Bernanke on economics

There's been quite a lot of coverage of former Fed chairman Ben Bernanke starting up a blog and a Twitter account. Someone - apologies, can't remember who - resurrected his 2013 speech, 'The Ten Suggestions', at the Baccalaureate Ceremony at Princeton, where he said of economics

Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much. However, careful economic analysis does have one important benefit, which is that it can help kill ideas that are completely logically inconsistent or wildly at variance with the data. This insight covers at least 90 percent of proposed economic policies.

The whole thing is worth a read - humour yes, but also quite a bit of wisdom. Speech here, and a video here.

How fast has wealth been growing?

Yesterday I posted about some new data that the Reserve Bank has collated on household balance sheets. It's important stuff, and unsurprisingly other commentators have also been talking about it. As part of the Twittering I rushed in where angels fear to tread, and have subsequently had to shelter in a foxhole in No Man's Land while the salvoes fly over my head.

The debate is about showing the full picture of what has happened to household wealth (and not just sub-sets of the history), and also about the growth rate of household wealth (with some unspoken subtexts, I'm guessing, about who was in government when wealth grew slower or faster).

So in the interests of putting some facts on the table, here are two graphs. They both show the growth rates of GDP and household (net) wealth, and they go back as far as the wealth data do, so this is as full a picture as you can show. Both take rolling four quarter totals, to smooth out the quarterly statistical noise: a side effect is that you lose some quarters at the beginning. And both use year on year growth rates rather than quarter on quarter ones, again to smooth out the noise, which means you lose some more quarters at the beginning, and so the graphs start at December 2000 rather than December 1998 which is when the household wealth series starts.

The only difference is that the first chart shows nominal wealth (the headline dollar number that the RBNZ has calculated) and nominal GDP, so both are in dollars of the day, and the second chart shows real wealth (which is nominal wealth which I have deflated by the CPI) and real GDP (which is Stats data, using the expenditure measure). Both have their uses, and there's already been some cross-fire about which to use, but for many purposes I'd suggest the second graph is likely to be the more relevant. That said, you get much the same shape of growth profile in both cases, so I wouldn't die in a ditch over which one to reach for.

Here they are.

Year on year growth rates - nominal $ terms

Year on year growth rates - real terms

What can you say about these results? First, that wealth is a good deal more volatile than GDP, which is as you'd expect, as asset prices can move a lot across the business cycle. Second, that the current business cycle isn't as strong as the heady days of the early to mid 2000s: GDP is growing respectably at a 2.5-3.0% sort of pace, but it's not as strong as the 4.0-5.0% pace we saw in the early 2000s, and wealth is definitely growing more slowly that it did back then. If people can see other trends in there, let us know.

As for who might get credit or blame, I'll just say what I said in a different context a few days ago - I was talking about jobs but it's as applicable here - that "voters these days know that governments don't create jobs (or not the bulk of them, at any rate). Governments can often, and fairly, take credit for allowing or facilitating or improving the environment for job creation, and that's no small thing: just look at all the counter-examples, from France to Venezuela, where governments have been incompetent managers of the macroeconomic environment. But job creation itself? Nah".

What do we own, and what do we owe?

The Reserve Bank has done everyone a big favour by coming up with improved data on households' assets and liabilities. This latest improvement is part of a series where Rochelle Barrow and her colleagues have been toiling away at finding or improving statistics that throw light on macrofinancial issues - I posted a while back about their extensions to the suite of interest rate data - and it's an especially important one. With the current Auckland housing boom, for example, we need good data on what the vulnerabilities might be in people's balance sheets - have they gone overboard on leveraging into a red-hot market? - and there are also other concerns, including what looks like an unusually low household savings rate by international standards.

