should pay to past volatility in the price of Bitcoin in thinking about its potential as a store of value in the future?

The author of an article in Fortune, entitled ‘Gold vs. bitcoin: An apocalyptic showdown’, has suggested:

“Of course, as a new technology, bitcoin is subject to much more volatility than gold. But over the long run, given the fact that no new bitcoins will be mined after the 21-millionth, we can expect it to ultimately serve as a better store of value than gold”.

I feel inclined to agree. However, the more difficult question for me is whether to put my money where my mouth is. 

Postscript:
Nicolas Dorier has provided the following response:

"There is nothing to to fear about Bitcoin, but like owning gold, if your lose the map where you buried it, you lose everything. So one should be confident in his ability to protect the map. To learn how to do so, one should start training by protecting some pocket money first before burying his treasure.

First, start small, and consider it a learning experiment rather than an investment. Bitcoin is relatively new, and the tools and ecosystem are not as user friendly as they will become. The learning curve might be a little steep. Owning Bitcoin means being responsible for your money, and most people are not responsible of their own computer.

So be careful, you can always try to buy a few (for 10-50 dollars), and play with it by trying to buy stuff, transfer them between addresses, backup them on paper etc, restore them etc. This stuff was easy to learn for me as I am a developer. But it is not for most people. 

Second, never let your bitcoin on fiat/bitcoin exchanges once you bought. You don't own bitcoins if you don't own the private key. Any balance you see on exchanges are just IOU, not bitcoins.

By playing with it you will learn little by little all what you can do with it that you can't with traditional fiat currencies, and all the business opportunities that it opens. But don't rush it, start playing with it first.

Bitcoin is also an hedge against monetary mismanagement and financial oppression, a typical example right now is Argentina.

The value of Bitcoin increases when governments take measures to restrict the movement of other forms of money. As they do everything to restrict it, it forces people to use bitcoin. Not because they believe or use it as store of value, but because, it is easier to transact. (It is for this reason that Bitcoin came to be used first in black markets.)

As the failure of our central banks becomes more and more obvious, they will start to impose capital controls. (War on cash, that you start to see happening everywhere). This is mainly what will ultimately drive the value of Bitcoin."

Should self-funded retirees be concerned that interest rates on term deposits have declined?

Some readers will wonder why I am bothering to ask this question. It appears to be fairly obvious that people who are relying on interest on term deposits to fund their retirement must have greater difficult in surviving without drawing upon their capital when interest rates are as low as they are now.

However, it is by no means clear that the relevant interest rate is lower now than it has been over most of the last 15 years or so.

So, what is the relevant interest rate? First, nominal interest rates should be adjusted for taxation since the interest income that people are able to spend is the amount left after tax has been paid.

Second, it is also necessary to take inflation into account in the calculation. Inflation tends to deplete the purchasing power of the amount deposited, so some part of the after-tax interest has to be saved in order to prevent the real value of the nest egg from being depleted. Retirees who do not take inflation into account in their calculations are suffering from money illusion - an affliction that enables them to spend their children’s inheritances without feeling any guilt until they realize how much the real value of those sums have depleted.

So, if a retiree is intent on preserving the real value of her capital, the amount of interest income available to be spent is real after-tax interest. You might well ask why a retiree would want to preserve the real value of her capital. That is a very good question. If she has saved the funds to spend during retirement, it does not make any sense for her to be obsessed with the idea of living on interest and preserving capital. The important point is that awareness of the real after-tax interest rate might help her to avoid depleting the real value of her savings more rapidly than she intended.

The chart below shows trends in Australian interest rates on one year bank term deposits, after-tax interest rates on those deposits assuming a marginal tax rate of 30%, and real after-tax interest rates (deducting the CPI inflation rate for the previous 12 months). The data used in the chart is sourced from the Reserve Bank of Australia.

From the chart it looks to me as though it is about 15 years since retirees have been able to spend any of their interest income from term deposits without depleting the real value of their savings. 

