Executive Summary Of Reviewing the Sale Of Liquor Act: Tax and Pricing Consequences

This entry was posted in Health on 30th June 2009 by Brian Easton.

Report prepared for the New Zealand Law Commission. Filed 30 June, 2009. The Executive Summary was reproduced in the Law Commission’s report Alcohol in Our Lives, p.172-175.

The full report

Keywords: Health;

Conclusions
            – on the whole, much alcohol consumption is benign or even socially beneficial, but some generates very great social harm;
            – this harm may be reduced by various interventions, but their effectiveness is limited because of the need to allow consumption which is benign and socially beneficial;
            – a specific tax on alcohol is a means of reducing the harm through internalisation of an external cost (the efficiency gain), and compensating those who suffer harm from others’ drinking (the equity gain). However neither objective can be precisely attained.
            – the New Zealand system of an excise duty on absolute alcohol has much to commend it. However more attention could be given to the minimum purchase price of absolute alcohol

1. The Policy Framework

The Sale of Liquor Act 1989 was based on the premise that most consumption of liquor was benign or even beneficial but that some was extremely harmful in comparison to most products. Rather than control everything, which had been the broad practice before 1989, the aim was to target consumption which was markedly harmful.

It involved a marked liberalisation of the supply of liquor, moving from ‘quantity licencing’ (the number of outlets) to quality licensing (anyone could set up an outlet, providing they met certain quality standards). At the same time there were associated measures to reduce certain kinds of harm, including more vigorous pursuit of drink-driving.

The Sale of Liquor Act was one of the most successful social reform of its times, vastly improving access to liquor for moderate drinkers, transforming and enlivening inner cities with a plethora of small bars and restaurants. There is no evidence that harm rose – indeed the downward trend of absolute consumption per adult continued across the reform period.

In recent years there has been some evidence of rising harm in some areas including
            – increasing teenage drinking;
            – increased evidence of binge drinking;
            – new forms of alcohol;
            – evidence of the magnitude of the social harm from alcohol, which is substantial.

2. The Harm From Alcohol

There have been two major attempts to provide estimates of the social costs of alcohol misuse. While their exact estimates may be challenged, each brings together the existing available data on social harm and assign values them. They show that there is substantial harm caused by the misuse of alcohol.

The harm can be divided into three components.
            – the additional costs to the public purse;
            – the material (or ‘tangible’) costs which are borne by the private sector;
            – the human (or ‘intangible’) costs covering the loss of quality of life and early mortality.

A major issue is the degree to which these costs are ‘internalised’, that is, taken into account by the person who purchases or imbibes.

External costs are a major justification for excise duty on alcohol, insofar as the drinker fails to take them directly into account when they make the consumption decision.

3. Rational and Irrational Drinkers

What costs are included in a drinker’s decision is an empirical matter. Economists’ default position assumes ‘rational economic man’ who takes into consideration all the costs of a consumption which impact on him but none of the costs which impact on others.

Some economists treat the notion of rational economic man as a useful analytic device for want of a better hypothesis; others treat the notion as a fundamental economic assumption which may not be challenged. The difference leads to a major difference as to what is or is not included in social costs.

There is hardly any direct evidence that ‘rational economic man’ is a realistic account of how humans make decisions. In recent years an alternative framework has begun to evolve around ‘behavioural economics’ which is characterised by close attention to psychology’s research and theories. It is much less an a priori approach than that upon which rational economic man is based.

Relevant to this report is ‘time inconsistent’ decision making, which is the notion that even without any new information a person may regret a decision which earlier had been made rationally. The time inconsistency arises because the discounting of decisions through time differs from that which is assumed for rational economic man. It leads to the conclusion that drinkers who suffer from it will retrospectively welcome a tax on their consumption since it limits the excessive drinking which subsequently they will regret. That means some consumption is not (subsequently) valued by the consumer, and therefore is an externality and a contributor to social costs.

4. The Case For Taxing Alcohol

It is clear from the evidence that alcohol consumption causes considerable harm which is not always taken into consideration when individuals make decisions to imbibe. Public policy has introduced a range of interventions which aim, one way or another, to internalise the decision, so that the drinker takes into consideration more of the harm which the drinking causes.

In practice it has not been possible to eliminate all the social harm by education, private arrangements and statutory and regulatory interventions. It has been a standard practice to use specific taxes on alcohol to deal with the remaining social harm.

There are two channels by which this may work – modification of drinking patterns and compensation for social harm; one is an efficiency gain, the other is an equity gain.

It is generally assumed that the demand for alcohol is largely price inelastic. However, it is believed that the main groups whose consumption is sensitive to changes in prices are
            – the young;
            – binge drinkers;
            – heavy drinkers.

Any reduction in the quantities they drink will reduce social harm to some extent. Thus a specific tax will increase the efficiency of the system. Where there is time inconsistent decision-making the tax will make such drinkers better off in the long run, and that they will welcome it from this perspective. It is assumed that the impact on the quantities drunk by moderate (time consistent) drinkers is zero. Insofar as the tax is not recycled back to them, they may be worse off in real income terms (although even then they may be better off from lower social harm).

It is not possible to state with any precision the exact winners and losers of a specific tax on alcohol, except that non-drinkers will be beneficiaries since irrespective of whether they receive any of the recycled tax revenue, they will pay none of it, and they will (probably) benefit from reductions in personal harm. Since there will be overall reductions in social costs from higher specific taxes, the aggregate gains (including the reductions in social costs) of the winners will be greater than the losses of the losers; there will be a net social gain from the efficiency gains.

There is a strong argument that there is an injustice when non-drinkers and moderate drinkers pay for the harm of others. It could be argued there is justice in specific alcohol tax transferring some of the burden of these costs from the non-drinkers and moderate drinkers to the drinkers who are generating the harm. Such compensation improves the equity of the system.

5. The Taxation Implications for New Zealand

When the price of alcohol goes up, many people have the option of maintaining their absolute alcohol consumption for the same cost, by reducing the quality of what they drink. However drinkers on the cheapest form of absolute alcohol do not have the option of reducing the quality of their consumption following a price hike. Some of the most harmful drinking occurs in these circumstances. Insofar as the aim is to use taxation to regulate absolute alcohol consumption with the objective of reducing harm, attention should be paid to the price of absolute alcohol levels, particularly where they are cheapest.

The New Zealand alcohol taxation regime is particularly suitable for this purpose since it is levied on the basis of absolute alcohol content.

There is a general acceptance that the aggregate revenue from the excise duty should at least cover the fiscal costs. The compensation principle suggests it might also cover the social cost to the non-drinker. In practice it is likely that the cost recovery would not be complete and that some harm would not be compensated – even crudely – through the tax system.

An alternative approach arises from the focus on modifying drinking patterns. Taxing Harm recommended that the excise duty should be set to target some minimum price of absolute alcohol.

In summary the two gains from a specific tax on alcohol – the efficiency gain from moderating harmful drinking, and the equity gain from compensating for the harm – give slightly different recommendations for the level of an excise duty on absolute alcohol. It seems likely that, whether the purpose is to ensure the minimum price of absolute alcohol discourages harmful drinking or whether the purpose is to adequately compensate for the harm, the current excise duty is too low.

Tax rates need always to be set with the possibility of avoidance in mind.

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The Commercial Value Of Taniwha Springs

This entry was posted in Environment & Resources, Maori on 30th June 2009 by Brian Easton.

Report prepared for Te Maru o Ngati Rangiwewehi (June 2009)

Keywords: Environment & Resources; Maori;

Introduction

My name is Brian Henry Easton. I am an independent scholar with particular expertise in economics, social statistics and public policy analysis. I hold a D.Sc. from the University of Canterbury and am an adjunct professor at the Institute of Public Policy in the Auckland University of Technology.

Over the last 40 odd years I have worked in a number of areas pertinent to this evidence, including project evaluation, regional planning, and resource economics; I have also provided evidence and advice in a number of Waitangi Tribunal and similar claims.

I agree to standards set down in the code of conduct for expert witnesses at Courts. I am also a Fellow of the Royal Statistical Society, a Member of the Royal Society of New Zealand and a member of the Professional Historians Association of New Zealand, all of which have their own codes of conduct, consistent with the Courts’ code, and by which I also abide.

I have been asked by Te Maru o Ngati Rangiwewehi to assess the commercial loss to them from the restrictions on their use of Te Puna o Pukehau Springs (also known as Taniwha Springs).

The reports analysis can be summarised as follows:

– This report shows is that the decision of the Environment Court in August 2008 to delay the return of Te Puna o Pukehau Springs (Taniwha Springs) meant a potential loss of revenue to Te Maru o Ngati Rangiwewehi because there will be a 10 year (at least) delay in the development of the premium tourist attraction of which the site is capable.

– Based on the Hamurana Spring Recreation Reserve leasing arrangements, the Net Present Value of this lost revenue is estimated to be $550,000 (at a 7 percent p.a. discount rate, and assuming no substantial growth in revenue after the development is fully operational) .

– This estimate covers the commercial loss only and is based on conservative economic projections and assumptions. Additionally It does not make any allowance for losses due to damage to the spiritual values of Te Maru o Ngati Rangiwewehi, nor for compensation for justified grievances.

The Issues To be Considered

Economic Issues

Since 1966 the Iwi has not has total access to its property at Taniwha Springs because the Rotorua District Council has been using it as a source of water for distribution to the households and businesses of the western supply area of Rotorua. The Environmental Court, ruled that the Council may continue its draw-off (subject to various restrictions) until 2018 (Decision 095/2008). The effect of this sourcing is that it markedly reduces the use of the Springs for other purposes.

Spiritual Values

My evidence is concerned only with the values of the restriction on commercial use by the Iwi. It is clear that they are of considerable spiritual value. These were taken into account by the Environmental Court, and were of sufficient value to result in a ruling that the Council should use alternative sources of water as soon as was practical, even though the alternatives (ground water bores) were more expensive.

My figures do not include any estimate for the spiritual values. to the Iwi.

Grievance Issues

The Waitangi Tribunal concluded that some of the events which had happened in regard to the taking of Taniwha Springs were inconsistent with the principles of the Treaty of Waitangi, leading to serious prejudice to Ngati Rangiwewehi. (Central North Island Waitangi Tribunal report, Volume III , p.506-507, 510).

My figures do not include any estimates for compensation to the Iwi for grievance.

Commercial Uses of Taniwha Springs

When the water draw-off from Taniwha Springs ceases the property has the potential to be a premium tourist attraction. I draw this conclusion from the evidence to the Environment Court of such experts as Dr Marian Mare, Tai Eru and Trevor Maxwell. The evidence from various materials published by the Ministry of Tourism on the prospects for cultural tourism in the Rotorua District, and the Destination Rotorua’s Ten Year Plan supports the view that there will be an increasing demand for further premium tourist attractions such as Taniwha Springs in the future .

To assess the commercial value of the Springs’ potential as a premium tourist attraction I use the evidence to the Environment Court of Mr Wetini Mitai-Ngatai. It relates how in 2005 Mr Wetini Mitai-Ngatai seized the opportunity to turn a run-down site known as Fairy Springs into a thriving business. His affidavit does not provide the complete story, but there is one salient figure which indicates the potential value of cold water springs of high environmental quality as a tourist attraction.

In the short period of his stewardship, Mr Mitai-Ngatai has built his Mitai (previously Fairy) Springs business up to an annual turnover of $3,000,000 (in 2008 prices, or $3.3m in 2013 prices, which will be used for the projection). He says he expects to increase the turnover further, but this figure is used as a conservative estimate of the potential of Taniwha Springs.

The assessment does not assume that such a turnover would have been realised in the past, Rather, at some stage in the future, the existing developments will reach their full capacity and further developments will be needed. .

The Ministry of Tourism projects that total visitor nights in Rotorua will increase from 3.43m in 2006 to 4.02m in the seven years to 2013, an increase of 1600 tourists on an average night. (http://www.tourismresearch.govt.nz/RegionalData/North+Island/Rotorua+RTO/) In addition there will be day trippers.

That means the region has to create over the next seven years sufficient activities to keep an additional 1600 tourists. and more. interested and entertained each day, over and above what it currently provides. If it fails to do this the official projections of tourist numbers will be too optimistic. If it does better, tourist numbers will grow faster.

Mitai Springs demonstrates that Taniwha Springs has the potential to contribute to those additional activities. While its possible turnover (of around $3m) would be small in comparison to the official estimates of total tourist spending, it will play a vital role in the regions’s tourist industry, because the main spending – on accommodation, food transport and sundry purchases, depend on the existence of premier attractions such as Taniwha Springs could be.

I observe that Mr Mitai-Ngatai ‘s project demonstrates that there need be no clash between the spiritual values of the Springs to the Iwi and the commercial values. The Iwi may even conclude that an appropriate commercial development would enhance its spiritual values.

The Agreement Between the Minister of Conservation and the Rangiwewehi Charitable Trust

The analysis derives a commercial value of the Springs to the Iwi using the terms in the agreement between the Minister of Conservation and the Rangiwewehi Charitable Trust in which the Trust leased to the Department of Conservation the Hamurana Spring Recreation Reserve, (Concession number BP-17887-SSE).

This Spring is to the north of Lake Rotorua (perhaps four or so kilometres from Taniwha Springs). The concession activities mentioned in Schedule 1 of the lease are as follows:

– to establish a cultural and commercial venture at the Hamurana Springs Recreation Reserve based at Hamurana Lodge and the Amenity Area;

– Lodge Area: to develop a cultural and commercial venture that will provide services and refreshments and a range of products and services that will add positively to the visitor experience at the Hamurana Springs Recreation Reserve ;

– Amenity Area: to enhance visitor experience by offering the use and enjoyment of the amenity area for recreation, relaxation and enjoyment at the Hamurana Springs Recreation Reserve.

These activities are not necessarily those that will develop immediately at the better located Taniwha Springs. However the terms of the lease are such that they would apply, were the Hamurana Springs Recreation Reserve to pursue the sort of development that might be envisaged for Taniwha Springs. They therefore may be applied for a potential lease for Taniwha Springs.

The terms of the Hamurana Springs Recreation Reserve lease are for 30 years (expiring in June 2037) with a concession fee as follows:

Years 1 to 3: $500 (+GST) per annum.

Years 4 and 5: $1000 (+GST) per annum.

Years 6 to 30: 2.5% of gross revenue per annum.

There is also a $1100 (+GST) per annum Environmental Monitoring Fee. This may be ignored as it reflects costs incurred by the monitoring. .

There is a provision in the lease (Section 7) for a Concessions Fee Review Data after three years from the commencement date and three years thereafter. The following calculations assume that there will be no substantive change when the reviews occur, and so the reviews may be disregarded.

The general form of the agreement may be interpreted as follows: The intention is to give the lessor a five year period to develop the commercial possibilities of the Reserve, during which a nominal fee is charged. After five years a commercial rate (of 2.5% p.a.) is applied.

The Commercial Value of Taniwha Springs as a Premier Tourist Attraction

It is assumed that had the Environment Court ruled against further water draw-offs by the Council from August 2008 the Iwi would have arranged the a lease similar to that it did (a year earlier) with the Department of Conservation in regard to Hamurana Springs Recreation Reserve, with on the assumption that the lessor would have developed a premium tourist attraction (like Mitai Springs) over the following five years.

As previously indicated it is assumed that in the sixth year the turnover is $3.3m (i.e Mitai’s turnover plus inflation) and that continues indefinitely with a nominal growth of 2 percent p.a. for inflation. This is a similar pattern to that reported by Mr Mitai-Ngatia – perhaps the build up is a little slower but he was taking over a existing concern. In his evidence to the Environment Court, Mr Mitai-Ngatia, said he expected that the turnover would increase in future years. This report takes a more conservative assumption of no increase except for inflation (although the assumptions robustness is tested below).

These assumptions determine a stream of income through time. This stream of revenue is consolidated into a .lump sum representing its value at the beginning of the period, The lump sum is called the Net Present Value. It represents the value to the Concessionaire, in this instance, if instead of taking a revenue flow over time, it had taken a lump sum at a point in time.

A nominal discount rate is required in order to calculate the Net Present Value. The figure used here is 7 percent p.a. (that is 5 percent p.a. real – assuming a 2 percent p.a. inflation rate).

Discounting the stream of income on the basis of the lease arrangements, Net Present Value of the lease was $1.18m.

However this assumes that the alternative is water draw-off for ever. But the Environment Court only gave consent for draw-offs until 2018. The relevant detriment to Iwi is the consequence of the delay of 10 years, rather than a permanent inability to develop the site. The Net Present Value had the scheme from delaying the development by 10 years is $0.73m in 2008.

Thus as a consequence of the Environment Court decision, the Iwi suffered a loss in its commercial interest in Taniwha Springs of $450,000 ($1.18m – $0.73m).

In summary

Net Present Value

of having immediate access to Taniwha Springs for commercial development $1.18m

of having access delayed ten years to 2018 $0.73m

Difference attributable to Environment Court delay $0.45m

Note that this figure is NPV in 2008. It should be increased by the interest rate (equal to the discount rate – 7 percent p.a.) for compensation after this date. Thus if the settlement is in 2010 the relevant amount is $520,000 (i.e. $450,000*1.07*1.07).

Variations on the Base Assumptions

This section considers the sensitivity of the outcome to the assumptions made .in the calculations in the previous section.

Phasing of the Development

It could be argued that 2008 was the wrong year to commence the development. However, after allowing for the business cycle (the current recession) the operation business would want to be fully operating by 2013. On the other hand, there is probably not enough demand for such a premier tourist attraction before then.

Perhaps a more serious phasing issue is that the delaying of the development as a result of the Environment Court decision, might be longer than 10 years if it allowed some alternative venues to develop and absorb the growing demand. A delay of the the development of one year after to 20119, would add a further $48,000 to the difference.

Thus the estimate provided here is conservative as far as the phasing of the development is concerned.

Inflation

The estimate is neutral in regard to different levels of inflation, providing the same real discount rate is used.

Discount Rate

The following table gives an indication of the effect of the choice of (nominal) discount rate

Discount Rate (% p.a.)	Commences 2008	Commences 2018	Difference	Difference Return p.a.
5.0	$2.09m	$1.54m	$0.55m	$273,000
6.0	$1.53m	$1.05m	$0.49m	$297,000
7.0	$1.18m	$0.73m	$0.45m	$315,000
8.0	$0.94m	$0.53m	$0.41m	$328,000
9.0	$0.77m	$0.40m	$0.37m	$337,000

As is usual for such calculations, the Net Present Value of a revenue stream is sensitive to the choice of discount rate, with a higher NPV for a lower discount rate.

