Tag: The Conversation

There are two big political problems buried in the latest budget update

From The Conversation.

Whether or not we end up in surplus in five years’ time, yesterday’s Mid Year Economic and Fiscal Outlook (MYEFO) exposes nasty political problems for the Turnbull government in the here and now.

Real GDP growth for 2016-17 has been sensibly but shockingly revised down to 2% – the lowest outcome since the global financial crisis, the second lowest in 16 years and the third lowest since the long upswing began in 1991/92. Sensible, because we know, from the third-quarter GDP numbers and other indicators this year, that the upswing in residential investment has peaked before (and perhaps well before) an upswing in business investment has begun.

Shocking, because if labour productivity continues to run a little above 1% – as it has for the last four years – the implied growth in employment of 1% or so will probably not be enough to stop unemployment rising. The MYEFO projects the unemployment rate in the June quarter next year at 5.5% – lower than today and lower than the average of 5.8% over the last four years.

Yet, at 2.6% year average GDP, growth in those four years has been markedly stronger than the 2% MYEFO now projects for 2016-17. Even with the projected decline in the participation rate, the MYEFO unemployment forecast will be a struggle.

Disappointing GDP growth is political problem number one for Malcolm Turnbull and Treasurer Scott Morrison. Problem number two is the implacable persistence of substantial federal deficits.

These deficits limit the government’s response to problem number one. In 2012-2013 government receipts were 23.0% of GDP, payments 24.0% of GDP, and the deficit 1.2% of GDP. Labor lost office a little over nine weeks after the end of that fiscal year.

In these latest projections for the 2016-17 Budget, four years on from 2012-2013, receipts are expected to be 23.3% of GDP, payments 25.2% of GDP and the deficit 2.1% of GDP. Compared to 2012-13, receipts have increased 0.3% of GDP, spending 1.2% of GDP and the deficit 0.9% of GDP. Receipts are up, but spending is up even more and so is the deficit.

There are plenty of reasons for this woeful fiscal performance, mostly to do with modest increases in profits and wages and the tax-minimisation policy of former Treasurer Peter Costello. But these reasons are not ones that square with Treasurer Morrison’s rhetoric, or which can any longer be laid at the door of the previous Labor government.

Nor does the MYEFO give any confidence that the troubles of the Turnbull government will soon be eased. The path to the return to surplus depends completely on increasing tax revenue.

Spending as a share of GDP is now, according to these MYEFO projections, locked in at 25.2% of GDP right through to the end of the forward estimates period (and beyond the next election) in 2019-20. The projected decline of the deficit arises only because tax receipts are expected to increase over that period by 1.6% of GDP.

A slow economy, a rising tax take, perhaps rising unemployment, and not much room to move. 2017 won’t be cheerful for the prime minister or treasurer – or for the rest of us.

Author: John Edwards, Nonresident Fellow at the Lowy Institute for International Policy and Adjunct Professor with the John Curtin Institute of Public Policy, Curtin University

Federal Reserve offers vote of confidence in US economy (so there’s no reason to panic)

From The Conversation.

No one was really surprised that the Fed raised its target interest rate by one-quarter of a percentage point. Yet some people are really upset about it and worried this will slow down a fragile economic recovery.

I would disagree with that view for several reasons.

My biggest reason is that a quarter-point is not a very big change. I recognize that the economy isn’t yet chugging along at full steam yet, but the Fed acknowledged that by making the smallest increase it could and implying that it’s unlikely to be followed by another increase in January or even in March or May. If we did get another increase that soon, it would only be in response to clear signs of strong economic growth in the U.S.

No magic wand

We should remember that monetary policy is not a magic wand.

Changes like this take time to percolate through the economy and are made with the expectation that their full impact won’t be experienced for several months. What the Fed really said today was that it fully expects that the economy will continue to strengthen over the coming three to six months.

One argument made by those against today’s rate hike (and any others the Fed might be considering) is that there’s still considerable slack in the U.S. labor market. Put another way, our recovery from the Great Recession hasn’t yet reached everyone – meaning a lot of people are still out of work or can’t get the jobs they want – and we should keep rates as low as possible to continue to encourage businesses to expand and to hire more workers.

There’s some merit to this concern. The Bureau of Labor Statistics’ broadest measure of labor underutilization is still at 9.3 percent (including discouraged workers and people who can’t find full-time work). While that certainly sounds bad, this rate was over 17 percent during the worst parts of the recent recession, so we’ve made tremendous progress.

The economy continues to create jobs at a healthy pace – adding 178,000 jobs last month and adding an average of 188,000 per month over the past year. In other words, the Fed is giving our economy a vote of confidence that this level of job creation is likely to continue.

Why a stronger dollar isn’t a concern

Another big concern is that this increase will lead to the dollar getting even stronger in international currency markets.

There are several reasons for the dollar’s rise – most of them have nothing to do with monetary policy. This means that the dollar would continue to strengthen even if the Fed did nothing. One way to look at the dollar’s recent rise is the world is saying they are confident that the U.S. economy will continue to outperform most other regions.