It is easy enough to understand that some elderly people might suffer from money illusion and consider it to be sinful to deviate from time-honoured prudential rules about living off nominal interest. One would hope that professionals in the investment advice industry would encourage such people to modify their views somewhat to take account of tax and inflation.

However, some senior people in the investment advice industry have been encouraging the view that low interest rates have reduced the real spending power of retirees. For example, Jeremy Cooper, chairman of retirement income at Challenger Ltd, and the man who chaired the 2010 review of the superannuation system, has been reported in The Australian as saying:

 “Back when bank deposit rates were around 6 and 7 per cent there was no great problem with self-funded retirees relying on bank interest”.

In the same article, Jeff Rogers, chief investment officer of IPAC funds at AMP Capital, made a similar point. He is reported as saying bank deposit rates “will now adjust to just below 3 per cent, so with core inflation at around 2.4 per cent your real spending power is very small” in a self-funded retirement and warns that even if interest rates do start moving up again, “they won’t be going back up any time soon to the level that provided bank interest of 6 to 7 per cent’’. (Article by Andrew Main, ‘Risk rules for retirees reliant on bank interest’, May 6, 2015.)

It looks to me as though the after-tax real rate was close to zero when bank deposit rates were around 6 or 7 per cent, just as it is now.

Do I agree with Steve Keen's views about the causes of the GFC and the NAR?

Who is Steve Keen? What is the NAR? And why am I wondering whether or not I agree with Steve Keen?

Steve Keen is an Australian economics professor, author of a book entitled ‘Debunking Economics’. His blog, ‘Steve Keen’s Debtwatch’, is dedicated to analysing ‘the collapse of the global debt bubble’. The NAR refers to the North Atlantic Recession, sometimes referred to as the Great Recession, that followed the GFC. I am wondering whether or not I agree with Steve Keen because of a comment on Jim Belshaw’s blog last Sunday. Jim wrote:

‘The second part of Winton's post focused on Irving Fisher's views is, if I interpret the argument correctly, very similar to views expressed by Professor Keen. Essentially, a key part of the problem was the combination of levels of private debt with income and price variations.’

Jim was referring to a post on this blog a couple of weeks ago: ‘Should the GFC be viewed as a 'balance sheet' recession of the kind Irving Fisher wrote about in the 1930s?’

My immediate response was to question whether it might be possible that I could express views similar to those of Professor Keen. While my views on economics have strayed somewhat from neoclassical orthodoxy in recent years, I still consider that the concept of equilibrium provides a useful starting point for economic analysis. Steve rejects all conventional neoclassical economics.

If my understanding is correct, there are two main elements involved in Steve’s views about the causes of the GFC and the following recession: Minsky’s financial instability hypothesis; and the concept of endogenous money creation.

Minsky’s financial instability hypothesis involves the idea that a growing economy is inherently unstable. Investments are initially conservatively financed, but it gradually becomes evident to managers and bankers that greater profits can be made by increasing leverage. Investors and bankers come to regard the previously accepted risk premium as excessive and to evaluate projects using less conservative estimates of prospective cash flows. The decline in risk aversion sets off growth in debt, growth in investment and growth in the price of assets. The euphoria is eventually brought to an end as rising interest rates and increasing debt to asset ratios affect the viability of many business activities. Holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded, panic ensues, the boom becomes a slump and the cycle starts all over again. (That is an abridged version, excluding Ponzi elements, of a summary which Steve provides in his paper: ‘A monetary Minsky model of the Great Moderation and the Great Recession’).

The concept of endogenous monetary creation involves the idea that banks create credit in response to demand. If a bank lends me money, my spending power goes up without reducing anybody else’s. So, bank lending creates new money, and adds to demand when it is spent. From this perspective, ‘aggregate demand is income plus the change in debt’. (My training in economics and national income accounting makes it difficult for me to understand why or how that can be so. Nevertheless, let us proceed.) If my understanding is correct, Steve is arguing that quantitative easing does not increase the money supply, because banks don’t increase lending when central banks purchase bonds from them. (See Steve’s article: ‘Is QE quantitatively irrelevant?’).