However, if instead the return on the NPV if it is invested at the discount rate is compared, the difference is much smaller, and a better annual return is obtained from the higher discount rate. (e.g. $0.55m * .05 = $273,000 etc.) This return is shown in the final column of the table, and indicates that there is less variation of return than there is of the NPV. (Indeed the ranking is in the opposite direction with the larger discount rate giving as better return.)

Growth of Revenue

It was assumed that a premier tourist attraction based on Taniwha Springs would have generated a revenue of $3.3m (in 2013 prices) in 2013, and after that there would be no subsequent growth other than from inflation. This is conservative assumption, but it is hard to identify a plausible alternative.

In order to illustrate the sensitivity of this assumption, the NPV is calculated assuming an additional 1 percent real (annual) growth after the first year of full operation.

This changes the base table as follows:

Net Present Value

of having immediate access to Taniwha Springs for commercial development $1.46m

of having access delayed ten years to 2018 $0.90m

Difference attributable to Environment Court delay $0.56m

Most of the difference between the bottom line ($450,000 vs $560,000) comes from the fact that delay means that the revenue level of the 2018 development is lower than the 2008 development in the long run.

A higher growth rate of revenue would, of course, increase the difference.

Summary

The assumptions made in the previous section are generally conservative. The result is most sensitive to the future revenue stream of the development.

Conclusion

What this report shows is that the decision of the Environment Court in August 2008 to delay the return of Te Puna o Pukehau Springs (Taniwha Springs) meant a potential loss of revenue to Te Maru o Ngati Rangiwewehi because there will be a 10 year (at least) delay in the development of the premium tourist attraction of which the site is capable.

Based on the Hamurana Spring Recreation Reserve leasing arrangements, the Net Present Value of this lost revenue is estimated to be $550,000 (at a 7 percent p.a. discount rate, and assuming no substantial growth in revenue after the development is fully operational) .

This estimate covers the commercial loss only and is based on conservative economic projections and assumptions. Additionally It does not make any allowance for losses due to damage to the spiritual values of Te Maru o Ngati Rangiwewehi, nor for compensation for justified grievances.

The Economic Crisis: Where Does ACC Fit In?

This entry was posted in Macroeconomics & Money, Social Policy on 29th June 2009 by Brian Easton.

Paper to the summit “Reviewing New Zealand’s Accident Compensation System” Wellington, 29 June, 2009.

Keywords: Macroeconomics & Money; Social Policy;

The world is facing a global financial crisis with the international system malfunctioning, as many banks – which provide the means of payment and facilitate investment – having to limit their lending because they have unsatisfactory balance sheets with insufficient equity relative to their liabilities (which are most commonly deposits). The limitations of the financial institutions means that the payments systems is not functioning properly with the consequence that it is difficult to borrow, thus seizing up the markets for trade credit, consumer credit and housing and business investment. This means there has been a reduction in demand and thereby a reduction in production and unemployment.

The global economy is so interlinked that even countries with relatively sound financial institutions – one might cite Germany – are suffering because there has been a fall-off of their

exports – in the case of Germany especially for the investment good exports they specialise in.

It would be easy to argue that is all New Zealand’s problem is. The fall in world demand is squeezing our exports and we face volume reductions last year, this year and possibly next. The fall in volumes is compounded by some weakening in export prices, which means that what we do export earns even less foreign exchange. This is what happened in the Long Depression of the 1880s and the Great Depression of the 1930s.

However the New Zealand economic situation is more complex than simply a lack of world demand for our exports as a result of the Global Financial Crisis. The great economist Alfred Marshall warned that any short statement in economics is wrong with the possible exception of this particular one. But if there was a short statement to summarise the current situation it might be that the Global Financial Crisis has exposed some fundamental weaknesses in the New Zealand economy.

That means we cannot get out of our economic difficulties unless we address those fundamental weaknesses. If we dont understand this we may pursue policies which will add to those weaknesses.

What are they? Because this conference is about ACC I am going to focus on a particular one, which is New Zealand’s indebtedness. We have a debt crisis.

I begin by insisting that as far as we know our banking system is sound, insofar as each trading bank has sufficient equity relative to its liabilities. Thus they are not like the international financial institutions which have generated the Global Financial Crisis. Our problem is that while sound, our banks have to borrow about a third of their funds offshore with the remaining two thirds are supplied by New Zealanders.

The Global Financial Crisis has made this offshore borrowing difficult. It is both relatively more expensive and it is shorter term. It is difficult to borrow for periods as long as a year, and so the banks are on a treadmill of rolling over their debt, knowing that if the global financial system seizes up again, they may not be able to. One hopes, of course, that it wont, and that the measures taken in Britain and the United States are leading to a normalisation of their financial systems. However, it would be imprudent to assume that such a crisis cannot happen again, or that the international banks will not return to business as usual as early as is hoped. Previous long recessions/depressions were characterised by false dawns – green shoots can whither.

So the macroeconomic problem that the New Zealand economy faces – aside from weaknesses in its export markets – is that it has a heavy borrowing commitment offshore. Since we are continuing to borrow from the rest of the world, we have to both roll over old debt and taken on new debt. This year to March 2010 we are expecting to borrow – one way or another – an extra 7 percent of GDP in addition to the borrowing rollovers. We need that extra $12b to pay for the imports needed to sustain the economy which we cant fund from exports; next year it may be another $10b.

The forecasts on which these estimates are based may be optimistic. Even so, they suggest that New Zealand’s net overseas liabilities will rise from about 100 percent of annual GDP in March 2008 to 120 percent in March 2011. That means remaining an outlier among the rich OECD economies, with the exception of Iceland.

So in addition to the weakness in the international economy undermining our export effort (which increases the need to borrow offshore), we face a debt crisis. The economy has too much debt, and that debt is increasing relative to the size of the economy.

You can see the policy problem we face. The orthodox response to a world economic downturn impacting on New Zealand is that the government should borrow to fund extra demand to tide the economy through the consequent internal downturn. But that exacerbates the debt crisis, making the economy more vulnerable if there is another international downturn or the weak international recovery that is expected lapses into further financial difficulties.

That is why we have had a rather strange public debate in which two parties are talking past one another. One party focusses on the weak economy which is a consequence of the international downturn. The (perfectly orthodox) response to this sort of demand weakness is that production and employment in the economy can be sustained by government spending and/or tax cuts filling the gap in demand. Ideally this demand stimulation should be temporary, unwinding as normal private sector demand refills the gap. Thus there is a merit on infrastructural investments – roads, telecommunications, house improvements – which can be ended as the economy recovers. It is a pity that the April income tax cut was not also temporary – say for just two years. I shall come back to the fiscal problem which it contributes to shortly.

The other party to the debate is concerned about the debt crisis, the excessive and unsustainable New Zealand external debt. Its prescription is that the economy is going to have to reduce the offshore debt, and that requires increasing national savings. That is exactly the opposite response to the weak economy prescription, which says we should spend our way out of the recession. For those concerned with the debt crisis that is equivalent to trying to resolving a hangover by having a hair of the dog that bit you the following morning.

There might seem to be a compromise if households save thereby reducing their debt while the government, which started off with a good balance sheet, spends. In effect that is what is happening; households are trying to rehabilitate their balance sheets by reducing their spending and increasing their savings; meanwhile the government is increasing its spending by borrowing.

But in the current circumstances, such a solution is a bit like an adolescent explaining to his father that he is broke because he has spent everything on heroin, and would his dad pony up the cash so he can keep to the smack. It’s a form of debt-shifting between domestic sectors but it does not resolve the national debt problem which is about total debt. In fact it makes it worse, because both son and father – households and government – are getting deep into debt.

The inconsistency between those who wanted to borrow more and those who said there was a debt crisis was resolved externally because the government found there was a limit as to how much it could borrow. The way the public saw it, the credit rating agencies said ‘no more borrowing’, or rather they said if we increased our borrowing interest costs would rise. The cost would not only be higher rates to the government and the taxpayers, but the costs to the banks rolling over their borrowings would rise, so that would raise the debt servicing costs to businesses and households.

Commentators demonised the agencies, but you dont think international banks who are lending tens of billions dollars rely on them? They do their own credit ratings. The government hires the credit rating agencies to tell us what those banks’ internal assessors think. So an agency’s assessments reflects what our lending sources think. We are not beholden to the credit rating agencies; we are beholden to the international banks we borrow from. That is always true for any debtor. Recall Mr Micawber’s “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

It is instructive that the when the government agreed to revoke its future income tax cuts, at least one of the credit rating agencies took us off credit watch. Clearly they thought the promised tax cuts were imprudent. Which leads one to speculate that had the April cuts been temporary, we could have – irony of ironies – borrowed more this year and next without raising borrowing costs.

Unfortunately there is no legislative provision for their reversal, so the public borrowing is limited this year and next. Further out we face an issue which we have only been aware of since the election.

Normally a government borrows during a recession, but as the economy recovers tax revenue also recovers and some spending (such as on unemployment benefits) abates, while some of the public infrastructural spending gets wound down. The fiscal position thereby returns to the situation before the recession. Since the New Zealand government was running a fiscal surplus before the recession we might have expected a return to fiscal surplus in, say, 2011. At which point the government would get a ‘big hooray’ from the credit rating agencies – actually from the offshore banks lending to us.

However, it turns out that the fiscal position does not return to a surplus after the recession. There seem to be two problems. One is that, as I have indicated, the permanent income tax cuts have reduced revenue in the long run. But also there is the problem of public expenditure.

The aggregate public spending track set out in the 2009 budget is similar to that in the 2008 budget track. There have been very slight cuts but they are minor compared to the projected increases. So if the track was OK in 2008 what went wrong a year later?

What seems to have happened is that the long run GDP track has been lowered. While it is expected that the post-recovery economy will grow at about the same rate as it did over the last decade, the future track appears to be about 3 percent lower. In effect during the last decade the economy was running hotter than was sustainable then, fuelled by the offshore borrowing. The forecasters seem to think there not only has to be a recession to stabilise the borrowing, but the economy will not run as hot thereafter.

There are a number of issues which follow from this, although we need a bit more work on the propositions I have just set down before we can fully explore them. However I think we can say something about the consequences for the fiscal position. If the economy moves onto a track 3 percent lower than the recent past, it follows that there is a case for saying that government spending projected on the old track is 3 percentage points of GDP too high. Meanwhile there is a loss of tax revenue relative to the old track of about 4 percentage points (higher than the 3 percent because of the fiscal drag in the tax system). Combined the two effects explain the shift from a structural fiscal surplus in the past to the structural deficit which is currently projected.

How we get back to a structural surplus is something which is going to preoccupy the government for at least the next three years. In the interim the government is going to be borrowing big with the threat to fiscal sustainability and our credit rating that implies.

These issues seem far from those facing you reviewing ACC. I would think more than 90 percent of the issues which this conference is considering have to be addressed whether the economy is in recession or boom. In either case it is important that the system of accident compensation is effective, efficient and equitable.

So has this session about the economy got anything to say about the ACC review? How does ACC fit into the macroeconomy and the economic crisis we all face?

As it happens the ACC is a major saver in the economy – its revenues exceed its expenditure. The surplus is invested in the ACC fund. The next paper by Michael Littlewood and Susan St John will discuss this fund in detail. I dont want to preempt their paper, but I do want to talk a little about the macroeconomics of the fund.

The justification for the fund is that it pre-funds the future expenditure which the accidents of the past have incurred. The idea is that the funding is invested to be used to meet the expenditure in the future.

As far as macroeconomists are concerned, pre-funding by government agencies is a form of public saving, which is invested when there is a fiscal surplus. I assure you given current private saving behaviour we need a fiscal surplus in the medium term – this is an issue that I have not discussed in this paper, although I am happy to do so at question time. The prefunds are a cunning means of squirrelling away part of the surplus, hiding it from those who do not understand macroeconomics and think that surpluses should be used for tax cuts to further their consumption binges.

From the macroeconomic perspective the difficulty is how to access the nest eggs when they are needed to sustain the macroeconomy when there is a fiscal deficit. Its like having a rainy day fund, which you prudently build up in sunny times, but which you cannot get at when it rains. The temptation has to be for the government to raid the pre-funds given the borrowing challenges it faces. Yet there are political imperatives which would restrain it from doing so. At issue is how to unlock the pre-funds without destabilising macroeconomic policy in the long run.

To go a little deeper, the issue, high-lighted by the credit rating agencies, is how to reduce the amount of borrowing from the offshore banks. Every $100m we dont have to uplift potentially reduces the level of interest rates we – the government, households and business – have to pay, and so reduces the interest rate burden across the economy. It is also a win as far as the offshore banks are concerned, because the New Zealand economy looks less risky to invest in.

One way of reducing pressure on the existing financial instruments is to find a new one especially if it unlocks our rainy day reserves. What I am I am going to suggest is a simple instrument – nothing fancy – attractive to a pre-funding government agency or even for a pension funds like Kiwisaver.

What the New Zealand financial system lacks is a long bond, say for 20 years. Fixed interest long bonds tend to be unattractive because of the risk of inflation. So let us make the new long bond’s return equal to a fixed premium above the rate of inflation. That need not be more expensive for the government. What it does is to shift the inflation risk from the investor to the government. If it gets it wrong the government (that is the taxpayer) pays, although if inflation over the 20 years proves to be lower than anticipated there will be a gain to the public purse. Moreover, insofar as the long bonds are held indirectly by New Zealanders, any wins or losses from inflation will be in part picked up by the tax system.

So let us explore the idea of a long bond which will be attractive investments to long term investors such as the government agencies which are involved in prefunding future spending, such as ACC, and indeed pension funds.

You might say the government is still borrowing, but it is borrowing from a different pot, so there will be less offshore borrowing from international whole sale matrkets. Moreover the offshore bankers, who are considerably more sophisticated than the commentators in New Zealand’s public debate, will recognise that the New Zealand government is unlocking some of its nest eggs – rearranging its balance sheet – so there will be no additional threat to the economy’s medium term sustainability as far as they are concerned.

There will still be a need for medium term fiscal measures to reduce the structural deficit. If we are on the lower growth track we are going to have to restrain the public expenditure path or raise taxes – probably both. But a medium term bond, attractive to the prefunds, such as the ACC fund, would give us a little more room for manoeuver during the difficult period of high under-utilisation of economic capacity – of slow economic growth and high unemployment. It would ease the drastic adjustments needed to resolve the debt crises, but those adjustments, of households and businesses saving more and spending less, remain necessary and a priority in the medium term.

So while the ACC issues are largely independent of the current economic crisis, ACC’s prefund and some of the others can contribute to relieving the short term stress while we tackle long term problems.

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Foreign Liabilities Versus Assets.

This entry was posted in Macroeconomics & Money on 29th June 2009 by Brian Easton.

Appendix to Forecasting New Zealand’s Net International Investment Position
Keywords: Macroeconomics & Money;
I really wanted to project foreign liabilities relative to all assets. It is a different story if the liabilities rise more slowly than the assets or vice versa.

Statistics New Zealand provides estimates of ‘Net Capital Stock’ which is the accumulated sum of depreciated fixed investment. In March 2007 this amounted to about $505b. To this can be added the value of inventories which includes the stocks of commerce (wholesale, retail and manufacturers) plus the value of livestock and the trees. They amounted to about $43b in 2007.

The major omission is the (unimproved) value of land. Blue Hancock of Quotable Value kindly provided me of an estimate of the Gross Rating Land Values as $584b in 2007 (some of the valuations are 2005 and 2006 ones).

Summing the three gives a total value of $1,132b for 2007, and implies a capital to GDP ratio of 6.8 years. (This might seem a bit high; I expected 4 to 5).

Hancock also supplied the Gross Rating Capital Value of $1,031b which (by deduction) suggests Gross Improvements $446m which is quite close to the $429m aggregate for the SNZ subcategories of residential building, non-residential building and other construction. The former includes the value of the stocks of trees, but the latter includes the cost of roads and such like. (Even so, I was surprised how little of New Zealand capital is in plant and machinery, transport equipment and intangibles assets; $75b in 2007 according to SNZ. Add in livestock and commerce stocks and it is less than $120m.)

Suppose the value of New Zealand’s assets was near $1,000b – a trillion dollars. Gross Foreign Owned Liabilities (that is ignoring off shore assets owned by New Zealanders) amounted to about $264m in 2007. So around one quarter of New Zealand capital assets are owned by foreigners. (The notion of ‘ownership’ includes New Zealand’s domestic assets either owned offshore or are a security for a loan sourced from offshore.)

This figure has to be treated as an order of magnitude only. Aside from the inconsistencies already discussed, there is unlikely to be exact consistency between the valuation methods of the two aggregates. For instance SNZ’s capital stock is based on the depreciated value of the installation cost of an asset, while the Gross Foreign Owned Liabilities values the same asset as that implicit is a company share price.

In the end I thought there were too many uncertainties to project these numbers, even if I had the detailed components of the (Treasury) forecast which are necessary.

Forecasting New Zealand’s Net International Investment Position

This entry was posted in Macroeconomics & Money on 28th June 2009 by Brian Easton.

This paper was prepared in January 2009 and revised in June 2009. Its purpose was to clarify some issues.
Keywords: Macroeconomics & Money;
Overseas debt had a significant role in the Long Depression of the 1880s and 1890s and the Great Depression of the 1920s and 1930s. This suggests it would be helpful to be able to forecast New Zealand’s overseas liabilities, especially as it enters what is expected to be another period of exceptional economic difficulty.[1]

After setting out some broad features of the overseas assets and liabilities, this paper derives a forecasting method which is then applied to current macroeconomic forecasts, and ends up discussing a related policy rule.

Its broad conclusions:
– in March 2009 the Net International Invest Position (NIIP) was 51 weeks (or 98 percent of annual GDP ) implying that it would take the production of almost an entire year to pay off net foreign liabilities;
– the ratio been rising in recent years, and is expected to rise further in the next five years. In March 2013 it seems likely that it would take over 13 months of production to pay off the NIIP.
– the implication is that New Zealand may come out of the world recession in worse shape in overseas liabilities than it entered, and even more vulnerable to the next international crisis;
– in March 2008 Gross Foreign Liabilities were about a quarter of New Zealand’s Domestic Assets (Appendix I);
– there is a policy rule that suggests that if New Zealand does not want its NIIP to GDP ratio to rise further it needs to keep its current account deficit below 1.3 percent of GDP over the next few years and below 4.8 percent in the medium term (Appendix II not included on this website). The CAD is forecast to average 5.8 percent of GDP over the next five years.

The paper is only possible because in recent years Statistics New Zealand has been collecting far more data on foreign assets and liabilities. There is still insufficient data to set out a full national balance sheet which would further assist analysis.