You'll find the Bank's news release about the new household data here, the background paper (pdf) that goes into all the technicalities here, and the data themselves (Excel) here and here. By far the major significant improvement is the inclusion of households' equity in small and medium sized businesses (whether incorporated or not). As in many economies, it's a big slab of the economic landscape: in New Zealand households' measured wealth goes up by $312 billion when their business equity is counted. "Goes up", by the way, is meant as a matter of arithmetical comparison between the old data on household wealth and the new ones: households haven't suddenly become much richer, it's just that the RBNZ data are now measuring what was always there, whereas before they weren't.

Here's a snapshot of what New Zealand households own, from the background paper.

The business equity that is now being counted is the darkish blue segment towards the bottom. Housing makes up about half of everything (more like 60% if you add in rental property, which I'll come to in a minute). Whether you regard that as normal, or as yet another illustration of Kiwis' one-eyed preoccupation with housing an as investment, is up to you, but the good news is that, because these new RBNZ statistics are being compiled on an internationally consistent basis, we'll be in a better place to make international comparisons and judge whether we're normal or odd. It won't be a stroll in the park - "Neither the previous New Zealand household sector balance sheet data, nor this new data, will necessarily be fully comparable with data presented by authorities in other countries", as the paper says, partly because other countries have their own funny ways of counting things - but we'll be able to move a good deal closer to making reasonable judgements about how we scrub up compared to other places.

I wondered where our KiwiSavers are, and the answer is, in that purplish segment second one down, 'net equity in superannuation funds'. KiwiSaver came in in 2007, and in December '07 households' equity in super was $31 billion. By December '14 it had risen to $57.8 billion: I know there is recent research from Treasury saying KiwiSaver didn't add to overall wealth accumulation, and perhaps KiwiSaver only shifted around how wealth is held, and maybe that's right. But in any event there's now a sizeable KiwiSaver pot where there wasn't one before.

Unfortunately, one of the side effects of moving to an internationally standardised way of measuring these things is that rental property - which you and I would regard as an archetypal household asset - is classified as a business activity rather than a household activity in the international Book of Armaments. As the background paper says, "most analysts will want to include the liabilities of rental properties as household liabilities because of the full-recourse nature of mortgages in New Zealand", and so the Bank "will continue to provide statistics that include rental property as an adjunct to the new series". Jolly good.

The only quibble I've got - and I had it about the older less complete data, too - is that I think the headline way of summarising the data doesn't really show the situation  in the intuitive way most of us would like to see. It's got its uses, I dare say, but it doesn't hit the spot for me. Here, for example, is one of the RBNZ's summary graphs.

There's net wealth at the top - fine, got that, your total assets less your total liabilities, no problem there. And then there's net financial wealth, which is your financial assets (money in the bank, the KiwiSaver, those Mighty River Power shares) less your financial liabilities (the mortgage, the credit card). But I'm afraid I find the net financial wealth calculation of no practical interest or utility at all: it makes more sense to me to net off the financial liability of the mortgage against the non-financial asset of the house (to show housing equity) and to show financial assets net of any other financial liabilities.

Here's my rejig, including rental property and mortgages secured against rental property. It's horses for courses, but for me this is a better way of showing how much we've got in the house and how much in other things. Indirectly, though, it  shows, again, the utility of the data, as they can be spliced and diced to suit your interest.

While a statistician's work is never done, it looks as if these enhancements to the household picture have largely filled in the one large big gap: the background picture notes some possible future extensions but I doubt if they're going to be of the order of $312 billion worth (though converting the SME equity from its current book value to market value could be worth a bob or two to the picture of household equity). We're now in a clearly better place when it comes to having a good picture of household wealth and debt - well done, the RB.

A must-read report on people's attitudes to competition

Economists sometimes get taken to task for wishing competition onto people, and there are often proponents of the idea that there are less divisive and less conflicting, or more collegial and more cooperative, approaches to life.

So it's extraordinarily useful to have a comprehensive survey of what a large group of people actually think about competition. It covers the Eurozone, and it's the latest in the European Commission's series of what they call Flash Eurobarometers, or "ad hoc thematical telephone interviews conducted at the request of any service of the European Commission. Flash surveys enable the Commission to obtain results relatively quickly and to focus on specific target groups, as and when required".