My objection to the first element arises because I don’t understand why a growing economy should necessarily be unstable.  In my view, it is necessary to introduce into the analysis a ‘too big to fail’ policy, or something similar, to explain why banks have a tendency to take excessive risks. I have attempted to outline the regulatory issues involved in a previous post:

‘Governments seem to have managed somehow to get us into a vicious cycle where fears of contagion have led them to encourage major financial institutions in the believe that they were too big to fail, while the belief that governments would bail them out has led major financial institutions to take excessive risks. If we can't let big financial institutions fail when they become insolvent, perhaps the next best option is to find the least cost way of regulating them to make it less likely that they will become insolvent’.

My objection to the concept of endogenous monetary creation is that it flies in the face of the reality that monetary policy can increase and reduce the rate of growth in nominal GDP (aggregate demand). It would make more sense to explain the fact that money creation through quantitative easing did not result in an immediate increase in bank lending in terms of funds being used to meet demands for liquidity (or repair balance sheets) than to redefine the concept of money in order to claim that the money was not created.

   

In my view Scott Sumner is on the right track in arguing that nominal GDP level targeting (along a 5% growth rate) in the United States before 2008 would have helped greatly reduce the severity of the Great Recession:

‘One reason asset prices crashed in late 2008 is market participants (correctly) saw that the Fed had no plan to bring the US economy back to the old nominal GDP trend line’ (See: ‘A New View of the Great Recession’, Policy, Winter 2013. The article is gated, but Scott has expressed similar views on his blog.)

The idea of targeting nominal GDP, to bring it back to the old trend line seems to me to be similar to Irving Fisher’s advocacy of reflation, as discussed in my post about balance sheet recessions.

So, coming back to the original question, I agree with Steve Keen that debt is important in explaining the GFC and the NAR, even though I have a very different view about the way economic systems work.

Should the GFC be viewed as a 'balance sheet' recession of the kind Irving Fisher wrote about in the 1930s?

I have been feeling a strong urge to write about the economic policies of the former government of our resurrected prime minister, Kevin Rudd. Whenever I begin to write on this topic, however, what comes to mind is my grandmother’s advice that if you haven’t got anything nice to say, perhaps you shouldn’t say anything. It might be churlish of me to attempt to remind people that Kevin – whom so many people seem to revere as much now as in 2007 – has a record of achievement that is somewhat less than perfect.

Fortunately, not everyone has such qualms and some excellent articles about the economic policies of the Rudd government have appeared in the media over the last week or so. The best newspaper article I have read so far is one by Henry Ergas, entitled ‘Rudd’s Real Record’, published in The Australian last Saturday (July 13, 2013). Ergas reminds us, among other things, that in 2009 Rudd mounted a massive scare campaign about the severity of the GFC in an attempt to justify a splurge of poor quality government spending.

I recall how Janet Albrechtsen suggested in The Australian at the time that the GFC provided Rudd and his treasurer, Wayne Swan, with an opportunity that they were only too eager to grasp:

‘The Rudd Government finds itself at a very fortunate juncture. As Rudd’s treatise in the present edition of The Monthly reveals, he can blame capitalism for the coming government extravagance funded by taxpayers. Prepare for Rudd’s hubris-filled pitch on how he “saved” capitalism and why you had to pay for it.’

Whether we are prepared or not, we are now hearing Rudd’s hubris-filled pitch:

‘As you know, here in Australia, we deployed a national economic stimulus strategy, timely targeted and temporary, which helped keep Australia out of recession, kept the economy growing, and kept unemployment with a five in front of it – one of the lowest levels in the world.’

The hollowness of the claim by Rudd and Swan that the fiscal stimulus pulled Australia though the GFC has been demonstrated many times. For example, in an article entitled ‘Wayne Swan’s legacy of unrivalled incompetence’ in yesterday’s Financial Review (July 16, 2013), John Stone, former secretary to the Treasury, points out that the hubris of Rudd and Swan overlooks the strength of Australia’s fiscal position prior to the GFC, the role played by monetary policy, the underlying strength of Australia’s banks and the growth in China’s demand for our minerals.