A Role for Balance Sheets in Economic Evaluation

Over the next few years the government debt position will deteriorate, largely as a result of the change in fiscal stance as a consequence of dealing with the expected long recession. The Treasury Budget 2009 forecasts think that net core crown debt will rise from 5.7% in June 2008 to 30.9% of annual GDP in June 2013.[2]

The way this ratio is usually presented ignores that it is in units of time, greatly offending an applied mathematician, so I will report it as 3 weeks of GDP in 2008 to 16 weeks in 2013, a change of 13 weeks over the five years.[3] (However I acknowledge the non-mathematical by including the conventional percentage of annual GDP in brackets.)

Measured as Gross Sovereign Issued Debt (excluding liquidity management) government debt is expected to change from 9 weeks of GDP (17.5%) in 2008 to 20 weeks (38.7%) in 2013, an increase of 11 weeks. (Another way of assessing the crown debt forecast is that it represents almost an doubling of the gross debt burden per person over the period.) [4]

In one way it is disappointing that there is going to be a such deterioration after 15 hard years aimed at reducing the relative level of government debt. But those who supported a low and falling public debt path argued that this would place the government in a stronger position when there was the sort of systemic crisis which the world now faces. (Another argument was that low government borrowing puts downward pressure on the exchange rate, thereby stimulating economic growth through the tradeable sector.)

How far should the debt ratio be allowed to rise? An easy answer is ‘enough to maintain high employment’. While I am not unsympathetic to that response it, is not sufficient. There is an interaction between the government balance sheet and the private one. An increase in government debt which is offset by a reduction in private net liabilities is rather different from an increase in all liabilities as the result of a consumption binge.

Further analysis really requires the private sector balance sheet for New Zealand. Alas we do not yet have one, certainly not one which is consistent with national accounts definitions. Bits and pieces of the household balance sheet are known, but the complex interaction with the business balance sheet has yet to be sorted out.

There are a few items in the national balance sheet known reasonably well.[5] One is the ‘Net International Investment Position’. The NIIP represents the difference between all the overseas assets owned by New Zealanders – including the government and businesses – and their overseas liabilities. These liabilities are owed to non-New Zealanders. Note that NIIP less the public debt is equal to the private liabilities of New Zealanders (although this requires that local authorities be treated as ‘private’.) .

How are we to judge the magnitude of the NIIP? The same absolute level of NIIP in a large economy is less significant to it (but not to the world as a whole) than in a small economy; a NIIP which is 2 percent of the aggregate domestic assets is a very different proposition from one which is 20 percent of assets. It is therefore usual to scale NIIP relative to annual GDP (as was done above in relation to government debt).

A more sophisticated reason is that this. GDP is a consequence of the assets in the balance sheet. For instance if we knew the return on all assets was 5% p.a., we could calculate aggregate assets by multiplying GDP by 20. Then NIIP as a proportion of twenty times GDP would give an indication of the importance of foreign liabilities relative to the items in the whole balance sheet.

There are some subtleties to this analysis. First, the previous paragraph should have been in terms of GNP, since the relevant assets are those owned by the nation. Today, GNP is about 92 percent of GDP so the change to the ratio is small (but it would be higher). This paper uses the GDP denominator, only because it is the current convention. However in the longer run the ratio to GNP should be used; especially if NIIP is rising faster than GDP, then GNP will be rising slower than GDP and so the NIIP to GNP ratio will be rising faster.

Second, we do not know the rate of return on New Zealand assets. But since the return is unlikely to change much in the medium term, changes in the ratio allow the monitoring of changes in the importance of the NIIP. Note there may be a case for using a cyclically adjusted GDP/GNP, since the economic value of the assets will not change as much over the business cycle as production does. During a recession the ratio will appear higher than during a boom (all other things equal).

The third caveat is that the capital in the balance sheet is implicitly valued by National Accounting standards which may not be the market price. .

Fourth, since we are comparing NIIP with all production, it follows that we have in mind all the assets which contribute to production. That includes human capital. This may be appropriate in policy terms; for instance if the additional public spending was entirely on education and training, then the rise in public debt would be offset by a rise in private human capital. However for some purposes one may want to match the NIIP against the physical and financial assets only.

(For reasons which are explained in Appendix I, it was not possible to progress the relation between Gross Foreign Liabilities (GFL ) and capital as much as was hoped.)

The official overseas liabilities series are available annually from March 1992 (currently to March 2009), although there seems to be a change in the data base in 2000.

the size of the liabilities have been rising. In March 1993 they amounted to $70.0b; fifteen years later in March 2008 they amounted to $178.8b, a nominal growth rate of 6.4 percent p.a.[6] Total NIIP seems to have been accelerating since about 2004, although the fixed interest securities began their acceleration from 2000. (There was some substitution between equities and the fixed interest securities which may obscure the turning points of the component.) Fixed interest securities have been growing faster than the equities.

Forecasting NIIP

The relationship between the NIIP and the current account deficit (CAD) can be summarised as:

NIIP at the end of the period = NIIP at the beginning of the period + CAD during the period + the effects of revaluations of the price of assets and liabilities.

Since the first two terms are well measured (and the CAD is routinely forecast), the revaluation effect can be measured. But can it be predicted?

Treating the reevaluation effects as a proportion of the total NIIP, the equation modifies to

NIIP at the end of the period = (1 + the effects of revaluations) * (NIIP at the beginning of the period) + CAD during the period
The ‘effects of revaluation’ measures the average increase (or decrease) in the prices of the liabilities represented in the NIIP (after the CAD has added to them).

An exploration found no evidence that the exchange rate affected the revaluations. Perhaps further torturing of the data could have found a relationship, but one would have had little confidence in any finding for forecasting purposes.

Clearly some of the revaluation effects are independent of the exchange rate. For instant changes in the values of equities reflect changes in share market sentiment. The exchange rate may impact on the sentiment or on the profits of some of the businesses which the equities represent.

But why do not foreign sources loans appear to be affected by the exchange rate? What is critical here is the degree of hedging. If the foreign loan is hedge (offshore) for changes in the exchange rate or if it is denominated in New Zealand dollars (which is much the same thing), exchange rate variations will not effect the value to the borrower and hence the level of debt which appears in the accounts. The SNZ statistics show that over half the net international liabilities are in New Zealand dollars (and about a quarter are in US dollars). A 2007 SNZ survey found that most loans raised in foreign currency had foreign exchange cover.

This does not mean the exchange raterhas no effect on individual items. But it is not implausible that the aggregate effect is small as the econometrics seems to suggest.

Because the foreign owned physical assets and equities are under a third of total NIIP – the rest being fixed interest liabilities – we would expect the effect to be, on average, less than a third of asset inflation . The average annual revaluation effect of the Net Capital Stock was about 3% over the period, so we might expect the ‘effects of revaluation’ parameter to be about 1 percent p.a.

Measured over the fifteen years beginning with 2000 the annual effects of revaluation averaged 0.7%, which is not inconsistent with the 1% guestimate .

This is a brief account of a lot of mucking about. In summary the following equation seems to be a reasonable predictor of future NIIP (or it has been since 2000).

NIIP at the end of the period = (1.007 )*( NIIP at the beginning of the period + CAD during the period)

However, the 0.7 percent annual revaluation could easily be in the range from 0 to 2 percent and we cannot rule out that in some years it could be outside it.

It may be that further investigation at the component level will reduce the estimation error. Lengthening of the series would be helpful.

Forecasting the Net Foreign Liabilities

If we know the NIIP at the beginning of the period and the CAD during it, we can now forecast the NIIP at the end of the period. We have the NIIP for March 2008 and the Treasury provides forecasts of the CAD out to year ended March 2013. By chain linking the NIIPs for each March we can forecast the NIIP to March 2013. The results are shown in the following table.

Net Overseas Liabilities: Forecasts

<>Year
<>CAD
<>NIIP
<>NIIP/GDP*
<>$b March Year
<>$b at March
<>Weeks
<>2009
<>15.4*
<>176.6
<>51.2 ( 99%)
<> <>Forecasts
<>2010
<>12.0*
<>189.9
<>56.6 (109%)
<>2011
<> 9.8*
<>201.0
<>57.8 (111%)
<>2012
<> 10.3*
<>212.8
<>58.5 (113%)
<>2013
<>11.1*
<>225.4
<>58.6 (113%)

* = Treasury Forecast (Budget 2009). CAD and GDP.

The Treasury forecasts of the Current Account Deficit suggest a sharp rise in NIIP in the March 2009 and March 2010 years, followed by some slowing down. Even so, the rise means Net Overseas Liabilities are expected to be nearing a quarter of a trillion New Zealand dollars in four years time.

The NIIP to GDP ratio rises from 51 weeks of GDP in March 2008 to 59 weeks in March 2013. Since the central government debt ratio is projected to rise by 11 or 13 weeks (depending on the measure) the implication is that there is no deterioration in the relative net savings record of the private sector – that is, private domestic consumption and expenditure are not rising faster than private domestic incomes. (However the impact of New Zealand Superannuation needs to be disentangled.)

How sensitive are these estimate to the revaluation parameter set here at 0.7% p.a.. Were it 1 percentage point pa. higher or lower NIIP would be 3.5 percent higher or lower. There is still a substantial deterioration. The public discussion is correct to focus on the current account deficit as the main contributor to net overseas liabilities.

Conclusion

This analysis of savings and investment contributions could be progressed using the forecasts at a more disaggregated level than is currently available. Moreover, as Appendix I explains, it has not proved possible to track the value of domestic assets, so it is not possible to say whether this is due to improvements in savings or reductions in capital investment.

Forecasts involve implicit assumptions about continuities of trends. They may not apply, especially for the current year to March 2009, which has been one of great financial turmoil. The exchange rate has fallen dramatically, as has the share market here and overseas. A number of financial institutions have collapsed (although the amount of foreign investment exposed in them is probably minimal), and housing prices are sinking. Implicitly in the projection based on the Treasury forecast is the assumption that these effects are unlikely to persist through to 2013.

The total of New Zealand’s Overseas Liabilities are high. These ratios have risen markedly in recent years, and are expected to rise further mainly, according to the Treasury forecast, because of the government’s borrowing program. However, there is evidence in the forecast that the Treasury expects the private sector balance sheet is recovering at the same time.

One of the main reasons that the New Zealand faces particular difficulties in the current world recession is excessive debt in the pivate sector. One would have thought any successful policy response would be to address this.. On current forecasts it seems likely that New Zealand will come out of the world recession in a weaker position than it entered it, so it will be even more vulnerable were a later crisis to occur, or if this crisis proves more prolonged than is currently expected.

APPENDIX I: FOREIGN LIABILITIES VERSUS ASSETS.

APPENDIX II: A POLICY RULE FORMULA

This appendix is available by request from the author.

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Endnotes
[1] This is an updated and condensed version of an earlier paper using a slightly different data base. copies available on request. I am grateful to a number of economists who reviewed the earlier draft, including Andrew Coleman, Dennis Rose and Bill Rosenberg.
[2] Excluding the NZ Superannuation Fund
[3] Note that the GDP measure used is for the preceding year – e.g to March – while the debt is at end of the March year (i.e. on 31 March). This paper uses this convention because it is so widely held, but under an irritated sufferance because the GDP at end of March would make more conceptual sense.
[4] These figures omit the New Zealand Superannuation Fund which reduces the ratios by about 4 weeks (7.9 percentage points) in 2008 and 7 weeks (13.8 percentage points) in 2013.
[5] The one serious omission seems to be assets held overseas by New Zealand households. This is unlikely to seriously change the conclusions of this paper but it does lower the NIIP ratios.
[6] Using the longest available series.

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Our Financial Ball & Chain

This entry was posted in Listener, Macroeconomics & Money on 27th June 2009 by Brian Easton.

When will the New Zealand recession end?

Listener: 27 June, 2009.

Keywords: Macroeconomics & Money;

If the international recession is going to go on for some time (Economy, June 13), what about New Zealand’s? The forecasters expect New Zealand production to hit its lowest point towards the end of this year. Subsequent growth will be lower than labour productivity, so unemployment will peak later, perhaps at the end of 2010. The unemployment rate may be misleading, for it excludes people who become jobless but are not defined as unemployed because they are not actively seeking work, which the international measure requires.

Output per person is not expected to recover to the 2007 peak until at least 2012. On this mechanical test, the recession will last about five years. It would be shorter than the Rogernomics recession, when it took seven years to return to the previous peak. Those who claim that this is already the worst recession in their lifetime (presumably they were born after 1935) have forgotten the 1987 to 1994 one; perhaps they were among the rich who got tax cuts, which maintained their income growth while the rest of the nation suffered.

As well as using these statistical measures, the June 13 column on the international economy looked at the imbalances. In New Zealand’s case, we have a pretty good idea about the sectoral balance sheets, which summarise the assets and liabilities of individual economic units.

Many households are carrying too much debt relative to their assets. Some have seen a sharp reduction in the value of their assets as house prices have fallen, while others lost their investments in collapsed financial companies. Moderate balance sheets may be undermined by the fall in income that comes with unemployment, which is why many people are trying to reduce debt. But this means they are saving more and consuming less (the buzzword is “deleveraging”), causing consumer demand and production to be weak. The forecasters think household balance sheets will not sufficiently recover until at least 2013.

House prices need to come down relative to consumer prices. In April 2007, I thought it might take until 2015 to get back to trend. They may be falling faster than that.

The Government’s fiscal strategy pointed out that although the debt level in the government balance sheet is low, it is rising sharply and the debt-to-assets ratio is projected to increase until about 2016. That is really bad news, because it limits the ability of the public sector to support the private sector.

Most businesses (outside the non-bank financial sector) are thought to have entered the recession with strong balance sheets. However, they will feel the pressure from poor economic growth and higher unemployment, which means lower profits and more bad debts. The farm sector may be an exception. Some farmers are already heavily indebted, and are depending on the good export prices and favourable exchange rate most forecasters are assuming. The external outlook may get worse than predicted.

Hopefully, all the weak non-bank financial institutions have fallen over, and the remainder have good-quality balance sheets. But if the recession goes on for too long, some more may struggle.

The balance sheets of the trading banks are thought to be strong, even if bad debts start to mount, although they could face difficulties if the farm sector gets into trouble. The Government can bail them out if, say, they can’t roll over their offshore debt (because of turmoil in the international money markets). But that just shifts the problem from the private sector to the public sector.

Collectively, the domestic sector balance sheets are reflected in the foreign balance sheet of the assets and liabilities owned offshore. As credit-rating agencies have told us, New Zealand’s net foreign liabilities are too high – over 100% of the annual GDP. We demonise the agencies, but the international banks that are lending us tens of billions dollars don’t rely on them. They do their own credit rating.

The Government hires the agencies to tell us what the banks’ internal assessors think. So, an agency assessment reflects what our lending sources think. We are beholden not to the credit-rating agencies but to the international banks we borrow from. That is true for any debtor. It is going to take many years to escape that shackle.

Housing Booms and Busts

This entry was posted in Macroeconomics & Money, Regulation & Taxation, Social Policy on 17th June 2009 by Brian Easton.

I was unable to address the housing paper in my end of my seminar commentary at the RBNZ Professorial Workshop on the Current Financial Crisis (17 June 2009). This covers some of the things I wanted to say. By way of background Luci Ellis, whose paper this note covers, is Head of Financial Stability at the Reserve Bank of Australia. She has also worked on these issues at Bank of International Settlements. Hers was one of the best papers, at a seminar noteworthy for the excellence of all its papers.

Keywords: Macroeconomics & Money; Regulation & Taxation; Social Policy;

The paper by Luci Ellis “Only in America? Must Housing Booms Always End in Housing Meltdowns?” argues that institutional differences substantially affect the evolution of the housing market and the required responses of policy-makers concerned with the stability of financial institutions which lend to housing. In particular the institutional arrangements for house lending in the US make it particularly prone to what she calls ‘meltdowns’, that is major collapses in the price of houses, whereas different institutional arrangements elsewhere (especially, given the seminar focus, in Australasia) mean that this sort of housing price collapse is less likely, and therefore the lenders (mainly banks) are in a different situation.

I want to wholeheartedly agree with the thesis, but put it in a wider context, before making a few remarks on the housing market.

Economics has too readily ignored institutional differences, not only in housing but everywhere. A particular version of this vice is to assume that the US institutional arrangements are some kind of norm, and adapt analyses and policies in other countries as if they had the institutions of the US. I illustrated the point in my seminar commentary when I pointed out that macroeconomic arrangements in recent years in New Zealand (and elsewhere) have taken as a given that monetary and fiscal policy cannot be co-ordinated, Given the peculiarities of the US constitution and government arrangements, they cannot be easily coordinated there. But other countries have different economic governance. John Singleton’s interesting paper which argued that there is likely to be changes in the way which Central Banks operate could have been written from the perspective that there is an increasing realisation there are models different from what American experience suggest are optimal (or did, until the Global Financial Crisis began).

Ellis’s paper beautifully illustrates the thesis in regard to housing, as it details the differences between the US housing arrangements and elsewhere. It argues, I think correctly, that as a result there is not likely to be a collapse in housing prices in Australasia and so the banks here are more financially stable than their US counterparts, as far as their mortgage lending is concerned. In particular far fewer (proportionally) of the mortgagees are likely to find the value of their property fall to the point when they will walk off it. Some will, of course, but it will happen slowly and not in catastrophic proportions; I am more concerned that high unemployment may cause the abandoning of mortgages. (I also observe this analysis does not apply to farm mortgages.)

There is a downside. If house prices are overvalued and they do not fall quickly, the housing market will be out of equilibrium for a long time during the downswing. Thus while the financial system may be more robust, it is possible that the labour and related market will carry the burden of adjustment with a consequent loss of efficiency and a prolongation of the downswing. Labour will be less geographically mobile, and those retiring or wanting to purchase their first home will find the transaction even clumsier. (The slow adjustment to reduce transport energy use by better location of housing is likely to be even slower too.)

My view is that the payments system (in the widest sense) is so fundamental to the modern economy that a less efficient housing market may be a small price for the financial stability the institutional arrangements generate. Even so, we need to think about how we can improve the efficiency of the housing market. I will not pursue here what should be done to improve the housing market, but the Ellis paper properly points out that – unlike the US in the past – we need to bear in mind how any changes might impact on financial stability.

Finally, and as a footnote, I mention that among my juvenilia there is a publication ‘The New Zealand Housing Market’ (New Zealand Economic Papers 10, 1976, p.1-29; not on the web). It uses some of the analytic devices in the Ellis paper to conclude that with both demand and supply very inelastic, the housing market will work rather imperfectly. (It did not look at the financial stability.) I have not really gone back to the topic over all these years, but I have observed the housing market for macroeconomic purposes. My conclusion is that housing prices in New Zealand will at best by falling slowly in nominal terms or stagnate while other prices rise so they fall in real terms – as occurred in the 1970s. That was the underlying model in my April 2007 forebodings about the housing market.