This latest one is on "Citizens' Perception about Competition Policy", and it's terrific. If you've got the slightest interest in competition, it's a must-read. The summary is here (pdf) and the full report is here (also pdf).

First of all, let's deal to the canard that people would prefer the quiet cooperative life without the jostle or hassle. The two graphs below say it all.

It's also true that people can see the other side of the coin, and are fully aware of the downside of having inadequate competition, as this graph shows.

That's the guts of the results, but there's lots more that's also fascinating. For example, some competition authorities - including, I'd suggest, our own - take the view that it's too hard to measure the state of competition, and if you wanted to, you could certainly convince yourself that HHIs are imperfect and you can't measure price to marginal cost and so on and so forth. Funny, though, that the person in the street in Paris or Prague doesn't have much difficulty seeing a lack of competition when it sneaks up on them, as this next graph shows.

You couldn't ask for a better roadmap of competition problems (and indeed you could easily see how repeated surveys along these lines would help show any competition authority whether it is making progress). 

And it gets better: if you go to the full report, you can see the country/sector breakdowns where you can immediately identify the hot spots. If the European Commission was born anew today, knowing nothing whatever about the state of competition across the Eurozone, in five minutes it would establish (from pp17-21 of the full report) that it should be looking at the energy sector in Bulgaria, Cyprus and Latvia; at the transport sector in France, Finland and Ireland; at the pharmaceutical sector in France, Ireland and the Netherlands; at telecoms and the internet in Croatia, Belgium and Spain; at food distribution in Finland, Greece and Lithuania; and at financial services in France, Ireland and Denmark. That's an immensely powerful guide to competition policy and enforcement priorities, and a very suggestive input into the kinds of structural reforms many of these countries need to undertake.

I won't go on much further: it's a great report, and you should really read it for yourself. I'll finish with just one final, and I thought somewhat poignant, point, and that's how attitudes to competition have changed. Some of those countries in the EU28 are relatively recent converts to the market economy, and back in 2009, when the previous survey was run, there were, for obvious reasons, relatively high levels of "don't have a clue, mate" responses to how competition feels and what it does or does not achieve.

Fast forward to 2014, when this latest survey was taken, and the "don't knows" have shrunk. In Romania, for example, they used to make up 16% of the populace: now it's only 2%. And where did those votes go? Overwhelmingly towards a more positive view of competition: when exposed to the wicked market ways of the West, 90% of Romanians now agree that competition gives consumers more choice, a 17% rise in just five years. Those who disagree have dropped from 11% to 8%. And there are similar shifts in opinion in Hungary, Lithuania, Bulgaria and Estonia, and smaller shifts in the same positive direction in Poland and Latvia. 

It's not completely universal: the Czechs, for example, don't seem to have made much of a success of their move to a more market economy. But as a general rule when people who have never had decent choice or fair prices get them, they love it. Something to remember for the next time a politician is afraid of the backlash from some protected group whose privileges are being exposed to competition: the vast majority of citizens will be behind you.

The Price Elasticity of Demand

According to the law of supply and demand the quantity demanded of a good or service will generally increase if its price falls. To see how strong this effect actually is we use the concept of elasticity. More specifically, the price elasticity of demand.

Depending on what we are analyzing there are different demand elasticities that can be considered (e.g. price elasticity, cross-prize elasticity, income elasticity). The most relevant of them is the price elasticity of demand which describes to what extent the quantity demanded of a good is affected by a change in its price. There are many factors that influence the elasticity so we will start off by looking at its most relevant determinants.

Determinants

The price elasticity of demand is determined by a multitude of economic, social, and psychological factors that each influence consumer preferences and choice in a unique way. Being familiar with the most relevant of those determinants will be crucial for analyzing and comparing elasticities of various products.