John Stone’s article also raised the question I am intending to address here about balance sheet recessions. Stone suggests that the Australian Treasury had erred in seeing 2008-09 as another cyclical recession like that of 1991-92, rather than as a ‘balance sheet recession’ of the kind that Irving Fisher wrote about in an Econometrica article in 1933.

In my efforts to overcome my ignorance about the characteristics of a balance sheet recession I have managed to find an ungated copy of Irving Fisher’s article. Fisher suggested that in ‘great booms and depressions’ … ‘the big bad actors are debt disturbances and price level disturbances’, with other factors playing a subordinate role.

   

Fisher argued that it is the combination of over-indebtedness and price deflation that causes the depression:

‘When over-indebtedness stands alone, that is, does not lead to a fall of prices, in other words, when its tendency to do so is counteracted by inflationary forces (whether by accident or design), the resulting "cycle" will be far milder and far more regular.

Likewise, when a deflation occurs from other than debt causes and without any great volume of debt, the resulting evils are much less. It is the combination of both—the debt disease coming first, then precipitating the dollar disease—which works the greatest havoc.’

Fisher suggested:

 ‘it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged’.

That seems to me to be similar to the rationale for the quantitative easing policies adopted by central banks in recent years, following the failure of fiscal stimulus efforts. Lars Christensen, a market monetarist, has written more extensively about this similarity on his blog.

John Greenwood’s analysis, conducted in the spirit of Irving Fisher, suggests that some balance sheet repair has occurred in recent years in the countries most affected by the GFC, with greater progress having been made in the US than in the UK and least progress having occurred in the eurozone. 

Postscript:

An article by Max Walsh in today’s Financial Review (July 18, 2013), entitled ‘Rudd’s demands could exceed all expectations’, is another excellent article about the implications of the economic policies of the first Rudd government. Walsh refers to Rudd’s essay in The Monthly (February 2009) in which he sought to differentiate the economic ideology of the two major political parties in Australia. As might be expected, Rudd sought to portray his political opponents as extreme proponents of free market ideology, but he also portrayed the Labor party as being wedded to interventionism.

Kevin Rudd wrote: ‘Labor, in the international tradition of social democracy, consistently argues for a central role for government in the regulation of markets and the provision of public goods’. Max Walsh comments: ‘That’s a view that looks to be at odds with the deregulation and privatisation initiatives of the Hawke-Keating years’.

Viewed in that context, it seems to me that the most likely outcome of Kevin Rudd’s recent promise to pursue microeconomic reform ‘with new urgency’ will be further restriction of economic freedom and lower productivity growth. 

Is there a house price bubble in Australia?

An article in ‘The Economist’ last week suggests that the ‘bursting of the global housing bubble is only halfway through’ (‘Economics focus: House of horrors, part 2’, November 26, 2011).  On the basis of the measures used, the authors claim that home prices are over-valued by 25% or more in Australia, Belgium, Canada, France, New Zealand, Britain, the Netherlands, Spain and Sweden.

How did the authors arrive at this conclusion? Two measures of valuation were used in the analysis: the house price to income ratio, which is a gauge of affordability; and the house price to rent ratio, which reflects the relationship between house prices and the benefits of home ownership i.e. rents earned by property investors and rents saved by owner-occupiers.

The reasoning seems OK so far. If the price to income ratio is above an appropriate benchmark of affordability and the price to rent ratio is relatively high compared with an appropriate benchmark of returns available from owning other assets, then there might possibly be some grounds to suspect the existence of a housing bubble.

The critical issue is what benchmark should be used to make such comparisons. ‘The Economist’ asserts: ‘if both of these measures are well above their long-term averages, which we have calculated since 1975 for most countries, this could signal that property is overvalued’. In the chart below I have graphed the data from the table that the authors use to make their assessment.