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Avoiding the Next Banking Crisis

This entry was posted in Macroeconomics & Money on 17th June 2009 by Brian Easton.

Contribution to the concluding panel of the RBNZ Professorial Workshop on the Current Financial Crisis: Historical Perspectives and Implications for New Zealand. 17 June 2009.

Keywords: Macroeconomics & Money;

I was recently involved in a non-government discussion about policy responses to the current recession which gave no attention to what was causing the downswing. I belong to another methodology – the one this seminar has honoured – to first define a problem before one tries to solve it. Most of this paper is concerned with the analytics of the recession, with a particular focus on the possibility of a future banking crisis.

I dont think New Zealand has ever had a banking crisis. Not a proper one involving serious problems in lots of banks. Chris Hunt reminds us there have been occasions where we have had bank crises, with a particular bank in difficulties, but that is an order of magnitude smaller. Our bank crises have involved banks being overwhelmed by their bad debts, following poor governance. That could happen again, and the Reserve Bank has measures to address the possibility.

Today I want to talk about a different sort of banking crisis – a systemic one involving a number of banks – which we have yet to experience, although we came close to one recently. The best parallel is what happened to Northern Rock, the British building society, although this involved only one bank. Like most of New Zealand’s banks, Northern Rock was heavily dependent on the wholesale credit market for its funds. When they dried up in late 2007, there was a run on the bank from its depositors; Northern Rock is now in public ownership.

New Zealand’s banks escaped that fate for at least three reasons. First, they raise only about a third of their funds in the international wholesale market, whereas Northern Rock was raising three-quarters. Second, the New Zealand banks are better managed; their borrowings were ‘plain vanilla, rather than fancy securitisation. And third, the Reserve Bank of New Zealand successfully handled the difficulties as the lender of last resort, and in its financial surveillance role.

But as long as our banking system is heavily exposed to the international wholesale credit markets, we could experience a Northen Rock type meltdown if those markets dry up again; the larger their exposure, the higher the probability of a meltdown.

Any analysis of a potential future banking crisis is complicated by four separate but interlinked sources of the downturn that New Zealand is currently facing.

The first is that, as a result of the macroeconomic policy regime, the exchange rate cycles to the detriment of the export sector. The TWI was at the top of the cycle in 2007, and that probably induced the New Zealand’s recession which began in early 2008. We are unwise to see the 2009 as a continuation of the 2008 recession. I wont say much more about this problem – not here anyway – but the 2008 downswing was of our own making. It looks as though the cycle bottomed out in early 2009, and is in an upswing phase again. If so, a lot of forecasts of the economy are compromised. In terms of banking crises the top of the exchange rater cycle is a potential source of bad debts from export ventures, especially those dependent upon debt on land.

I have more to say about the second source of the fiscal crisis that the economy faces. The problem of a large structural fiscal deficit is evident in the Treasury projections. Unless the medium revenue and spending streams are addressed, we shall see, among other things, either the trading banks increasing their recourse to international wholesale credit markets, or the New Zealand government doing so. A given is the greater the recourse, the higher the cost of borrowing.

The third source is the international economic recession, which is reducing our export sales thereby depressing the economy. In the past such downswings are often associated with a fall in the terms of trade. A fall has not happened yet, but it will add to the nightmare if it does. It will be source of bad debts, as it was during the Long Depression.

I call the fourth source a ‘debt crisis’; it could lead directly to a banking crisis. I am not concerned here about overseas liabilities which arise from foreign direct investment.– that is another policy issue. The debt crisis is about the degree to which our financial system is exposed to the international wholesale credit markets. Many would argue that it is already over-exposed; yet on current forecasts the exposure is likely to increase.

I have highlighted the last two sources – the fall in demand for exports from the international downturn and the debt crisis – because the orthodox policy responses to each are in conflict. An economy in recession from a temporary international downturn can maintain production by measures which increase domestic demand, but that reduces domestic savings. However an economy with a debt crisis should increase its domestic savings in order to reduce offshore debt.

Where there is also a medium term fiscal crisis and an exchange rate upswing, the case for increasing domestic savings is reinforced. Yet if we increase the savings the economy will initially contract further, and unemployment and poverty will rise.

The lesson I draw from this analysis is that fiscal policy and monetary policy cannot be independent. In the medium run the real and monetary parts of the economy are not orthogonal. (I am not even sure they are in the long run, because long run behaviour is path dependent, but that is for another discussion.)

The nonsensical notion of policy independence arose from the peculiarities of the US constitution where fiscal policy is the responsibility of Congress and monetary policy of the Fed, with no institutional mechanism to coordinate them. There is a famous statement by Carl Christ at an economists’ conference in the 1950s, which said that since monetary policy was slow to take effect and fiscal policy was quick, while Congress was slow to move and the Fed quick, then the Fed should be responsible for fiscal policy and Congress for monetary policy.

Our constitution – which comes from the British tradition – allows much better institutional coordination between monetary and fiscal policies. I am glad we have abandoned the practice of the 1990s whereby the Treasury and the Reserve Bank were divided by The Terrace. The two institutions have been joined at the hip dealing with the current crisis. That is what one would hope.

What is especially pertinent here is that the Reserve Bank has only limited abilities to reduce further the threat of a banking crisis. Certainly it can do more about the surveillance of non-bank financial institutions, and it needs to remain alert to rising bad debts and poor quality governance. But as long as our banks have to raise funds from international wholesale credit markets they are vulnerable if it seizes up. If that happens then the Reserve Bank can do a number of things, as it did in 2007/8, or would have done if things had got worse.

But while there may be little more the Reserve Bank can do to prevent a banking crisis than it is already doing, there are areas which are in the responsibility of the Treasury whose management can lessen the probability of banking crisis.

The fiscal track will have a major influence on the monetary situation. As the government borrows more, either the banks will borrow more offshore or the government will have to raise offshore denominated debt itself.

Retrospectively, it is a pity that Kiwisaver was not introduced years earlier, so we had more domestic savings. (It is also a pity that the April 2009 tax cuts were not temporary. Had they been the government could have borrowed more this year without being put on credit watch.)

I have used almost all my time to define the problem. What the analysis suggests is that government borrowing policies can affect the probability of a banking crisis. And yet we need to borrow to protect New Zealanders from the worst effects of a world economic downturn. As an analytical economist I like the tradeoff, but it is little comfort to New Zealanders. So let me, in the little time left, make one suggestion of how we can ease the pressure on borrowing offshore.

Next week I elaborate a proposal that the government issue a long bond – say 20 years out – which will be attractive to Kiwisaver and other pension funds, and to those government agencies which have prefunding arrangements for future expenses including the ACC fund, the Government Superannuation Fund and the NZ Superannuation Fund. In order to make it attractive, I expect that the interest rate will be inflation plus a real margin.
Insofar as the long term investor funds change the balance of their portfolios towards the New Zealand government long bonds and away from overseas denominated assets, that will reduce the amount of overseas borrowing. In effect the economy as a whole will sell some of its overseas assets thereby reducing the borrowing from international wholesale markets.

(In parenthesis, I add, a long bond is not an emergency measure. It makes sense to have one anyway. Its lack has exacerbated New Zealand’s macroeconomic difficulties. Any time is a good time to introduce one, but especially now.)

However it must be emphasised that while a long bond will give a little respite, it will not resolve the debt crisis as long as we – households and the government – fail to save. As long as we have a debt crisis we have the threat of a banking crisis. We just avoided one in 2007 and 2008; we need to act now to reduce the probability of a next one.

Footnote. There was not time to address an interesting paper by Luci Ellis on housing booms. I have put some thoughts here. .

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Don’t Dream It’s over

This entry was posted in Listener, Macroeconomics & Money on 13th June 2009 by Brian Easton.

When will the global financial crisis be behind us?

Listener: 13 June 2009.

Keywords: Macroeconomics & Money;

Hucksters trying to sell you something will tell you the global financial crisis will soon be over. But what do we mean by “over”?

If we mean it’s when the world economy reaches the bottom of its abrupt dive, then that will happen at the end of the year, according to many observers. Unfortunately, even some of the best forecasters have already got the bottom point wrong – some were confident it would be reached a year ago.

But will the crisis be over once the floor is reached? The world economy may just bump it along. The majority of forecasts suggest some growth will occur after the nadir, but expect it to be weak in most parts of the world. Is that the end of a recession?

Another view is it all ends when the world gets back to where it was, say, a year ago. The forecasts for that level of production are some distance off, and getting back on the same world economic growth track as before 2008 (that is, allowing for both population and productivity growth) is not in the five-year forecasts I have seen.

Another way of thinking about the end of the global crisis is when its causes are addressed. Here is a short list:

The private overspending and insufficient savings – especially in the English-speaking countries – has to be reversed. Many economies also have to roll back their fiscal deficits. If they do this, those economies will have modest internal growth, because consumer and government spending will be restrained.

Those economies – especially East Asian ones – whose savings financed the spending excesses of the rest of us need more public and private consumption growth. However, their capacity to grow is likely to be lower in the next decade than in the last, since their sources of big productivity gains are almost exhausted, although their growth will remain high by the standards of the rich (OECD) countries.

The world’s big banks need to get their balance sheets in order, increasing their equity relative to their deposits. The US Government has actively helped its banks and the optimists hope these banks’ balance sheets will look good by the end of the year – although one might expect the banks will still lend only cautiously. European banks may be in a worse situation than their US counterparts. Yet the European authorities are doing less to remedy their imbalances.

Bad debts have to be substantially reduced and the excessive prices of assets (houses) have to get back to normal. Slowly, slowly.

The regulatory regimes that encouraged the financial instability need to be replaced. People are beavering away at this, but even when they come up with reform proposals, hurdles will be erected: by the financial sector, which does not want its freedom limited, even if it might cause future crashes; by the parliaments that have to enact the legislation; and by the international community that has to coordinate it.

Somehow the excessive liquidity (money) injected to moderate the downswing has to be absorbed. If not, prices will rise.

So the world economy may return to a sickly growth next year, but the crisis will not really be over and the danger of world inflation remains.

When the crisis ends, the world economy will be different. The global-warming, peak-oil and water-shortage crises will be looming larger, and the distribution of production will be different.

Most notably, the US economy will be relatively smaller. (It has already fallen from around 30% of the world’s production in 1950 to 20% today.) And it will be weaker, because debtor nations like the US – in this situation as a consequence of the Bush profligacy and the need to sustain a collapsing economy – have less authority than creditor nations. The US may still be the largest economy (or second largest if the European Union is treated as a unity) but it will not be the “hegemon” – the dominant leader – it has been.

<>The details are for a future column. A separate column will look at when New Zealand‘s recession will be over.

Budgets I Have Known

This entry was posted in Listener, Macroeconomics & Money, Political Economy & History on 30th May 2009 by Brian Easton.

When the economy is dire, first Budgets can be good, bad or an ugly shade of black.

Listener: 30 May, 2009. Keywords: Macroeconomics & Money; Political Economy & History;

: Macroeconomics & Money; Political Economy & History; The first Budget of a new government is a defining moment. The Key Government’s is on Thursday, May 28. How will it stack up against earlier ones?

1958 The (second) Labour Government – led by Walter Nash and Minister of Finance Arnold Nordmeyer – took up office in late 1957 with export receipts deteriorating sharply. Like the outgoing National Government, it had promised substantial tax rebates for the year – made possible by the introduction of PAYE. This “Black Budget” contained draconian measures to rein in demand and reduce imports, including raising taxes on alcohol, petrol and tobacco. But it also included a lot of social spending. By what seemed a miracle, unemployment barely increased; the economy stuttered but returned to a growth path. Although the Budget was an economic success, it was a political disaster. Labour lost nearly five percentage points of voter share – and office – in the next election.

1961 The second National Government’s first Budget is probably the one the Key-English Government is hoping to emulate. It opened with the lament that export prices are falling once again and “New Zealand is living well beyond its income”. But 1961 was not as serious as 1958, and there was no black Budget. Although there were grumbles that government spending had increased too much in the previous years under Labour, public spending continued to rise. There were “tax adjustments” rather than “tax cuts”. Prime Minister Keith Holyoake called it a “steady-as-she-goes” economic strategy. (Harry Lake was Minister of Finance.) It worked, partly because, as Holyoake acknowledged, he was lucky – as were we – and the external situation recovered. Lucky or just competent, National lost only 0.5 percentage points of vote share in the next election, and held office for 12 consecutive years.

1973 Labour returned to power, led by Norman Kirk and with Bill Rowling holding the finance portfolio. Its first Budget was relatively easy as the economy was booming and external conditions were favourable. But the international oil crisis hit the economy in 1974, and Labour lost 8.6 percentage points of voter share in the election the following year.

1976 National, led by Rob Muldoon, who was also Minister of Finance, returned to an economy in dire trouble. The first Budget was a tough one, announcing “the time had come for us to take a deliberate cut in our standard of living”. Muldoon was not lucky, and he failed to solve the economic problems. The party lost 7.6 percentage points of voter share in the 1978 election. The quirks of the winner-takes-all electoral system kept National in government for almost nine years, even though Labour won more votes in 1978 and 1981.

1984 The first Budget of David Lange’s Labour Government reminds me of Barack Obama’s Budget earlier this year. Facing great economic difficulties, Lange and co – especially Finance Minister Roger Douglas – were determined to be a radical government. Lots of reforms followed, but the public didn’t wake up to the extremism of the Rogernomics revolution until after the 1987 election. However, the economic management was not fiscally conservative but relied on temporarily hiding the structural deficit. Labour’s share of the vote went up five percentage points in 1987 (and crashed in 1990).

1991 Both Prime Minister Jim Bolger and Minister of Finance Ruth Richardson were determined to eradicate the public borrowing. Rather than a “steady-as-she-goes” phasing in of spending cuts, this “Mother-of-All–Budgets” was the real “Black Budget” of the past 75 years. It hit the marginal and poor particularly hard, turning – as Opposition leader Mike Moore said – “the fiscal deficit into a social deficit”. Unemployment rose to over 11% of the workforce. National lost nearly 13 percentage points of voter share in the 1993 election. However, it remained in office, limping through three terms. At least three of National’s front bench today bear the scars of that political trauma.

2000

<>By past standards, Michael Cullen’s first Budget speech (under Prime Minister Helen Clark) was extraordinary, focusing on the Government’s economic and social strategy of rebuilding a fair and sustainable social and economic order and honouring election commitments, while saying little about the minutiae. Buoyed by a strong economy, its voter share went up 2.5 percentage points in the next election.

Someone’s Going to Pay

This entry was posted in Listener, Macroeconomics & Money on 16th May 2009 by Brian Easton.

Come Budget day, expect some wailing and gnashing of teeth.

Listener: 16 May, 2009.

Keywords: Macroeconomics & Money;

We are in the recessionary equivalent of a phoney war. The economy is certainly in a recession – it began in early 2008 and is already one of our longest postwar ones. We may be able to see signs of it ending – some forecasters have been promising this for almost a year. But we know long recessions have spurious recoveries that give the unwary a glimmer of hope before lapsing into gloom again.

What is beyond doubt is that unemployment has risen by about a quarter in the past year; that means the demand for labour is not rising as fast as people are moving into the workforce. There is no sign of this imbalance reversing, with forecasters expecting unemployment to roughly double in about a year’s time. Why the complacency? One reason is that so far the recession has been milder than it is likely to become. A second is that some of the big overseas economies are in dire trouble, but the world recession is feeding only sluggishly through to New Zealand. The only sector having obvious difficulties is international tourism, and even that is sheltered by the many current tourists who booked before the world recession became evident. In the next round of bookings, there will be fewer of them.

But perhaps the main reason for the complacency lies in the peculiarities of our public commentary on the economy.

What struck me last year was how the economic account on which the 2008 election centred was so out of kilter with what was happening. It was like a family having a dispute over who should put logs on the drawing-room fire while ignoring that the west wing was ablaze.

The framework of the election debate was based on the benign world economy before August 2007 and a belief that a (largely self-induced) New Zealand recession could be quickly remedied with an appropriate fiscal stimulus. From September 2008, following the major trauma in the US and other financial centres, such a view became untenable. But it was too late for electioneering politicians to change their stories.

As soon as the incoming National Government was briefed after the election, it realised the state of the economy was very different from the one on which it had campaigned. Both the minister of finance and the prime minister have cautiously tried to warn us, but the inertia of the conventional wisdom continues to favour the out-of-touch election scenario. Even the Job Summit was 2007 thinking.

I expect the public complacency to end on May 28, when the Budget will have to not only set out the economic and fiscal challenges the economy faces – these are already available in public documents – but also respond to them.

The sobering news is that further government borrowing is limited – too few international lenders are willing to come up with the dosh. And as I explained in my March 28 column, there is a longterm structural imbalance, so that after the recession, government spending will still vastly exceed revenue, generating, in the minister’s words, “decades of debt”. Nobody expects foreign lenders to fund the Government for decades, so the Budget has to tell us what the Government is going to do about reducing the need to borrow – and that means cutting spending and/or increasing taxes.

Even if the Government tried to fudge this issue (which it so far hasn’t done), the credit agencies and expert commentators would draw attention to any sham, causing our credit rating and ease of borrowing offshore to plunge.

So, on Budget day the public is likely to be told tough decisions have to be made. I can guess what some of them will be. Whenever I do the calculations, I conclude there have to be some cuts and deferments that will be very harsh on someone or other. These people will be indignant and angry on Budget night and after. The phoney war will be over.

The Brendan Thompson Prize for International Economics

This entry was posted in History of Ideas, Methodology, Philosophy on 5th May 2009 by Brian Easton.

<>The Waikato Management School annually awards a prize in memory of Brendan Thompson to the to student in the international economics course. By coincidence I was in Hamilton for the 2009 School of Management Prize giving on 5 May, and again was asked to give the prize awarded in his memory ( 2008 speech.)

<>Keywords: History of Ideas, Methodology & Philosophy;

<>Thankyou for the honour of inviting me to give the Brendan Thompson prize again. I miss Brendan, who died twelve years ago, after teaching for many years at the University of Waikato in international economics and economic history.

<>I am writing a history of New Zealand from an economic perspective. This very month I am using some of his work – a data series he constructed. But more than that, I regret that Brendan and I are not discussing the project. He would have been intrigued at my latest discovery – in effect that the New Zealand economy ‘took off’ at the end of the nineteenth century, similar to what the scholar Walt Rostow described – and the following lively discussion with Brendan would have increased my understanding of it.

<>You know, what you get from your university education is not what you learn but what you remember twelve years later. That’s what Brendan would have wanted for his students, and for today’s students. That is why we remember scholars like Brendan, and why he would be so pleased with the prize which recognises a student who will have much international economics to remember for many years in the future.