• necessity of the product: If a good is considered a necessity (e.g. water, bread, toilet paper, etc.), a change in the price of the good will not significantly affect its demand. Since people always have to satisfy their basic needs they do not respond much to price changes for basic goods. If a product is considered a luxury good however, demand will be much more elastic, simply because people do not actually need those products to survive.
• availability of close substitutes: Close substitutes allow consumers to switch between different goods that satisfy the same (or similar) needs, thus if a good has one or more close substitutes, demand will be rather elastic. In that case people can just buy the substitute to satisfy the same needs if the price of the original product increases. On the other hand if there are no close substitutes available, consumers cannot just switch between equivalent products so they will not respond as strongly to a price change.
• proportion of income devoted to product: Products that are expensive (i.e. take up a high proportion of the available income) tend to have more elastic demand. Absolutely speaking, a 1% increase in the price of an expensive good is more significant than a 1% price change of a cheap good. As a result, consumers generally respond more strongly to price changes if they have to devote a larger proportion of their income to a certain product.
• relevant time horizon: In most cases demand is more elastic in the long run as compared to the short run. There are many occasions where consumers face significant switching costs in the short run (because of binding contracts, opportunity costs, etc.). Those costs are usually lower in the long run because contracts can be allowed to expire and there is more time to prepare and to evaluate all available options.

Now, please note that there may be additional determinants that are not mentioned here but are applicable in certain situations. This is not supposed to be a complete list. Basically every aspect that affects consumer preferences in any way will have an effect on the elasticity of a good or service and can thus be considered a determinant of elasticity.

Types of Elasticity

There are different types of elasticity. In particular, a demand curve can be elastic, unit elastic or inelastic. In fact, since elasticity is always measured at a certain point a single demand curve can have segments of all three types simultaneously. To see how this is possible, we will have to crunch the numbers and look at how elasticity is computed. The price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in the price of a good. This can be illustrated using the following formula.

To give an example, let's assume that an increase of 2% in the price of ice cream causes consumers to buy 6% less of it. According to our formula the elasticity in this case can be computed as 6% / 2% = 3. So the elasticity of demand equals 3. 
However we still need some kind of classification to actually work with that number, right now it does not really say much. This is where the different types of elasticity mentioned above come into play. With their help we can classify the demand curve and thus interpret the result.

• If the elasticity is greater than one, a demand curve is said to be elastic.  In this case consumers respond strongly to price changes. As a result the quantity demanded changes proportionally more than the price.
• If the elasticity is equal to one, a demand curve is said to be unit elastic. In that case consumers respond proportionally to price changes which means the quantity demanded will also change in the same proportion as the price.
• If the elasticity is less than one, a demand curve is said to be inelastic. In this case consumers do not respond strongly to price changes. Therefore the quantity demanded changes proportionally less than the price.

Hence, since elasticity in our example is equal to 3 we can conclude that demand for ice cream is elastic at this point. Once again it is important to note that this elasticity may change as we move along the demand curve, so there may be other examples where the ice cream has different elasticities on the same demand curve. This is due to the fact that we use relative proportions to calculate the elasticities.

Additional Demand Elasticities

The cross-price elasticity of demand is used to measure by how much the quantity demanded of a certain good changes as the price of a different good changes. It is defined as the percentage change in quantity demanded of a certain good 1 divided by the percentage change in price of a good 2. This results in the following formula.

If the cross-price elasticity is a negative number the two goods are said to be complements. In this case an increase in the price of good 1 reduces demand for good 2. On the other hand if the elasticity is positive, the goods are said to be substitutes, since an increase in the price of good 1 results in an increase in the quantity demanded of good 2.

The income elasticity of demand is used to measure to what extent the quantity demanded of a good changes as consumer income changes. It can be computed as the percentage change in quantity demanded divided by the percentage change in consumer income. Again, this can be illustrated using a simple formula.