The chart shows that the price to income and price to rent ratios for a heap of countries, including Australia, are well above long-term averages for the period from 1975 to the present. I think mean reversion (sometimes referred to as regression to the mean) deserves some respect. If we don’t have good reasons to expect a variable to remain substantially above or below its long term average at a particular point, it is often sensible to assume that deviation from the mean is more or less random and that the variable is more likely to return to the mean than to remain at extreme levels.

So, do we have good reasons to expect rental yields (the inverse of the house price to rent ratio) in Australia to remain below their long term average for the period since 1975? In order to answer this question it might be helpful to consider the level of rental yields in Australia at present and how much capital appreciation (expected growth in house prices) is implicit in current rental yields. The underlying reasoning is that if potential home buyers – including investors - perceive that there is likely to be substantial capital gain in the years ahead they will tend to bid up house prices to a greater extent (other things being equal) and thus tend to depress rental yields. You need to work out how much capital appreciation they anticipate in order to assess whether or not their expectations are excessively optimistic.

Current rental yields in Australia - of the order of 3% to 4% in net terms – do not seem to me to imply unduly optimistic expectations about future capital appreciation if we use an annual nominal return on investment of say 8% per annum as a benchmark. One way of looking at this is to ask yourself whether you would expect average house prices and rentals to grow more or less rapidly than nominal GDP. I expect average house prices and rentals to grow more rapidly than nominal GDP in Australia because the effects of growth of population and incomes will tend to intensify the locational advantages of the median house relative to houses in the outer suburbs. A recently published Reserve Bank research discussion paper by Mariano Kulish, Anthony Richards and Christian Gillitzer  (‘Urban Structure and Housing Prices: Some Evidence from Australian Cities’) uses a model to illustrate, among other things, how growth in population tends to raise house and land prices to a greater extent in suburbs that are closer to the CBD of large cities. This is consistent with the empirical evidence presented in the paper that house prices in the inner suburbs in Australia rose by about 1.3% more per annum more than in the outer suburbs over the period 1992/3 to 2009/10.

Why are rental yields in Australia currently so much lower than the long term average over the period since 1975? The most plausible reason, it seems to me, is that as in many other countries high nominal interest rates (reflecting high inflation rates) were suppressing demand for housing over the first half of that period. As inflation rates and interest rates came down, housing affordability improved markedly during the 1990s, but this led to increased demand for housing, a sharp rise in house prices and a decline in rental yields. Mean reversion doesn’t apply in this instance because the mean was distorted.

Why should we expect house prices in Australia to avoid the fate of house prices in the US in recent years? Luci Ellis of the Reserve Bank gave some reasons why the US housing market is different in a speech she made last year. Unlike other developed countries, mortgage arrears on home loans in the US started to rise in 2006, more than a year before the unemployment rate began to rise. The leverage of the housing stock in the US was substantially higher than in Australia before the global financial crisis.

In addition, the decline in housing prices in the US that resulted from the bursting of the housing credit bubble was exacerbated by deflationary monetary policies that led to a major recession. This suggests to me that current rental yields in the US (of the order of 8% to 12% in some areas) should be viewed as being extraordinarily high at present and unlikely to persist in the longer term.

The final sentence of the article in ‘The Economist’ states: ‘A credit crunch or recession could cause house prices to tumble in many more countries’. Well yes, that does seem quite possible. If it does happen, however, I think there is a good chance that rental yields in Australia will eventually return to somewhere near the ‘normal’ levels that currently exist in this country.

Does the modern world make us feel like powerless creatures in the coils of an invisible monster?

‘What most alarms us in our contemporary world, what unsettles and scares us, is the extent to which the forces that shape our lives are no longer personal – they know nothing of us; and to the extent that we know nothing of them – cannot put a face on them, cannot find in them anything we recognize as human – we cannot deal with them. We feel like small, powerless creatures in the coils of an invisible monster, vast but insubstantial, that cannot be grasped or wrestled with.’ 