<>So I would like to congratulate Hayley Sutcliffe for achievement in international economics. I hope you will be as gripped by the subject as Brendan was, and will contribute over the years to our discipline in the way in which he did.

Why I Am a Scientist

This entry was posted in History of Ideas, Methodology, Philosophy on 5th May 2009 by Brian Easton.

<> Café Scientifique; University of Waikato, May 5, 2009

<>Keywords: History of Ideas, Methodology & Philosophy;

<>I was asked to talk about my time as a science student at school. I shall do a little of that, and also at university, but do so in order to provide a foundation for a discussion on how an economist can remain a scientist. So the second part of this paper is about how as an economist I have interacted with other sciences, and the final part is about in what ways economics is a science.

<>My Scientific Education

<>My father, lacking a tertiary education, was an electrician, which with hindsight I see as an applied scientist or engineer. My mother was more literary, a great reader of books, and later a school librarian at Hillmorten High School encouraging hundreds of students to read. Dad later became a psychopeadiac nurse at Templeton Hospital and Training School, which changed his scientific bent to the applications of medical science. But like Mum he was greatly committed to, and interested in, the people he worked with. I guess you can see patterns that their son inherited.

<>I had an ordinary schooling – this is the 1950s. Perhaps the highlight was in my Standard Four class, and the following year, we had a a couple of hours a week from a university mathematics lecturer, who was particularly interested in mathematical education: W. W. Sawyer was already well known for his Mathematicians Delight. and taught mathematics as interesting, fun and useful. It was a delight, and it engaged with the world. One of his biographers remarks that he had an inventiveness in finding physical illustrations of basic concepts. He taught me so well that I did not realised this was unusual.

<>A few years later I came across J. R. Newman’s four volume The World of Mathematics, which is a collection of papers about mathematics and its applications, Wonderful stuff for an early teenager with a mathematical bent. As well as meeting all sorts of new mathematics and giving them a historical context, it applied them to areas which may not immediately strike one as mathematical – like art. One paper was Archimedes’ ‘Sand Reckoner’ – in which he counts the number of grains of sand in the universe – with Newman’s forward explaining that Archimedes was figuring out how to give names to large numbers, a humbling exercise for a kid realising that one of the world’s greatest mathematicians had to work out how to count. I recall many of the papers but one that perhaps should be mentioned is an essay on Newton as the last magician, by a man who would have as great an impact on my thinking as Newton, although I did not know of him at the time: John Maynard Keynes.

<>My secondary school was solid rather than spectacular. We all did the same set of subjects in the third form year, and I did really badly at French. I seem to be a couple of neurological shunts short to be a good linguist. (My ear is not too good either.) I was probably not outstanding in general science either because biology seemed to be more about memory than theory. My memory varies from the good to the dreadful. I suspect one of the reasons I did not do as well at school as with hindsight you might have expected, is because in many of the subjects gave a premium to memory over analytic skills.

<>To give an example. In school certificate physics we were given an electrical circuit and asked which way the current ran. I did it from first principles, recalling the chemical reactions involved in the battery and deducing which way the electrons flowed. But blow me down, I forgot that the current ran in the opposite direction, a consequence of the convention being invented before they understood the chemistry and physics. Zero marks for my analysis. If I had gambled, or remembered only the rule from anode to cathode, I would have done better.

<>Poor language performance but reasonable achievement in English and Mathematics destined me for the N stream in the fourth form. The other professional streams we F for French and L fo Latin. N meant non-languages – science courses at that time were defined negatively.

<>My Christchurch Boys’ High was dominated by teachers who were near retirement rather than inspiring. On the whole I cant complain, although I envy those who recall English teachers who set their imagination alight – I doubt they went to all-boys’ schools. There are a couple of teachers I would mention. My fourth and fifth form physics teacher – alas he went to another school in my sixth form year – was Trevor McKeown, who gave the class a thorough grounding in the foundations of mechanics. More than fifty years on, I can repeat the first thing he taught us: ‘the absolute unit of force is that force which gives unit mass, unit acceleration’. See, my memory is not bad providing the information which belongs to a matrix of related ideas.

<>In the lower and upper sixth I had Alan Wooff for chemistry. I have recently learned he belonged to a group of Canterbury chemists committed to raising the quality of and interest in chemistry teaching. He certainly did that for me. It may be that it was only because I was clumsy in the laboratories – indeed I was a positive danger – that I did not become a chemist. One of his strengths was that he taught the foundations. I can still recall Avogadro’s number – 6.023 times 10 raised to the 23 – the number of molecules in a mole. (It is instructive I could remember the number, but had to look up the spelling.) Incidentally, I remembered that the 6.023 was actually 6.022, a small error to help us remember. A thorough understanding of the notion meant the rules of chemical interaction had a meaning. Six years after I learned them, and four years after I had given up Chemistry, I used this knowledge to assist a student through Biochemistry II.

<>I also did physics and applied mathematics in the sixth form. In my last year I attended a couple of Royal Society lectures which aimed to give students a wider perspective of the possibilities of science. One by Professor Jack Vaughan on phlogiston was terrific – history of science again. But it was the other lecture which almost seduced me. Dont remember much, except Professor Robin Allen said at its beginning that a lecture was not the best way to appreciate geology, and there would be a bus outside the university on Saturday morning so we could go for a field trip. Terrific, never-to-be forgotten, day, although I was glad I never took geology because I still cant remember the names and dates for various geological eras.

<>Another set of lectures was run by the mathematics club set up by Walter Sawyer. I particularly recall Robin Williams, then head of the Applied Maths Division of the DSIR (subsequently vice-chancellor of two universities and chairman of the State Services Commission), on the statistics of field trials, especially when you lost one of the observations in the experimental plots. Another was by Professor Derek Lawden who described integration by analogue computers. I asked whether they could integrate the inverse of x (1/x), and was told dismissively ‘of course’. What Lawden did not realise was that I was worried about what I would later learn was called a ‘pole’ when x equalled zero, which was probably pretty sophisticated for a sixteen year old. An analogue integrator works fine providing it does not integrate across a pole.

<>Add my wide scientific reading – including a chemistry section which Alan Wooff had set up in the school library; I was reading about RNA and DNA before the double helix reached New Zealand – and I lived in a pretty stimulating scientific environment despite the school syllabus being largely a solid scientific foundation of dullsville.

<>Since my scientific strength was mathematics, I did it at university. The Canterbury department was led by Lawden who was a first-class applied mathematician and an exciting lecturer, although between him and Walter Sawyer I never really got a taste for the rigours of pure mathematics. To me mathematics was a means of engaging with the world. Actually the universe, because I almost became a cosmologist. Probably a good thing I didnt, because Lawden also taught quantum mechanics and my ambition was to reconcile them. Better men than I have failed.

<>It was usual for good mathematics students to take an extra subject as well as a foreign language knowledge. I totally respect that scientists need to work outside their own language culture, but in truth for most of us English was a foreign language. I was not going to do French – I had already failed that. I struggled through German but the timetable clash meant I could not do statistics and numerical analysis (I did them in the following year). So I did economics I instead.

<>The story of how I got into economics belongs elsewhere. (In Part.) But a couple of points are pertinent here. First, as well as reading science I had been reading widely including a lot of social commentary, so the progression to the social sciences was not surprising..

<>Second, in the same week I was taught the mathematics of lagrange multipliers, my economics lecturer covered an economic issue which can be elegantly set out using that mathematics. I have not the time here to explain lagrange multipliers but they are shadow prices and integral to a deep understanding of price theory. This had only really been found out a decade or so earlier, so I was close to the mathematical economic frontier, even doing first year economics.

<>While I became a social scientist, I never left the natural sciences and mathematics. I still read about them for recreation. I confess that I am thoroughly confused over particle physics, but dont feel alone. I have also moved into areas I have did not study at school, such as ecology and evolution. (I greatly admire Stephen Jay Gould’s writings.)

<>An Economist Working With Scientists

<>As an economist, I have had to interact with science and scientists. If they are quarrelling in an area – say peak oil, global warming or A2 milk– you either have to take one of the sides at face value with the danger that you may simply adopt the ideologically convenient one, or spend a bit of time trying to master the subject. Often any conclusion is on the soft side but firm enough make some economic progress.

<>For instance I was aware of the theory of global warming, before it was scientifically firm. I concluded then we could not be sure that it was significant possibility but the prudent action was to slow down the processes which might be contributing it. Of course one needs vehement advocates, and in this case they seem to have been proven right, but decisive moderation also has its role, especially when they use the precautionary principle. They tell me it takes thirty miles to stop an oil tanker, so you should slow down if there is any evidence of threats on the horizon.

<>As a professional statistician I am well aware of the difficulties of forecasting. I usually mention when I teach in my first econometrics class that prediction is unwise – especially about the future. The confidence intervals blow out as you look further ahead; I do wish forecasters would give those ranges more often. That has been one of the problems with the peak oil debate. It is inevitable that one day oil production will peak and then fall, but there is considerable uncertainty when. Whatever the uncertainty, the consequential interactions are even more complicated. There are substitutes for oil, typically more costly, but those costs are coming down. One cannot be certain, but it turns out that as far as I can see some prudential responses are clear enough. We should accelerate the adoption of oil substitutes and since it takes about thirty years to reconfigure locations to make best use of public transport arterial routes, we should be putting the routes in now, even if not expecting to get an immediate commercial return. Similarly for electrification of rail and for insulation and energy efficiency in the housing stock.

<>While I am talking about the uncertainty of forecasts, a word about Club of Rome projections which are still sometimes raised with me, despite their forecasts having been demonstrably wrong. Some colleagues backcasted their runs – time is not an arrow in a model – and found they gave a massive world population boom to about five billion and bust around 1800. So dont forget history. For an economist it is a source of data for testing current theories – I have found working on the Long Depression of the 1880s and 1890s (seventeen years in all) immensely helpful for understanding the current Global Financial Crisis.

<>But there is something else here, even more important and subtle. The Club of Rome model is a non-linear dynamical system, which unlike a linear dynamic system is not stable. Famously Laplace told Napoleon that he had no need of God. What he was probably referring to was that he had solved the problem which Newton’s linear system had left open: whether planetary orbits were stable; if not, every so often God might have to tap the planets back on track.

<>Newton’s insight was amazing. In principle a handful of equations can predict the paths of heavenly bodies for centuries to come. Of course it is more complicated than that, but we now know that the stability properties which make such accurate forecasting possible do not apply to non-linear dynamic systems. Trivial differences in initial conditions or minor contingent events may alter immensely the long run behaviour of the phenomenon we are tracking. Chaos theory is one name for this. You will know the story of how a butterfly in Japan can cause a hurricane in New York – or even a financial storm, I suppose.

<>It may be that the properties of a non-linear dynamic system is one of those mind-changes so enormous we have yet to come to terms with it. For three centuries, Newton has been model for the sciences. Even economics has been seduced by its elegance. In his Wealth of Nations Adam Smith refers to Newton more than to any other intellectual. Economists have since been driven by the notion that a few simple ideas – such as economic rationality – would not just underpin our understanding of the economy, but enable us to analyses and predict it. What chaos theory tells us is that any predictions are likely to be largely wrong in the long run, because contingent events will affect the track. Perhaps like Laplace we no longer need the hypothesis of God in science, but as scientists we continue to need a humility before Her.

<>History becomes important. I am currently writing a history of New Zealand from an economic perspective. The need arises from an ongoing failure by historians to recognise that economic history has a been important, even at an elementary level. For instance the great prime ministers identified by historians are typically those associated with economic booms while, conversely, some very effective politicians are forgotten because they struggled with economic depressions – Harry Atkinson in the 1880s and Gordon Coates in the 1920s and 1930s.

<>When I first applied for a grant to do the history it was to a scientific fund. Thinking about their needs I said I would pay attention to science and the environment in my history. Sadly the grant has not been forthcoming. When I applied for funding from some humanities organisations I dropped the references to science – mainly because the structure of the book structure was becoming unwieldy.

<>The humanities funding was more responsive (but as it happens its pockets are not as deep and the study is only half finished). Blow me down though, when I began writing the book, I could not keep the science out. The first chapter of the book, entitled ‘The Economy Before Humans’, is primarily a scientists’ chapter about the geology and ecology before the ancestors of the Maori arrived. It begins 650 million years with the cratons of Gondwanaland long before there was any land mass we might call ‘New Zealand’ (or the Zealandia continent). This is not some conceit. The land mass and its ecology are integral to many features of the modern economy.

<>You will have to read the book – if I can get the funds to finish it – but let me give one example. The wool economy was critical to nineteenth-century New Zealand. But 93 percent of the sheep were south of Taupo in 1891, while two thirds of Maori were north of the lake.Thus Maori were largely cut out of the wool economy, which adds to the story of their economic failure at the end of the nineteenth century, in addition to having been undermined by the loss of their land. By the time the dairy industry phased in (north of Taupo and elsewhere) the Maori seem to have been too impoverished to take advantage of the capital intensive industry, even where they kept their land. Why were sheep so scarce in the top of the North Island? The simple answer seems to have been footrot and bush sickness – in the realm of science. Why were Maori common there? That is explained by nutritional science.

<>Let me complete these illustrations of how my life as an economist has interacted with the natural sciences with three further examples. Economics has something to say about resource management. Take water. Economists have been coming to the view that water may be more important to the future of the world than oil; it has fewer substitutes, it is relatively more expensive to transport, and it is much more poorly managed (an economist might say because its markets are more screwed up). It would appear New Zealand has a comparative advantage in water. Are we going to ignore the potential benefit by continuing poor management?

<>The second involves psychology. Over time economists began to adopt with increasing rigour the notion of rational economic man, whose decisions were based on optimising some well specified objective function. There were two practical reasons for doing so. First there was not an obvious alternative; second the mathematics is very simple, since just about all the second order terms disappear. Perhaps there was a third ideological reason which said that nobody – especially the state – should override an individual’s decision.

<>In recent years a number of (mainly American) economists have been paying close attention to the psychological literature, and as a result have created a new area called ‘behavioural economics’ – the mathematics of which is almost as elegant as that for rational economic man. It was an underlying justification for Kiwisaver, and is important in the work on addiction of such drugs as alcohol and tobacco, although thus far its applications are limited, as you might expect of a new field. As it evolves I shant be at all surprised if it makes a major contribution to explaining the irrational behaviour in the financial sector which led to the Global Financial Crisis.

<>My last example is a celebration, for my role had little to do with the science, just the giving of some economic advice. Apparently those with diabetes 2 produce more of the cuprous than cupric forms of copper, which weakens their (especially heart) muscles and shortens their life. (I describe the ions by these terms rather than copper 1 and copper 2 – to honour my Chemistry teachers.) The proposed drug, Lazarin, reduces the excess of the wrong ion, moderating the diabetics’ deterioration. When I had this explained to me I said ‘it’s a chelate’. (Astonishment from the scientist, Garth Cooper; thankyou Alan Wooff who introduced me to the notion forty years earlier.) It’s a ‘Rutherford’ experiment, an apparently simple idea with lots of complex science underpinning the simplicity. Because diabetes 2 is a growing epidemic among the affluent, the finding may have enormous consequences. It could even lead to the first Nobel prize for research on New Zealand soil. My role was small in the development, but I am proud have been involved.

<>You may have noticed that I have made numerous references to mathematical modelling. Lawden (and earlier Sawyer) trained me well in that discipline; later I was to have the good luck that an economics teacher, John Zanetti, facilitated the transfer of the modelling skills to economics.

<>I belong to the Marshall School of modellers. Alfred Marshall was a great economist – his textbook first written in 1881 was still recommended to students in the 1960s, forty years after he died. A mentor of Keynes and perhaps even a better mathematician (he was a junior wrangler at Cambridge), he wrote that he had

<>“a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules

<> (1) Use mathematics as a shorthand language, rather than an engine of inquiry.

<> (2) Keep to them till you have done.

<> (3) Translate into English.

<> (4) Then illustrate by examples that are important in real life.

<> (5) Burn the mathematics.

<> (6) If you can’t succeed in (4), burn (3).

<> This last I did often.”

<>Earlier in his textbook he had relegated his mathematics to footnotes – it is regrettable that his successor economists have not been as scrupulous. A son of the manse, and deeply involved in the questions of the day, Marshall put on the title page of his Principles the Aristotelean ‘natura non facit saltum’ – nature does not make sudden jumps. In my youth I thought this was a defence of his use of calculus. But Darwin had earlier used the phrase. Marshall the mathematical economist was also interested in biological development.

<>I model a lot. I can walk into a situation and start setting out equations in my head about an aspect which intrigues me. It is likely to be a process model than an optimising one – the heritage from Lawden, whereas many economists focus on optimising behaviour. Like Marshall I try to suppress the modelling when I am explaining something to the general public. I am so intuitively a mathematical modeller I thought all economists were, but the stark realisation of recent years is that the majority of the profession are not as naturally proficient.

<>Is Economics a Science?

<>Interacting with science and scientists does not make one a scientist. Many would be surprised that an economist can be one. I begin my explanation by noting that in the 1960s the University of Canterbury was still greatly influenced by the thinking of Karl Popper, who continues to influence my approach to science generally and economics in particular – he’s another author on my reading list. To be a Popperian means one believes there is a realm which is real and whose domain is subject to Popper’s methodology of scepticism and a continual testing of the hypotheses of theoretical models against evidence, modifying them where necessary. An important implication is that there is a realm of our total experience, which is subject to scientific methodology, but there is also a world which is not. That second world is no less important than the world which scientists investigate, but we should not get them confused.

<>Of course economics is like astronomy, ecology and biology in that experimental testing is limited, but they are no less sciences either, because they are based on propositions which can be in principle be tested by scientific standards. Max Planck, one of the fathers of modern physics, said that he eschewed economics because it was too difficult. He’s right. Physics is sometimes called the Queen of Sciences, but it has progressed so successfully because it is easy, compared to some of the others. This is not to diminish physics; I greatly admire its achievements, But a more typical science – the middle class in the middle of the spectrum – would be ecology.

<>As I have indicated economics is like ecology – their names even come from the same Greek word for ‘household’. Unfortunately in both cases – and indeed in some other difficult sciences such of psychology – we expect more from the scientists than they can deliver; in the case of economists much more than we can ever deliver.

<>To cover the ignorance, we have much pseudo-science in public discussion, based on‘theology’ or ideology. All subjects contain some – an existential belief in some truisms which cannot (or may not) be readily tested. Physics requires various assumptions about the real world which are unprovable; Hume asks how we know the sun will rise each morning. Gödel’s incompleteness theorems haunt mathematicians in one way or another. However a scientist aims to limit such beliefs to that which is absolutely necessary. Everything else is open for debate and has to be rigorously tested.