If the income elasticity of a good is a positive number it is considered a normal good, because a higher income increases the quantity demanded. However there are goods that have a negative income elasticity, they are considered inferior goods. For those goods a higher income will result in a lower quantity demanded.

In a Nutshell

The price elasticity of demand measures how the quantity demanded of a good or service changes as its price changes. It is determined by a number of factors, including the necessity of the product, the availability of close substitutes, the proportion of income devoted to the product, and the relevant time horizon. The demand curve of a good or service can be elastic (i.e. greater than 1), unit elastic (i.e. equal to 1), or inelastic (i.e. less than 1). It is possible to have different types of elasticities along the same demand curve. Apart from the price elasticity of demand there are two additional demand elasticities: the cross price elasticity of demand, and the income elasticity of demand.

Lies, damned lies, and durables orders

There are days when you really, really wonder about the efficiency of the financial markets.

Apparently (according to the AP coverage), US shares have been sold off because "Traders were discouraged to see that orders for long-lasting manufactured goods fell in February for the third time in four months". The weak state of US durables orders appears to be having effects closer to home too, with the Sydney Morning Herald saying yesterday that "The [ASX] market was down from the opening bell as Wall Street stocks were sold off sharply after unexpectedly weak US durable goods orders".

Could everyone get a grip, please?

Here are the durables data they're all supposedly worried about (from the terrific, and free, FRED data resource that the St Louis Fed provides).

Over longer timeframes, the monthly changes in the durables orders series are pretty much useless as a cyclical guide. You did get a run of consecutive falls in the post-GFC recession (the darker shaded area in the graph), but that's it. Even in what is now a prolonged recovery, you don't get a corresponding clear string of good durables numbers: if there is one in there somewhere, it's been well hidden by the monthly volatility.

It's even worse if you're not taking the longer view. Here's the past couple of years on their own.

The volatility is very large: 4% or 5% moves up or down in a single month are quite common, with the occasional even larger humdinger to throw you completely like that 22.6% spike in July '14 (some huge order for transport equipment, as it transpired).

So the noise is immense, and the signal (if there is one) is inaudible. I know journalists have to write something to keep the ads apart, and economists and analysts have to do something in the office till the pubs open, but durable goods orders? Really?

Wings clipped. Good

On Tuesday the ACCC said it was minded not to allow a proposed coordination agreement between Qantas and China Eastern on the Sydney-Shanghai route (media release here, full draft decision as a pdf here).

Good. It was hard to see how they could find otherwise as the likely detriments were large and the benefits (though real) small in comparison. As the Summary of the decision noted

Qantas and China Eastern had a combined share of capacity (seats flown) on the Sydney – Shanghai route of 83% over the 12-month period from October 2013 to September 2014

...the ACCC considers that Qantas and China Eastern are the major carriers on the Sydney – Shanghai route and each other’s closest competitors. The competitive constraint they impose on each other is likely to be lost if the Proposed Conduct proceeds.

For these reasons the ACCC considers that the Proposed Conduct is likely to result in significant public detriment. It is likely to give Qantas and China Eastern an increased ability and incentive to unilaterally reduce capacity, or limit growth in capacity, relative to that which would occur in the absence of the Proposed Conduct, thereby allowing the Applicants to increase airfares on the Sydney – Shanghai route

The ACCC considers that the Proposed Conduct is likely to result in a range of public benefits. However, the ACCC considers that the magnitude of these benefits is likely to be limited.

The ACCC considers that on the Sydney – Shanghai route the extent of the reduction in competition, and associated public detriment, is likely to be significant and outweigh any benefits of the Proposed Conduct.

The airline industry, left to its own devices, can be too clubbable by half, and there's a very strong argument for regulators outside the industry, like the ACCC or the Commerce Commission, to be an arbiter of proposals like these: we need someone to take the pro-consumer, and not just the pro-industry, line. I don't know exactly what "regulatory approvals" Air New Zealand says it needs for its proposed coordination with Air China, but I hope they include our competition authority.