That quote seems to me to sum up the main point that David Malouf was making in: ‘The Happy Life; The Search for Contentment in the Modern World’, Quarterly Essay, March 2011.

In the paragraphs preceding the quoted passage, the author argues that it is possible for humans to be happy even in the most miserable conditions if they perceive their world as having human dimensions. He explains that a world with human dimensions is one that humans can recognize and encompass. In his words:

‘We start always from the body, and relate everything back to it. In a way that goes back to our most primitive beginnings, we use it to establish direction – where we are facing, where we might move to; to gauge distance – how far off an object is and how far we have got along the way towards it; to determine how each thing we are observing stands in relation to our own being – its size in relation to ours, how light or heavy it is when we try to lift it or weigh it on our palm; how much it occupies of the space we share; how it smells and tastes, how it feels to the touch or when we roll it between finger and thumb’.

I feel in awe of people who manage to maintain tranquillity in the most miserable conditions. It is probably correct to say that such people do experience the sources of human misery as having human dimensions – they feel uncertainty, discomfort, pain, fear and anger just like the rest of us – but they are not overwhelmed by such feelings. The fact that they have normal human feelings doesn’t mean, however, that they necessarily see major sources of human misery – extreme climatic events, for example – as having human dimensions.

Irrespective of their capacity to maintain tranquillity in the face of misfortune, our ancestors saw God (or the gods) as the most likely explanation for extreme climatic events – and just about everything else they experienced. Malouf acknowledges this, but he suggests that when we were in the hands of the gods we had stories that made these distant beings human and brought them close. Of the gods, he writes:

‘They watched over us and were concerned, though in moments of wilfulness or boredom they might also torment us as “wanton boys” do flies. We had our ways of obtaining their help as intermediaries. We could deal with them’.

By contrast:

‘The Economy is impersonal. It lacks manageable dimensions. We have discovered no mythology to account for its moods. Our only source of information about it, the Media and their swarm of commentators, bring us “reports”, but these do not help: a possible breakdown in the system, a new crisis, the descent on Greece or Ireland or Portugal, like Jove’s eagle, of the IMF. We are kept in a state of permanent low level anxiety broken only by outbreaks of alarm’.

I admire David Malouf’s writing style, but I have a couple of problems with this line of reasoning. First, personal gods left good people bewildered as to why bad things were happening to them. Remember the biblical story of Job, the virtuous man who suffered from ‘acts of God’. Job was not a happy chappy – he cursed the day he was born. My reading of the story is that Job tried to deal with God, but that didn’t work. Job found tranquillity only after he accepted that God was not a person that he could deal with. He had to learn to accept that some factors affecting his life were beyond his capacity to understand and influence.

Second, many people seem to have difficulty in accepting that economic forces are impersonal. Economic crises, in particular, are often viewed in very personal terms – for example, in terms of the excessive greed of human agents, such as Wall Street bankers, or even in terms of conspiracies involving bankers and politicians. Modern conspiracy theories have their demons (and super-heroes) in much the same way as ancient religions had their personal gods.

One of the features of the modern world is that the role of the personal gods has tended to be displaced impersonal scientific explanations of the forces that shape our lives. Do these scientific explanations leave people feeling unsettled? I don’t think so. Psychological evidence discussed by Timothy Wilson (in his book ‘Redirect’, discussed recently on this blog) indicates that people who are affected by negative events tend to feel worse when they are uncertain about the nature of those events and why they occurred.  Reducing uncertainty about negative events is a good way to bounce back from those events.

It seems to me that it is the uncertainty associated with recent economic crises that has made them particularly unsettling. With the onset of the global financial crisis there was a great deal of public discussion among economists about the inadequacy of existing scientific explanations of what was happening. When leading economists admit that they can’t understand an economic crisis, other people have good reason to feel unsettled. Over the last couple of years, however, there has been growing support among economists for the idea that (unconventional) monetary policy can be influential in shaping expectations about the growth of aggregate demand, even when interest rates are very low. This provides grounds for optimism that the world will be able to avoid a major economic downturn over the next few years. (At the same time, as I suggested in a post a few weeks ago, there are still some grounds for concern that the European Central Bank will maintain deflationary policies that will exacerbate the financial crisis in Europe and impact adversely on the world economy.)