<>Many people are less rigorous, and hold beliefs that are in principle testable but they wont contemplate the possibility. They muddle the Popper’s distinction between the first world and the second, transferring propositions about the first world into the second.

<>Melvin Reder calls their methodology the ‘tight prior’, a reference to the Bayesian who commences with assumed parameters which are so well specified that new evidence does not change them. Instead, Reder argues, the skill is to interpret any evidence so it is consistent with the nigh-on-inviolable theory. A strategy – frequently practised in New Zealand – is to ignore contradictory evidence, which is one of the reasons why the dominating conventional wisdom tends to ignore our history, or uses it very selectively.

<>One of the most pernicious problems is how most people get their understanding of economics from ideologists and journalists who know only what ideologists tell them. It is very much the blind leading the blind, and all fall into a pit of ignorance of economics. It is especially irritating for an economist when we are told of what economics or economics believe drawn from this source.

<>I do not want to make here making the distinction between what we call positive economics – how the world is and how it functions – and normative economics – how the world should be and how we should change it. This paper is focussing solely on positive economics, although we should note that some ideologists seem to require the positive world to conform to their normative vision of what should be done. I illustrated this earlier, when I suggested one of the attractions of the model of rational economic man which is an account of the actual world, was that it reinforced those who were ideologically anti-statist which is a normative vision.

<>The distinction with which I am concerned can be better explained in terms of Kuhn’s paradigm, the way that a profession organises its investigations. One of the features of such paradigms is that some theories are taken for granted. It is not that they are unchallengeable. Of course no scientist challenges every part of a paradigm, but in principle he or she may. Kuhn sees scientists as revolutionaries; the conventional wisdom of the counter revolutionaries wants to prevent the revolution – to stop genuine scientist.

<>The result of this approach is that there are hypotheses whose truth a scientist may want to test but the conventional wisdom does not, that it is threatened by any challenge, and that it punishes those who in the ordinary course of their scientific endeavour challenge them. That which may not be challenged, frequently reflects self-interest (or the interests of the employer) or some ideology.

<>There is so much that is in this category, that a scientist leaves many of the ‘truths’ for another day, when the evidence against them becomes compelling. We are in such a era today; the Global Financial Crisis is undermining many of the conventional wisdom’s accepted truths, although it is interesting how many are grimly held onto by the non-scientific ideologists. Planck’s law reminds us

<>“A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

<>I could easily illustrate these issues with many economic conflicts, but tonight I choose science policy, partly because this audience will be more familiar with the area, but also because it has both a paradoxical conclusion and a sobering one.

<>Many people pontificate on economics without understanding it. For instance, many attacks on economics amount to the idea that economics analysis contradicts the laws of thermodynamics. But as Paul Samuelson has pointed out, economics is grounded in those laws – without them there would be no production functions and no trade-offs, fundamental notions of economics..

<>Similarly I am often told, by those who have not studied economics, that economics depends upon unlimited economic growth. That cannot be true since many great economists – Ricardo, Malthus, Marx, Keynes and Schumpeter, for instance – were stagnationists, that is, they expected economic growth to end; Keynes wrote of the ‘euthanasia of the rentier’. What he meant, and others thought too, was that as capital was accumulated, the return on capital would fall, until there would be no incentive to invest, so economic growth would stop. (This is a consequence of the laws of thermodynamics.)

<>The difficulty with this approach was that per capita incomes in the rich world quadrupled in the 180 years between Ricardo and Schumpeter. You can set up auxiliary hypotheses to explain it, but in the 1950s, as the data became available, it became evident that a theory of economic growth dominated by pure capital accumulation was inconsistent with the facts.

<>There is a famous 1956 paper by Bob Solow, much quoted by the scientific community, which demonstrated there had to be some other contributor. He called it ‘technical change‘, saying

<>“I am using the phrase ‘technical change’ as a shorthand expression for any kind of shift in the production function. Thus slowdowns, speedups, improvements in the education of the labour force, and all sorts of things will appear as ‘technical change’.” (Solow’s italics)

<>Solow’s paper is the source of the widely quoted claim that 80 percent of economic growth (output per person) is attributed to technology. True, but only if the word ‘technology’ has Solow’s specialist meaning of that it is what we cannot explain, of what a couple of economists, Tommy Balogh and Paul Streeten, called the ‘coefficient of ignorance’. A physicist might call it ‘dark matter’ – there is something out there which is affecting our understanding of how the world works but we dont know what it is. (While reading a Sceintific American on the way to this presentation, I was reminded that dark matter is also about four to five times more important that the matter we can observe.)

<>It was perfect situation for any group with a self interest to promote to claim the coefficient of ignorance for their own. They all did – educationalists, managers, capitalists, and of course scientists, who claimed that it was science which drove economic growth. (Many of those who argue for increasing the coefficient of ignorance strike one as having sufficient ignorance to make a real contribution.)

<>Unfortunately half a century later we remain uncertain what this dark matter is. In the case of economics no one is willing to spend five billion dollars – the amount we are spending on the Large Hadron Collider – investigating the economic problem. The cynic might argue that rather than promote scientific research in economics we let the ideologists run wild, and they have destroyed over four trillion dollars of value, almost a thousand times more than the cost of an LHC.

<>Scientists seized on the hypothesis that technology, as they understood it rather than as Solow defined it, was the driver of economic growth, not only because it made them important but it seemed to justify spending large quantities on public money on research science and technology.

<>So Solow’s hypothesis about how the economy functioned became an ideology. I recall in the 1980s being at a Royal Society meeting on science policy and being shouted down when I raised some of the problems with this view. Paradoxically, in a room of professional scientists I was the only one behaving scientifically.

<>If you are to sup with the devil, they say to use a long spoon. If it is a short spoon at least understand who is on the other side of the table. Unfortunately the science community was too committed to its ideology, too hungry for the public cash, to do so. Instead – to mix the metaphor – they got into bed with the commercialisers, who had quite a different agenda,.

<>The effect of the devilish alliance was to direct science in a particular direction, one which many scientists told me they disagreed with. We have spent the last decade trying to unscramble the decisions of the early 1990s – in science but also in other areas, including health and tertiary education which were also transformed by commercialisation.

<>The story is not over. Another review of science funding and organisation is underway, and again the science community will be vulnerable to change in policies which are not in their interest. With their ideology, they will find it difficult to engage with those who want change to make (as they put it) the spending on science more effective (actually to reduce it). I am repeatedly struck by the inflexibility of the scientific community in relation to economic issues, because of the ideological underpinning of their approach to science policy, which ultimately can be summarised as Oliver Twist’s ‘more’. What happens when the pot is limited? There is already evidence of tensions within the science community.

<>Those of us who are genuine scientists have little to contribute to this row because it is an ideological not a scientific one. Ironically the scientist have little standing in the scientific community when it comes to science policy and, in any case, Planck’s law warns that it takes a long time to for an ideology to die – silver crosses and garlic aside.

<>Of course science policy is not the only area where the unwise adoption of ideological positions has led to difficulties. In a gathering of economists I could give many other illustrations. You might conclude from such examples that the economics profession is dominated by ideology and that scientists have but a marginal role. The economic scientist may think you are right, but nevertheless defend the notion that economic scientists exist, and that parts of economics can be a science.

<>Crucially, what I have tried to explain tonight is that there is a scientific component to economics – sceptical and empirical – and there are economic scientists who labour in that vineyard under great difficulties. If we ignore them; if we deny them – whether the ‘we’ is scientists, financiers or the general public – we do so at our peril.

<>Go to top

Paul, Timothy Money and the Economy

This entry was posted in History of Ideas, Methodology, Philosophy, Macroeconomics & Money on 3rd May 2009 by Brian Easton.

<> Presentation to begin a discussion on the Global financial Crisis; to the ‘God Talk’ series at the the Cathedral Church of St Peters, Hamilton Cathedral, May 3, 2009.

<>Keywords: History of Ideas, Methodology & Philosophy; Macroeconomics & Money;

<>I thought context for this evening’s discussion would be a biblical text – verses 6 to 10 of chapter 6 of the first pastoral epistle from Paul to Timothy

<>6: But godliness with contentment is great gain.
7: For we brought nothing into this world, and it is certain we can carry nothing out.
8: And having food and raiment let us be therewith content.
9: But they that will be rich fall into temptation and a snare, and into many foolish and hurtful lusts, which drown men in destruction and perdition.
10: For the love of money is the root of all evil: which while some coveted after, they have erred from the faith, and pierced themselves through with many sorrows.

<>The last verse is often misquoted as ‘money is the root of all evil’. The difference is important. Paul is not ruing out that money may be a useful part of an economy and society, a means to an end. The evil arises when it becomes an end in itself.

<>Money is, of course, vital for a modern economy, because a medium of exchange makes specialisation possible. Without money, exchange would depend upon barter and a coincidence of wants. Without it we would have to be largely self-sufficient in our production and consumption; our standard of living would be much lower.

<>There is a difference between money today and two millennia ago. In those days the money was – in the jargon – ‘fully backed’. Its coins were made of metal equal to their face value. Thus the denarius of the bible was made of silver – it was a day’s pay for a labourer. We have since realised that the material content of a coin – or even more so a note – need not be equal to its face value. What is required is that the community trusts that the money will be valued at its face value – thus saving the use of gold and silver and copper in the coin. Ultimately, a currency’s value is that the government will accept it in payment of taxes – giving an unexpected meaning to ‘Render unto Caesar the things which are Caesar’s.’

<>While the monetary system works is a complicated story, the epistle’s direct message is that while money may be an integral part of a complex economy, it should not be an end in itself.

<>It is not a great stretch of Paul’s meaning to replace the term ‘money’ with ‘wealth’. The epistle says we need sufficient to live with, but if we pursue wealth after that sufficiency we tread a path of destruction and perdition. That is not a bad description of what has increasingly happened in recent years. Instead of using money as a means to help attain a sufficiency, it has become an end in itself.

<>What strikes one about the bonuses that those in financial systems paid themselves is that they could not possibly spend them. A million dollar bonus was not unusual – what an unskilled worker earns in a lifetime.

<>Those with such wealth thought it somehow indicated that they were of greater value, ignoring the epistle’s cautions. To display their wealth they practised conspicuous consumption, the lavish spending on goods and services acquired mainly for the purpose of displaying their wealth in order to achieve a social status – not just on food and raiments.

<>The strategy succeeded. We attribute to them desirable characteristics such as wisdom, beauty, intelligence and virtue which would not be evident, were they ordinary citizens. We rarely mentioned that their achievement certainly had an element of luck, and that they may have – as the epistle says – gained their goals in ungodly ways.

<>This cult of the pursuit of monetary wealth and its accompanying driver of greed has become the religion of the modern capitalist state, peaking in those extraordinary bonuses and the power and deference which were given to the captains of finance. As it unwinds we know not where we are going. We may be on a path of destruction and perdition,

<>The ‘we’ is not just the rich, insofar as others honour the goals of the rich, even if they cannot attain them. The entire society has adopted monetary goals as appropriate social goals – consider the demand that we should accelerate the economic growth rate to join the top half of the OECD. That is not what Paul is counselling Timothy as the way to godliness.

<>We face one of those moments in history where there are doubts about the path we are on. It is not simply a moment in economic history, as the world economy goes into what may be the worst experience it has ever had. It is not just a matter of technicians worrying about how to fix it, while the rest worry about what will happen to them.

<>It is also, potentially, a moment of an ethical crisis, one which two millennia ago we were warned against. While we have had vigorous ethical disputes, they have rarely touched on the economic system, other than concerns about the poor. What is the purpose of an economy, is rarely addressed. Is money a mean to an ends or the end itself? By not addressing such questions we implicitly answer that what the economy is doing broadly meets our approval. Would it have met Paul’s approval?

<>If we treat the Global Financial Crisis as merely a technical one, we will, I’m afraid, once more fail the ethical challenge. The crisis is not just a matter of having pierced ourselves through with many sorrows. As Paul cautioned Timothy, we have erred from the faith – of what is really important about being a human.

<>Go to top

The Curse Of Cassandra

This entry was posted in History of Ideas, Methodology, Philosophy, Listener, Macroeconomics & Money, Political Economy & History on 2nd May 2009 by Brian Easton.

Would you rather be comforted or told the truth?

Listener: 2 May, 2009.

Keywords: History of Ideas, Methodology & Philosophy; Macroeconomics & Money; Political Economy & History;

April 26 is the centenary of the birth of the great 20th-century newspaper columnist William Connor, who wrote under the byline Cassandra. The allusion is to a princess of Troy whose gift of foresight was wasted because nobody took her forecasts seriously, including her warning about the Trojan Horse.

I have long wondered why. It seems likely she thought more deeply than those who stick with conventional wisdom.

Why would the Greek army leave a huge wooden horse behind, knowing the Trojans would treat it as a trophy? The triumphant Trojans, thinking the Greeks had abandoned the siege, ignored such questions – what would a mere girl know? – and brought the trap inside the city walls; the rest is history.

Today, “the curse of Cassandra” applies to valid warnings or concerns that are dismissed or disbelieved.

Because Troy was sacked, we don’t know what the conventional wisdom was after Cassandra was proved correct. But you can be sure the failure to see what suddenly seemed obvious would have been glossed over, and the starting point would have been that the conventional wisdom now must be right. That Cassandra had been right in the past would be given no weight in evaluating her subsequent prophecies.

A lot of people are right but for the wrong reasons. Many predicted the economic bubble of the past decade would burst, but most had no coherent explanation.

There were some thoughtful economists, such as Robert Shiller, who coined the phrase “irrational exuberance” after a lot of careful research on the history of booms and busts. Others were Paul Krugman, Joseph Stiglitz and George Akerlof, who has just published Animal Spirits with Shiller.

Robert Wade, a New Zealander holding a chair in economics at the London School of Economics, got into a debate with Times journalist Anatole Kaletsky, who now admits he got things terribly wrong, blaming his mistakes on the economists who misled him. He should have listened to Wade and the other critics, instead of ignoring them.

As John Maynard Keynes observed, “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.” Perhaps that’s why the New Zealand media stick to their friends, no matter how often these friends have been proven wrong in the past.

After all, they might get it right one day, mightn’t they? Is this what the media’s audiences want?
Another laziness is to promote the views of someone who has no expertise in economics but has succeeded in some other area. I await the interview of a New Zealander who wins the world tiddlywinks championship. Every platitudinous comment on the state of the world economy will be faithfully reported. After all, this person has mana; his or her regurgitating of conventional wisdom – often badly – comforts us, even when it is patently wrong.

As a rule, journalists will not fess up to the part they played in misleading you – so let’s give Kaletsky credit for doing so. Nor will they go to the Cassandras they ignored in the past, seemingly assuming a good record of prediction is no indication of a better forecasting ability.

The purpose of the media seems to be to entertain and comfort rather than to inform and provide guidance about the future. And as in Kaletsky’s case, how would journalists know who was competent? They tend to follow the conventional wisdom, reinforcing it by publishing it.

The smarter ones know they are ignorant, and ignore the difficult topics. That must be why so many current affairs programmes are failing to address the economic issues facing the nation. Better to focus on trivia. The business pages are often little better.

In the 1930s, Connor’s Daily Mirror column persisted in warning that fascism was a threat to the world, when the conventional wisdom was to look for an accommodation. He broke off the column during the war to join the army, restarting it after the war with: “As I was saying before I was interrupted, it is a powerful hard thing to please all of the people all of the time.” Cassandras don’t even try to do this. Instead, they try to get it right.

The Global Financial Crisis: Some Accounting Features

This entry was posted in Macroeconomics & Money, Statistics on 20th April 2009 by Brian Easton.

One Stop Update for Accountants in the Public Sector 20 April 2009, Wellington.

Keywords: Macroeconomics & Money; Statistics;

Balance sheets are integrally involved in the greatest economic crisis in our lifetime. So while my remit is to provide the conference with an economic context to its deliberations, I have to engage with accountancy. What I am going to do then, is describe briefly the state of the world economy and how it got into the current muddle. Then I shall explain how it affects New Zealand, and the New Zealand public sector. Part of the story involves accounting conventions. All the previous great economic crises have involved these issues, but this is the first time that we have had such comprehensive balance sheets that we can systematically include their effects. Keynes’ General Theory, written in response to the Great Depression, only alludes to balance sheets. A modern day Keynes could not avoid making them central to the analysis.

As I began, the world economy is facing the greatest economic crisis for 80 years; perhaps ever, because globalisation has intensified the linkages between economies, industries, and financial systems. Its causes go back a long time – perhaps even to the Bretton Woods settlement in 1944. For our purposes in 2002 the Bush administration increased the US fiscal injection. As a consequence of the US government spending much more than its revenue there was an increase in the dollar denominated assets available to the world’s financial system. Fortunately, at about same time a number of other countries – especially China – ran fiscal surpluses which they chose to invest in these dollar denominated assets, thereby temporally obscuring the rise in the liquidity of the financial system.

However the increased liquidity was not all mopped up by the sovereign funds. A share of the additional assets reached the balance sheets of financial institutions which used them to increase their lending. A lack of prudential supervision and new ways of financial leveraging led to balance sheets which with hindsight proved to be highly vulnerable to a downturn. In particular there were widespread investment in assets at prices which were unsustainable.

The best-known of these unsustainable assets were the sub-prime mortgages to ‘Ninjas’ – people with no income, no jobs and no assets – and with no ability repay their debts. Instead they hoped the house prices would rise, and cover their debt servicing. This required ongoing increases in housing prices.

Prices for assets do not rise for ever (unless product prices do too). When their inflation stopped the underlying weaknesses in the balance sheets of the financial institutions became evident. Borrowers who had relied on the inflation to service their debts found they were exposed.

Because today’s story is a balance sheet one I pass over the poor alignment of incentives where those who made decisions – such as sell mortgages to Ninjas – did not take on the risk on the debt they issued. This was a major contributor to the boom and no doubt will lead to major changes in the regulatory framework, including better measurement of risk in balance sheets.

Whatever the details, the outcome was that a whole range of assets which had been put into balance sheets at one particular price, proved to be less valuable. Writing down the value of over-priced assets is routine, but a group has proved particularly difficult because there is no agreement as to the level to which they should be written down. Typically these are assets where there is considerable uncertainty as to the revenue stream they generate. The valuation of these so called ‘troubled assets’ can differ by a factor of three. ‘Troubled’ is a transferred epithet. It is the holders who are troubled, not the assets; a more common expression is ‘toxic’ assets.

Toxic assets in a balance sheet mean that the value of aggregate assets is uncertain and so, therefore, is the value of the ownership equity. This severely limits the ability of a prudent financial institution to make advances or other investments. If that applies to enough financial institutions then there will be a shortage in the system of the credit which is necessary for trade, business investment, house purchase, consumer durables and so on. Production in the economy contracts too, with resulting reductions in investment and consumer purchasers and layoffs; the economy sinks into recession or even depression.

Toxic assets mean that monetary policy cannot effectively moderate the downswing. Normally lower interest rates induce more investment and spending. But financial institutions, uncertain about the true state of their balance sheets, will be reluctant to make the required credit available even if, as applies now, world interest rates are near zero in the short term. Instead public policy turns to fiscal reflation, that is adding to aggregate demand by increasing government spending relative to revenue.

Let us elaborate the balance sheet story with a homely example. Although toxic debt is at the centre of the current crisis, I shall assume none in this example.

Suppose you are the owner of a house worth $300,000. Your investment rule is to maintain a fifth in equity and borrow four times as much. Your statement of financial position might look like this:

ASSETS (house)          $300,000
DEBT (mortgage)         $240,000
EQUITY                      $ 60,000

Suppose that the price of your house was to increase by a half (above the equilibrium level of house prices) – which, incidentally, is my estimate of what happened between 2002 and 2007.

Your balance sheet would now look like

ASSETS (house)          $450,000
DEBT (mortgage)         $240,000
EQUITY                      $210,000

At this point there are a number of options. You might think that nothing has really changed and do nothing. Or you might borrow to fund – say – a holiday. But we’ll look at the situation where you decide to use the capital gain to purchase an additional house or houses.

As a result of the additional asset purchase(s), after maintaining the gearing ratio of equity to debt of one to four your balance sheet looks like

ASSETS (houses)        $1,050,000
DEBT (mortgages)       $ 840,000
EQUITY                      $   210,000

Now suppose the value of the houses you own returns to its old level – a half up, a third down.

Perhaps I should add – I dont want to panic you – that for various reasons I dont think house prices will quickly fall back to their long-run equilibrium. However, let’s assume they do. In which case your balance sheet will look like

ASSETS (houses)        $700,000
DEBT (mortgages)       $840,000
EQUITY Negative      $140,000

The effect of the house price decline is to wipe out the original equity converting the positive $60,000 into a negative $140,000 , and leave the home owner severely in debt.

(As an exercise lets look at what happens if you use a higher gearing – say double, or one to eight. Your balance sheet sequence would look like

ASSETS (house)

$300,000 $450,000 $1,650,000 $1,100,000

DEBT (mortgage)

$266,667 $266,667 $1,466,667 $1,466,667

EQUITY

$ 33,333 $ 183,333 $ 183,333 -$ 366,667

Doubling your gearing doubles your equity loss. The higher the gearing the more vulnerable to the downswing.)

More generally, the higher the gearing, the more an investor is vulnerable if prices turn down. In particular, a bank which is typically geared at ten and more to one, will have to contract its advances (i.e. its assets) if there is fall in its asset prices. This is a key mechanism in the credit contraction during a financial crisis.

Few home owners would as highly leveraged in assets with such price collapses. But many financial institutions, particularly hedge funds, were even more highly geared with very volatile assets.

The point of this illustration is that the gearing associated with an apparently rational investment on the upswing based on ever increasing prices can be disastrous on the downswing. Its effect is to exaggerate the boom. The higher house prices generated the capital gain which leverages additional house purchases; this raises higher house prices further, there are higher capital gains and so the market spirals up.

Stein’s law says if it cant go on forever, it wont. What halted the house price boom was the difficulties of servicing the debt. The rents tenants were willing to pay did not rise as quickly – they are connected to their ability to pay and so their actual incomes and the price of products. Landlords found they did not have sufficient revenue to cover their loan commitments. They gave up further purchases of houses, individuals speculating on rising house prices found they were not rising fast enough, at which point house prices steadied or began to fall.

Once the boom was over, the weakness of individual and institutional balance sheets became exposed. Market sentiment turned, financial institutions tried to remedy their balance sheet deficiencies, and the credit contraction began which, ironically, intensified the weaknesses in the balance sheets.

This illustration of the boom bust process used housing. However the same could be told about financial institutions – how rising asset prices give them the leverage to increase their advances. And how, when reality breaks through, they also suffer losses of asset values which compromises their ownership activity. Some went bankrupt; others had to be taken over by other private institutions or the government.

It is at this point the toxic assets become critical. It is not just their value decreases; we dont know by how much, so we do not know to what extent the financial institutions are insolvent or potentially insolvent. As a consequence other financial institutions are reluctant to lend to them. Interbank and other inter-financial lending stalls, at which point the money markets gum up, and credit becomes difficult to obtain. That is the point we have reached today.

Getting proper values for assets becomes vital. The Obama administration has had a number of initiatives, including stress-testing the big banks, that is independently assessing their balance sheets.

In addition the financial institutions have criticised mark-to-market valuations, the approach implicit in my story of the house owner who geared up on capital gains. They argue that markets are so illiquid that the true value of the assets in their balance sheet is understated.

There is an irony here. There was no complaint about mark-to-market valuation from the same institutions when it favoured them during the boom; now they point to its deficiencies when it becomes a drag during the bust. Mark-to-market is pro-cyclical. accelerating the economic upswing but also reinforcing the economic downswing. This is not to blame the entire boom and bust on the accounting standards. Mark-to-market was only a contributor to the boom and the unsustainabilty which generated the bust. Other factors contributed too.

American financial institutions have recently got America’s Financial Accounting Standards Board to agree to a mark-to-model approach; European and International standards may well follow. That means that during a bust assets may be valued in the balance sheet based on some assessment of their medium term worth, above their current market value. We saw mark-to-model misused in the case of Enron – it seems possible that it were also misused during the more recent boom. – so I have reservations. On occasions one mutters GIGO – garbage in, garbage out. One hopes the accounting profession will set out a very clear set of standards, and the auditors will enforce them. Otherwise we face the possibility of the corruption of the system as we saw happen with Enron.

It is not my purpose here to judge whether mark-to-market, market-to-model, mark-to-maturity or some other valuation approach is appropriate. That is something for the accountancy profession to work out, and in any case I have no proposals for an alternative. I do note however, that economics only provides a rigorous justification for mark-to-market under certain conditions, which have obviously not been pertaining during the boom. At best mark-to-market is a heuristic rule, perhaps the best available, but far from perfect. Whatever the accountancy measurement conventions regulators could use a different measure of the value of assets when they are setting their prudential ratios.

Are these issues relevant to New Zealand public sector accounts except in a background sense? As far as we know, New Zealand’s banks do not own substantial quantities of toxic assets. Our problem is different. The trading banks have substantial offshore borrowings – around $90b – which have to be rolled over because they are on-lent to New Zealand house owners and businesses. As a consequence of the gumming up of international markets, the funds can be borrowed only for very short periods. That is not a good way to run a bank. It is like having all one’s domestic deposits on call with the possibility they could all move rapidly offshore.

Additionally, the public sector has moved from being a net lender to a net borrower. In order to reduce the rise in unemployment the New Zealand government is attempting to maintain aggregate demand by spending more and lowering taxation. Even if the New Zealand private sector does not require any additional overseas borrowings, the country as a whole has to increase its overseas debt.

This places a restraint on the size of the government deficit – the excess of spending over revenue. The difference has to be borrowed, and that requires willing lenders. As best can be judged, were the New Zealand public deficit to get any larger, there would be a credit downgrade. The least damaging outcome would be that the offshore debt would be more costly to service with higher effective interest rates – not just the new debt but the over-rolling debt. But as painful as that would be, we cannot rule out that the overseas lending could dry up all together. New Zealand (with Australia) is unusual in the world financial system; we are an affluent debtor with no patron: Iceland was bailed out by the Nordics, the emerging economies in Europe have the European Union, the Latin American countries – our closest comparators – have the US.

The restrictions on the government borrowing mean that the fiscal injection is constrained, so unemployment will rise to levels which a couple of quarters ago would have been judged unacceptable. I’m afraid that cannot be avoided. But there is a second problem.

The current fiscal forecast is that when New Zealand gets through the recession the fiscal position will still require heavy borrowing. The fiscal deficit is not just a temporary measure to deal with the international global crisis; we now have a structural one. The Minister of Finance warned us of this when he talked about the prospect of ‘decades of deficits’. He has rightly said that such a situation is unsustainable.

To what extent reducing the deficit will involve cutting spending or raising taxes will be seen when the 2009 budget is announced on May 28. I hope there will be no tricks with mirrors. The public may be fooled, but potential overseas lenders will not.

It will be obvious to this conference that the quality of the government accounts is crucial. In the 1970s there were plenty of opportunities for smoke and mirrors, while there were not the forward projections displaying the structural problem which short term measures can obscure. Over the last three decades there has been considerable work done improving the transparency of the government accounts. Additionally there will be projections out to 2014.

The projections involve economic forecasts. The interaction between the public accounts and economic analysis is not ideal. The biggest problem has been that the headline statistic, OBEGAL – the operating balance before gains and losses – is not a good indicator of the overall impact of the fiscal stance on the economy. It has led to calls for tax cuts which were not economically sustainable. It has been a terrible example of Gillings Law – the way the game is scored affects the way it is played. Popular commentators took OBEGAL (and its predecessor OBERAC) as the score and their commentary was dreadful and misleading.

Let us be clear that OBEGAL is a better measure for some purposes than the (more volatile) operating balance including gains and losses. But OBEGAL does not give the full impact of the government on the economy. Government decisions are properly political rather than commercial, and are subject to different analysis. Some of the less commercial decisions occur outside the core accounts, while public investment is not included in OBEGAL (but depreciation is).

Again I am not criticising the accountants’ definition. My purpose is to remind everyone that accountancy and economics are different professions with different concerns; their concepts do not always interface well. We need to work together while respecting each’s perspective – and even more important we need to get these different perspectives across to the public.

A particular area where this is going to be problematic is in the asset valuations of balance sheets – the statement of financial position – which cover the gains and losses not included in OBEGAl. My understanding is that there is little problem with the assets in the core government accounts, but there are likely to be major write-downs in a number of accounts which sit outside it but are of great interest to the public. These include those of the ACC, the Government Superannuation Fund which provides for the retirement incomes of public servants, and the New Zealand Superannuation Fund, (the ‘Cullen fund’) which is intended to pre-fund the rising requirements of an aging population. All these funds will being writing down the value of their assets, reflecting the general fall in the price of some financial assets in the last few months.

In part the assets were overvalued in the past because of the boom conditions and their values are being scaled down to more realistic levels in the long term. But as I explained the mark-to-market valuation over-reacts on the downswing as well as the upswing, and it seems likely that many assets will be valued at below the realistic long-term levels.

No doubt there will be much consternation when the public (that is the media) becomes aware of the apparent losses. It will be very easy to panic and assume that ACC, say, is in some deep trouble that it was not in a year ago. Undoubtedly there are some problems with its costs, and they need to be addressed. However the weaknesses in its statement of financial position reflect the deep problems which face the whole of the world economy. Just as with OBEGAL, the politicians and pundits are likely to go off half cocked. It is important that at this point accountants and economists stand shoulder to shoulder and try to quell the hysteria, while giving to the genuinely concerned a clearer understanding of the real issues.

This paper is a reflection of this approach insofar as it has tried to set out for a general audience – this time of accountants in the public sector – issues which face the economy as a consequence of the Global Financial Crisis. It will be evident that there are issues of deep complexity, which we must try to get across to the public as well as ourselves. The same problem applies to the government accounts, which are not, I’m afraid, transparent even to this economist, and will be even more opaque and misrepresented on budget day. It is of little benefit if we get a particular matter conceptually right, but fail to get its implications across to the polity. Gillings Law Rules – and it is not always OK. I hope the remaining papers at this conference properly pursuing these technical issues will keep in mind the needs of a wider audience.

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Competing Interests

This entry was posted in Business & Finance, Listener on 18th April 2009 by Brian Easton.

<>Is the Government tipping the balance away from consumers?

<>Listener: 18 April 2009

<>Keywords: Business & Finance;

<>Some years ago I was involved in a merger case before the Commerce Commission. The chief executives of the firms involved did not know whether to co-operate, which was the (desired) outcome if the commission approved the merger, or compete, which they would have to do if the commission overruled it. Proceedings before the commission can go on for some time; one can understand businesses disliking any official regulator.

<>And yet they can easily praise the commission when it untangles a monopoly that stops them competing. The privatisation of Tele-com provided a classic case, as the company’s dominance prevented more agile firms from providing cheaper, different or better services. Our telecommunications infrastructure got behind the rest of the OECD; the impasse had to be unlocked by competition law.

<>Whatever views business has about competition policy – they vary from case to case – consumers would be much more positive if only they knew how often the commission has acted on their behalf. New Zealand businesses do not often “rip off” consumers, in part because of competition. But where that is not effective, legislation like the Commerce Act, Fair Trading Act, the Consumer Guarantees Act and the Credit Contracts Act has been used to protect them. Sometimes the mere existence of legislation or a related case decision is sufficient for businesses to be careful.

<>New Zealand competitions policy has never been as vigorous as, say, that in the US, where the Sherman (Antitrust) Act was passed in 1890. Not until 85 years later, in 1975, was our first Commerce Act was passed. That was partly because New Zealand was such a small economy that market competition could not be relied on to regulate the few firms in each market. The countless public interventions meant the Government had other means of controlling monopolies – sometimes its interventions created them. Our commerce legislation is the counterbalance to the Government withdrawing from close involvement in business decisions.

<>Paula Rebstock has chaired the Commerce Commission for the past five years, and for many years before that successfully practised as an economist in New Zealand. An American with a London School of Economics masters degree, she brought passionate US anti-trust attitudes with her. Some businesses thought she was too passionate – but they would, wouldn’t they?

<>Perhaps Rebstock got her reputation because she is one of those feisty, competent women whom New Zealand males sometimes find so threatening. But whatever the chairperson’s style, the Commerce Commission’s powers are restrained. They are subject to the law, and can be overruled by the courts (although that takes time).

<>Rebstock’s recent resignation has led to widespread speculation that the Government wants to be less strict on business. I doubt her successor, lawyer Mark Berry, would see it that way, but there is always the Bush administration trick of leaving the regulators in place but underfunded.

<>Or legislation change could reduce the commission’s powers. The previous National Government said it would replace the objective of promotion of competition with that of “efficiency”. Sounds reasonable, except it is damned hard to measure the efficiency gains from a merger. Much economic literature shows the promised gains when a merger is announced are rarely attained when the merged entity settles down. (I recall one case in which the promised rationalisation of production included closing a factory; decades later the factory was still there.) In the end the Government did not go down that track.

<>Efficiency gains can benefit the business at the expense of consumers. Competition law exists because untrammelled competition does not always work in the interests of consumers. (If you doubt this truism, remember that the global financial crisis is a prime example.)

<>The purpose of the Commerce Act is to promote competition in markets for the long-term benefit of consumers. So, how the Government handles competition policy could be a test of the extent to which it supports big business over consumers.

<>The public have little sense of how the vigorous application of consumer law has so often benefited them. I hope they don’t find out the hard way – by the law, or its implementation, being gutted.

Fair Means or Foul? Discussions About Tax Reform Are Ignoring Some Crucial Issues.

This entry was posted in Listener, Regulation & Taxation on 4th April 2009 by Brian Easton.

<>Listener: 4 April, 2009.

<>Keywords: Regulation & Taxation;

<>At a recent conference sponsored by the Centre for Accounting, Governance and Taxation Research, the first two expert speakers each had 25 years’ experience in taxation reform, one in Australia, the other New Zealand. But if they haven’t got it right after a combined 50 years, something seems desperately wrong.

<>The other conference papers demonstrated what was wrong: not one of them was devoted to the distributional effect of taxation. Who would be better off, who would be worse off and whether the changes would be fair are questions any politician asked to implement the various reform proposals promoted at the conference would want to know. But no one addressed such points.

<>The main economic issue was whether changing the taxation system could improve economic efficiency. What the conference goers had forgotten was that efficiency makes sense only if the losers are compensated by the winners. The usual idea – often honoured in the breach – is that when efficiency is improved, some lose out, but their losses are offset by a tax system that transfers some of the winners’ gains to the losers. If the efficiency gain is from the tax system itself, the argument is going around in circles.

<>Whether tax levels affect overall efficiency has been a bitterly contested argument. The conference consensus seemed to be that they do not (or if they do, the effect is too small to measure). A minority argued otherwise, but the conference did not take them seriously.

<>Neither, as I said earlier, did it take fairness seriously. To give but one example: would favourable tax treatment for foreign investors increase a country’s domestic production (its GDP)? Apparently, the empirical evidence says “no”. But suppose it said “yes”.

<>A politician would say: “I am not really interested in the gross domestic product, but in the gross national product (GNP); I am interested not in what is produced in New Zealand, as this includes foreign profits generated here, but in what New Zealanders produce, which excludes those foreign profits. What does your research say about GNP? Won’t giving concessions to foreigners be at our expense? Could they possibly get more than the increase in GDP and cause the GNP to fall? What does your research say about that?”

<>To which the researchers would have to say “d’oh!” No wonder politicians don’t take tax reformers seriously – unless it is in the interests of their constituents.

<>One reason distributional issues are not discussed is that the most strident advocates of tax reform use the veneer of “efficiency” to hide the reality that they want to skew the income distribution in favour of themselves, their class or those who pay them. I find their dishonesty obscene.

<>It would be honest to say such and such a group deserved to be better off (a proposition that may be true and ought to be thought about), so we should change the tax system to do this. At least the general public would know where the advocates stood, and ask who would be worse off. Obscuring a redistributional argument in the confused cloak of efficiency is deceitful.

<>Some tax reform advocates have an even bigger agenda. For instance, some want to have a smaller government and to privatise health, education and retirement provisions and a whole lot more. Their deceit is to advocate lower taxes (especially for themselves and their clients) while failing to mention that the price of this will be the need to reduce public spending (which will have redistributional effects).

<>I discussed the paradox of failed reformers with one of the long-time tax experts sitting on yet another reform committee. He smiled wearily, for of course he knew the arguments. He explained the challenge nowadays was to deal with new issues that were not a problem a quarter of a century ago – such as electronic commerce and globalised businesses.

<>I can sympathise with that. All administrative structures have to adapt continually for new technologies, new opportunities and new threats to their effectiveness. That was what the conference was about. It was interesting from that perspective. But I do wish it had paid a little attention to fairness.

The Global Financial Crisis I (index)

This entry was posted in Index, Macroeconomics & Money on 31st March 2009 by Brian Easton.