More robust scientific explanations of economic crises could be expected to help the people who have adversely affected to adjust to their misfortune, but would they not still feel like small, powerless creatures in the coils of an invisible monster? Quite possibly.  Yet, a better understanding of the economic forces involved may give them reason to hope for better outcomes in future. A surfer who is dumped by a wave might feel like a powerless creature in the coils of a monster, even if he has some understanding of wave mechanics. But his understanding of why he was dumped might give him reason to hope that in future he is more likely to experience the exhilaration of riding the wave.

Should we be more concerned about the policies being followed by the European Central Bank?

Jim was obviously agitated by my response to his question. He had just asked me whether I thought that the latest political deal in Europe would resolve the European financial crisis. Instead of saying I didn’t know I had tried to list some relevant factors, none of which I knew much about. I ended my list by mentioning that the policies being followed by the European Central Bank (ECB) were preventing the governments of southern Europe from following their pre-euro strategy of using high inflation to fund their profligacy.

‘I suppose that means you would be a strong supporter of the ECB’s anti-inflation policies’, Jim said. ‘You were an inflation hawk back in the 1980s. And I can remember a discussion in 2006 when you told me you were worried about expectations of higher inflation in America and the possibility of a re-run of the stagflation of the 1970s and 1980s. A year or so later inflation expectations started to fall. Then in 2008 we had the global financial crisis and it became obvious to everyone that there was actually more reason to be concerned about deflation than inflation’.

Jim was right about the 1980s, but I couldn’t recall our conversation in 2006. I pointed out that it wasn’t necessarily inconsistent to be concerned about rising inflation expectations in 2006 and to be concerned about the emergence of deflation a couple of years later. I suggested that central banks should be aiming to keep inflation expectations low and stable.

Jim said: ‘The fact that you keep talking about inflation expectations suggests you must have read some of the material on Scott Sumner’s ‘Money Illusion’ blog.  I started to try to explain that Scott actually recommends that central banks should target NGDP (nominal GDP i.e. aggregate demand) rather than inflation expectations, but Jim cut me off. He said: ‘I followed the link on your blog to Sumner’s blog to try to understand the European financial crisis. You obviously haven’t read whatSumner wrote a couple of weeks ago about the ECB’.

I had to admit that I haven’t been reading Scott’s blog regularly over the last couple of months. Jim said that in the post about the ECB Scott had a chart about inflation expectations in Europe that had been sent to him by Lars Christensen. At that point Jim got slightly distracted. He told me that I should read a post that Christensen had written recently on his blog, ‘The Market Monetarist’, about Calvinist economics and the gold standard mentality. ‘Christensen must have written that post with people like you in mind’, Jim said.

Jim eventually came back to the chart showing inflation expectations in Europe. He explained that the chart implies that the ECB has been driving inflation expectations sharply lower during August and September despite its mandate to produce stable inflation.

Jim ended by saying: ‘Look, why don’t you write something on your blog telling people to read Scott Sumner’s post about the ECB. And don’t forget to quote the passage where he points out how why it is so important for inflation expectations to be kept stable in Europe at present’.

I’m not sure which passage Jim wants me to quote, but this one seems to capture the main point:

‘I’m not saying a policy of steady eurozone inflation would solve the debt crisis, obviously it wouldn’t.  But the current policy is making it far worse than it needs to be.  The US made the same mistake in mid-2008.  Even at that time the subprime crisis was well understood, and estimated losses to the US banking system were quite high.  But when the Fed drove NGDP expectations much lower in late 2008 … the debt situation got far worse, and spread far outside the original subprime sector.  Now we are seeing the euro sovereign debt crisis spread to more and more countries.’

Perhaps we should be more concerned about the potential effects of the aggressive anti-inflation policies being followed by the ECB.