Writings to the end of March 2009

Keywords: Macroeconomics & Money;

The following is a summary of my writing on the Global Financial Crisis beginning in August 2007, when it became evident that the world financial system (and probably the world economy) was going to face great stress. I compiled it to enable me to reflect on and monitor my thinking, but it may be of interest to others. (The list does not record various broadcasting and other media contributions.)

What may be not evident is that underpinning what I have been writing is close attention to the international debate. I have a friend who sweeps the major daily papers in English and sends me articles, I read hard copy of magazines, there are blogs and I am dialogue with colleagues here and overseas.

(The dates for Listener columns are the cover date. The column would be finalised about three weeks before. Other items would be finalised much closer to the presentation data, and often subject to (typically) minor revisions after.).

Columns published between April 2009 and September 2010 can be found at www.eastonbh.ac.nz/?p=1353

[1] The turbulence struck in early August 2007 when uncertainty over the value of some financial assets resulted in the money markets seizing up. I responded with .Of Ninjas and Private Equity: Will there be a worldwide financial crash? (www.eastonbh.ac.nz/?p=852, 25 August, 2007) to alert readers but also to explain the origins of some of those assets which were later to be called ‘toxic’.

(There had been a number of pre-August 2007 which reflected worries about the US economy, although I did not focus enough of the financial bubble. e.g. Yankee Dollar Blues: How will the US correct its external deficit? (www.eastonbh.ac.nz/?p= 643, 12 March 2005) .Recovery and Deficit: Where is the US economy going? (www.eastonbh.ac.nz/?p=508, 21 February 2004) and .Millennium Depression (www.eastonbh.ac.nz/?p=174). (See[16].)

The column concentrates on housing mortgages. I had long been aware that the valuation of other financial instruments could be problematic: .Corporate Chaos: Is the collapse of Enron and Worldcom the beginning of an end? (www.eastonbh.ac.nz/?p=89, July 2002) There are many other articles on Enron. Reflecting, I realise I have not written in detail on ‘mark-to-market’. Will one day.)

[2] A month later it was necessary to give an explanation of market value in .Value Judgements: What is the value of your house? (www.eastonbh.ac.nz/?p=852, 22 September 2007), using the readers’s housing experience as an illustration of the general problem.

(This column was very much informed by a note I had prepared in April 2007: .Housing Prices Relative to Consumer Prices (www.eastonbh.ac.nz/?p=837). See also .Housing Mortgage Stress: How Much Has it Risen? written for the Sunday Star-Times (www.eastonbh.ac.nz/?p=849, 5 August 2007). See also my concerns about household debt: A Fate Worse Than Debt: We owe too much. Go figure. (www.eastonbh.ac.nz/?p=789, 9 September 2006).)

[3] One of the frustrations of the experience was the message that at the time that the global crisis was not serious. The subtitle of .Recession Procession: Ignore the happy brigade.. The forces of recession are already in motion (www.eastonbh.ac.nz/?p=873, 1 December 2007) reflects that concern. Note this column is about the impending world difficulties, not a local recession.

[4] I dont recall thinking of .Public Debate? Yeah, Right: Current economic debate rarely extends beyond hearsay and uninformed opinion (www.eastonbh.ac.nz/?p=874, 15 December 2007) as a contribution to the analysis of the Global Financial Crisis. although there was a glancing reference in it. Its purpose was to celebrate 30 years of writing Listener columns, and to make a sort of policy statement. Had I foreseen the standard of public discussion over the following year, the column might have been more vitriolic.

2008

[5] Not surprisingly commodity and exchange rate markets became turbulent too. .New World Order: The days of having a dominant world currency are coming to an end (www.eastonbh.ac.nz/?p=880, 9 February 2008) was intended to provide some background to the headlines of the day, while preparing readers for the long term.

[6] As we ran up to the 2008 budget, there was the usual uninformed cacophony demanding tax cuts. This fiscal conservative wrote .A Good Keynes Man: Alan Bollard’s not a Grinch, he’s just doing his job. (www.eastonbh.ac.nz/?p=889, 5 April 2008)

[7] Still running up to the 2008 budget and the unremitting cry for tax cuts continuing, I repeated the theme in an international context. .Bubble Trouble: The liquidity drunks have taken over the economic asylum (www.eastonbh.ac.nz/?p=891, 3 May 2008) also provides of an account how excessive world liquidity from the American fiscal injection had got us into the mess.

[8] Through much of 2008, many journalists seemed consumed with portraying the (then Labour) Government in a poor light. I’ll leave those who study the politics of the media to analyse that, but one consequence was that they were misleading the public about the state of the economy and the options available. Or perhaps it was that having under-reported the impending international recession, the media flipped to the other extreme over the domestic one. .Media Messes: Are journalists making the economic situation seem worse? (www.eastonbh.ac.nz/?p=894, 31 May 2008) The actions of anyone (unwisely) taking any notice of them would have deepened the shallow 2008 New Zealand recession.

(The 2008 New Zealand recession was largely self induced – a consequence of the medium term cycles generated by the floating exchange rate. It is not quite true that it had nothing to do with the evolving Global Financial Crisis – it intensified it – but it was something different. Perhaps the commentators got the two muddled. I need to write this up some day.)

[9] The time came to move the macro-argument on. So I wrote about the regulatory problem in .Financial Ruin: Aftershocks from the liquidity earthquake (www.eastonbh.ac.nz/?p=904, 14 June 2008) reaching out to the audience by referring to the New Zealand experience. But it is really about the international one.

[10] The uninformed calls for tax cuts continued. I responded with . So You Want Tax Cuts? Cutting ‘wasteful’ public spending will not be easy. (www.eastonbh.ac.nz/?p=905, 28 June 2008) It will be interesting to see how the uninformed will respond to the fiscal crisis described in [28].

[11] Looking back I can see how many of my columns were responses to the inadequacies of the public debate, which was imbalanced towards the simple, the uninformed and the crude. Monetary policy was not exempt. .Shock Value: From manic muddle to melancholic mess. (www.eastonbh.ac.nz/?p=914, .23 August 2008) The column is also persisting with the message that things are pretty troubled out there.

[12] By about this time the uninformed commentators thought that Keynesianism had been resurrected. Their Keynesianism was presented badly and seemed to suggest that the undisciplined to do what they liked. It had little to do with John Maynard Keynes. And so .Keynes to the Kingdom: An “exclusive” interview with economist Dr Brian Easton (www.eastonbh.ac.nz/?p=915, .6 September 2008) where I tried to explain what modern Keynesianism is on about in a small open multi-sectoral economy.

[13] By late September 2008, The world financial system was in chaos. Headlines included the bankrupting of one of the US merchant banks (Lehman Bros) and the (partial or full) nationalisation of other financial institutions (such as AIG, Fanny Mae and Freddie Mac). I was in journalistic difficulties. because New Zealand was in the midst of an election whose economic context was that nothing had happened since July 2007 which might require a rethinking of economic policy. It was as if those involved were thinking it was still summer, while the storm clouds of winter were billowing on the horizon. What was I to do, especially as I have a policy that my columns do not comment on electoral matters during the high season of the election? So I wrote about what was happening overseas, trying to give some insight as to how to think about the financial crisis: .Kerr-ching! Choosing the vanilla type of financial institution has its advantages. (www.eastonbh.ac.nz/?p=918, 18 October 2008) Part of its purpose was the less complex financial activities should not be condemned.

[14] By now it was becoming clear to even the uninformed that there was a Global Financial Crisis. To the informed it was evident too that this one was so far outside their experience and they were struggling to understand it. I set out the stages of a financial crisis in .Future Shock: Hard times are ahead – and they won’t be over soon (www.eastonbh.ac.nz/?p=919, 1 November 2008)

[15] Even the New Zealand academy began to think about the issues. So I gave my first presentation at an Institute of Policy Studies seminar on 6 November 2008: .Responding to a Severe Recession: This one will be different. (www.eastonbh.ac.nz/?p=923)

[16] Election over, it was time to return to the big themes (if I ever left them). .Swing Low: Is the global “millennium recession” arriving too late? (www.eastonbh.ac.nz/?p=920, 15 November 2008)

(I opened the column confessing to my prediction earlier in the decade of a Millennium Depression. (www.eastonbh.ac.nz/?p=174) As the column explains, particularities – especially the Bush tax cuts – delayed its arrival, making it worse. What is instructive from the website list on the millennium depression is how in my previous writing I had spent so much time looking at lesser financial crises which had occurred throughout the 1990 – none of them had the catastrophic monetary jamming which characterises the Global Financial Crisis,)

[17] At a second Institute of Policy Studies seminar on 22 November 2008 I chose to give a paper .Cycles and Depressions in New Zealand History (www.eastonbh.ac.nz/?p=926) which analysed previous great downswings (or whatever one wishes to call them). The precipitant was various people saying they thought this time would be as bad as the Long (Rogernomics) Recession. It and the Asian Crisis of 1997/1998 were the only ones the younger ones had experienced personally. Sadly, too many economists are not taught the general theory of depressions nor have read much economic history.

(I have been looking at the downswing issue since the 1970s. Perhaps the first version of the paper – Three New Zealand Depressions (www.eastonbh.ac.nz/?p=353) – was published in 1980. I have done a lot of work on the Great Depression (1929-1934) – see chapter 4 of In Stormy Seas. (www.eastonbh.ac.nz/?p=100) and I have probably done more research on the Long (Rogernomics) Recession (1986-1994) than any other economist. By coincidence at about this time I was reviewing my earlier work on the Long Depression (1878-1895) as a part of my main activity of the year, writing about the nineteenth century for a history of New Zealand from an economic perspective. I dont say this in the paper, but the next downswing may be more like the Long Depression than the others – an external shock or two giving a long but shallow depression.)

[18] As luck would have it, I was invited to address the Christmas function of the Wellington Branch of the Institute of Directors on 4 December 2008. At a time meant for genial hospitality, I was faced with telling them about the gloomy Prospects for the New Year. (www.eastonbh.ac.nz/?p=922)

[19] With the new government settling in, and the increasing expectation that the mild 2008 recession would not be ending soon, but persisting through 2009 and perhaps beyond, my Listener columns began to turn their attention to what should (or should not) be done. So .Not So Simple: Why we shouldn’t have a tax cut right now. (www.eastonbh.ac.nz/?p=930, 13 December 2008) Note how it argues for a shifting of fiscal policy in the same policy framework as previous columns, but implemented in different circumstances.

[20] One had no sense of this from the public debate, but I am certain the last few months of 2008 were very tough for the banking fraternity – both here and internationally. One banker remarked to me that he was making up a new policy every day, not because he wanted to, but because with the financial system operating outside its traditional range it was necessary to. It has been said that the throughout the world orthodox central bankers had to introduce unorthodox policies. New Zealand has been well served by our Reserve Bank. .Well Played, Bollard: My team of the year is the Reserve Bank of New Zealand. (www.eastonbh.ac.nz/?p=932, 27 December 2008)

2009

[21] I published little on the crisis in January, but I was reading and preparing for the rest of the year. By now I was in the habit of waking up each morning and asking ‘what dreadful event happened over night?’ because – as I said to the Wellington Directors – Northern Hemisphere markets and regulators dont sleep while New Zealand is on its summer holidays. The first February column was a review of where we were: .Balancing Act: What goes down may well come back up, but who knows when? (www.eastonbh.ac.nz/?p=935, 7 February 2009).

[22] Public presentations began. On 10 February I spoke to the Wellington Branch of the New Zealand Institute of International Affairs on .The World Economy in 2008: And After (www.eastonbh.ac.nz/?p=937), which gave me the opportunity to talk a little about how over the years the world had got into its current situation, and what the long term outcome was likely to be.

[23] Two days later (12 February 2009), in a rather different forum – ‘Drinking Liberally’, I gave a paper in two parts. The first part was on the current state of The World Economy (www.eastonbh.ac.nz/?p=939). …

[24]… and after the audience had a chance to top up, the second part was on the current state of .The New Zealand Economy. (www.eastonbh.ac.nz/?p=940)

(One of the problems I am having is that every presentation has a time limit. Given my propensity to explain to the audience rather than tell them ‘the truth’, I am always short of time for a complete account. My longest account is at [29].)

[25] Listener columns tried to be topical without being repetitive. Bernard Madoff’s $US50b fraud led to a column on Ponzi schemes .Robbing Peter: Is the entire financial system just one big pyramid scheme? (www.eastonbh.ac.nz/?p=936, 21 February 2009) But as the subtitle indicates, it was also concerned with in what sense the entire financial system is, or is not, fraudulent.

(A July 2002 column had drawn attention to Enron (www.eastonbh.ac.nz/?p=89) as a Ponzi scheme.)

[26] I dont usually give investment advice, but such was the irresponsibility of some media comment I felt it appropriate to explain the general issues in .Spend or Save?:The paradox of thrift: what is good for you may not be good for your country. (www.eastonbh.ac.nz/?p=949, 7 March 2009)

[27] Observe the Global Financial Crisis columns were coming thick and fast early in 2009. The next issue was the coming fiscal crisis covered in .The Treasury Nightmare: The Government’s accounts are heading into dangerous territory. (www.eastonbh.ac.nz/?p=950, 21 March 2009)

[28] Despite the description of the medium term fiscal outline set out in the Listener column of 21 March ([27] above) being alarming, it over-simplified. I gave a more detailed account in a longer format to the Policy Evolution conference on 16 March: .The Macroeconomic Crisis: Policy Implications. (www.eastonbh.ac.nz/?p=946)

[29] The Wairarapa Branch of the New Zealand Institute of International Affairs gave me the space for a 50 minute coverage of .The Age of Financial Turmoil: Prospects for New Zealand. (www.eastonbh.ac.nz/?p=947) Despite the length of the presentation I found myself drawing on other material from this list when I was responding to questions. A feature of the paper is that I began to move into the area of identifying policy responses. (I slightly reduced version of this paper was presented to the Wellington Branch of the WEA on 23 March 2009.)

That’s it up to the time of writing this (end March 2009). Among the things I have yet to write about are

– the run up to the 2009 Budget (23 May 2009);

– the foreign debt (net overseas liabilities) situation (I have a longish research paper on this; the next major task is to revise it);

– the terms of trade (relative prices for exports). I know the theory but I dont know the future path. All the previous major downswings have been accompanied by a deterioration in the terms of trade. If that happens the New Zealand economy will be truly hammered.

– and no doubt a whole lot more, including what happens in the world economy;

plus, of course,

– the impact of the crisis on political ideologies and perceptions.

An earlier review – The Millennium Depression – which presages the Crisis will be found at www.eastonbh.ac.nz/?p=174.

David Sheppard’s Letter Of July 13, 1984.

This entry was posted in Political Economy & History on 28th March 2009 by Brian Easton.

This letter is discussed in What Happened in July 1984: and the Aftermath: (OCR of Original)

Keywords: Political Economy & History;

DAVID SHEPPARD’S LETTER OF JULY 13, 1984.

                                  DEPARTMENT OF ECONOMICS
                                  13 June, 1984
The Rt. Hon. Sir Robert Muldoon
Minister of Finance,
Parliament Buildings,
Wellington
Dear Sir Robert,
     Thank you for the acknowledgment of my last letter.
     I understand that you pay attention to comments that critics of the Government’s economic policy make on the media. Reluctantly – as I find my own academic work far more interesting – as a public exposure economist and as a critic, it is fitting that I elaborate on one of the comments I made on TV on Sunday night as it is important that you and your advisers understand It. Regrettably, Ian Fraser did not ask me why I saw no reason why Hew Zealand should adopt a ‘financial policy’ which directly conflicts with the conventional accepted orthodoxy of letting interest rates rise to crowd out inflationary trends. I understand why: he did not think, rightly, that most viewers would understand my explanation, and therefore did not wish to solicit my response that conventional orthodox economics is simply designed to explain how a ‘free market’ mechanism works in a world which does not exist. It – neoclassical macro economic theory – is certainly beautiful; it has a well-ordered determinate structure. Regrettably, however, it is based on premises and postulates which are simply completely at variance w the world in which we live; their treatment of the concept of time is ridiculous; they assume there is some ‘God’, called a Walrasian auctioneer, who makes sure that prices are set so that markets clear, and they seem to have a fixation that we Jive in a one-commodity world, rather than in a multi-commodity world in which many prices are set by the hand of man, the corporate marketing division, and that the adjustment of them is a protracted and expensive business.
     This means that the concept of ‘price’ as expressed by a price index is, as you have recently pointed out in criticising P. Harris’s contentions, often not much better than a vacuous concept. As such, its movements have far more to do with a charge in the distribution of income, that is a change in the rewards paid to various producers of output and services (income relativities) than with serving to eliminate excess demand or excess supply in the marketplace. The only exception to this case is when the price index is relatively stable (not much more than say 2 to 3 percent per annum change. Only then does the national unit of account, the measure of value in exchange, proxy a useful measure of an invariant standard of value in the marketplace. Out of this context, when the so-called indices are bouncing along at rates of increase of say 10 percent or more per annum, our measuring rod of value is distorted, and opportunities exist which are taken up to make price changes rather then output charges a n of appropriating extra profits or extra wages, over and above the amount due for increases in our shares of the annual flow of goods and services produced.
     These contentions, mine, have distinct and different implications for successful economic management .In essence, in circumstances when the price indices are rising at an unacceptable rate, the State simply cannot afford to reject the consideration that incomes, prices, interest rates and exchange rates need to be managed in the collective interest. I point out that there is a new line In economic theory which supports these conjectures. It is called post-Keynesian economics and is advocated by sundry professional economists such as A. Okun, Paul Davidson, A. Eichner, A. Lerner, H. Kalecki, all of whom your neoclassical advisers would be hard-pressed to dismiss as nut cases, in as much as they take the time to consider the argument presented.
     Obviously, however, while these post-Keynesians do produce robust justifications to State-imposed, that is determined, price, income, exchange rate and interest rate settinq, they ado two important qualifications: a) the consequences of the setting must be made on a consistent basis – – arbitrary decisions, that is those which have been made without such an assessment, may well make matters worse; b) such State setting may be used malevolently, and in any event inevitably does create an expense in the form of the State’s appropriation of the right of the seller or buyer to determine the price which he is prepared to take or offer for goods/services available in the marketplace. Liberty, that is the freedom to choose, is also an item of value.
     I will not write more now except this. The key to your advisers’ difficulty in failing to understand why the State must have and at times exercise the right to determine prices in the marketplace is that they have overlooked the importance that Ricardo ascribed to trying to always make sure the national unit of account, the $NZ, is a vital element in the conduct of economic management. If they can be brought to considering this critical concept, then they too will gain some appreciation as to why there is a case to be answered as to why New Zealand should adopt, in certain circumstances, market imperfections to condition their laissez-faire fixation.
                             Yours sincerely,
                             D.K. Sheppard,
                             Professor of Money and Finance