A rate increase is probably a good thing right now because we’ve had the lowest interest rates ever for nearly a decade, and loose monetary policy has probably done about as much as it can for now. It’s not that I think higher rates will be even more helpful, but that I think low rates aren’t likely to help the economy much anymore.

I’d like to see rates return to a slightly higher level so that we have the flexibility to decrease them if needed. In the past, we’ve relied almost exclusively on monetary policy to moderate the ups and downs in the economy and that flexibility isn’t available to us right now.

Some risks

The Fed has certainly heard President-elect Donald Trump talk about his ideas for significant tax cuts and infrastructure investments. Congress has expressed mixed feelings about these proposals, so it’s not certain that they will actually happen. If they do, each of these would boost the economy some, although not right away.

Another reason to raise rates earlier rather than later stems from the beliefs of some economists that loose monetary policy has been a causal factor in several past recessions.

I’m not a strong proponent of this view, but I agree that this potential exists. I’m a more worried about the potential for inflation when banks decide to start using the US$2 trillion they have saved up and deposited at the Fed, but that’s a conversation for another time.

Looking ahead to 2017, a lot will depend on how well the new administration does and how successful they are at getting their proposals through Congress. Assuming the economy continues to plod along, I’d expect another quarter-point increase in mid- to late 2017.

Author: Robert Rebelein, Associate Professor of Economics, Vassar College

Why EU rules risk making Italy’s banking crisis a whole lot worse

From The Conversation.

In the wake of the Italian constitutional referendum, the country’s banking crisis is going from bad to worse. The European Central Bank (ECB)‘s decision to refuse an extension to Banca Monte dei Paschi di Siena to raise €5 billion (£4.2 billion) has left the country’s third-largest bank facing a government bailout that looks likely to inflict severe pain on many ordinary Italian savers.

As if that were not enough, Italy’s biggest bank, UniCredit, announced a restructuring plan that requires a capital raising of €13 billion in the first three months of next year. Given the torrid time Monte dei Paschi has had trying to find sufficient private backing, will UniCredit need help from the Italian taxpayer, too?

The problems at Monte dei Pashci and UniCredit reflect the parlous state of the country’s banking system. The economy has been struggling for a number of years and borrowers have been defaulting, creating a mountain of bad loans. Around 20% of bank loans are bad, amounting to a staggering €360 billion (about one-third of all bad loans in the eurozone).

More than 70% of these loans are to small and medium-sized businesses. Small firms in Italy tend to have numerous bank relationships, commonly with accounts at four or five banks. Hence their defaults have polluted bank balance sheets across the sector.

I hear critics saying the Bank of Italy, the regulator, was slow to deal with the problem, only intervening within the past 18 months. Individual banks also stand accused of being complicit in rolling over non-performing loans – disguising the true picture. The situation is worse for banks in the south, where economies have been faring even worse. And Matteo Renzi’s defeat in the referendum exacerbates the whole problem by denying the sector reforms to help banks recover bad loans by speeding up insolvency processes, among other things.

Too much good life? Irene van der Meijs

The bail-in problem

The Bank of Italy restructured four small banks last year, but its ability to rapidly resolve problems at bigger banks is hindered by EU bank bailout and state aid rules. These say direct state aid cannot be provided until a bank has looked for private injections of capital, including making investors in a class of bank debts known as bail-in bonds take some pain by converting their bonds into shares.

The logic is that these unsecured bondholders should bear the same risks as shareholders, thus reducing the burden on the taxpayer in the event of a rescue. Investors have nonetheless been lured into these bail-in bonds, including those of Monte dei Paschi and UniCredit, by higher returns than other bank bonds, betting they would not end up being converted.

In most countries institutional investors including pension funds and insurance companies are the main investors in unsecured bank bonds. But in Italy there’s an additional problem: households own about a third of the total – 40,000 retail investors own Monte dei Paschi bonds, for instance.

When the four small Italian banks were restructured, the value of their bonds was wiped out. In addition to political condemnation, there were widespread protests and at least one suicide. Particularly when the country is going through such a politically volatile period, the government will be very wary of another bail-in as part of any Monte dei Paschi rescue. Depositors above around €90,000 are also supposed to lose out, though it is hard to see this being politically possible regardless of the rules.

What comes next

The ECB decided the request from Monte dei Paschi for a deadline extension for its recapitalisation from year-end to January 20 was a delaying tactic. It said the bank had to sort things out faster – together with the new Italian government, headed by Renzi loyalist Paolo Gentiloni. This means the world’s oldest bank, established in 1472, now has barely two weeks to find a private solution and avoid inflicting a bail-in on the country.

The recapitalisation plan has three components. The first is a voluntary bond swap – similar to bail-in bonds, except bondholders choose whether to convert their bonds to shares or not. This has raised around €1 billion from institutional investors, but there has been no take-up from retail investors. They have viewed the exchange as too risky and have been concerned about whether the regulator has fully approved the retail swap transactions.

Second, Monte dei Paschi hopes to get €1 billion from Qatar’s sovereign wealth fund. Finally, a consortium of banks has said it will try to sell the bank’s shares in the open market. They will not be underwritten, however, so there is no guarantee of raising significant funds.

The sick old man of Italy. francesco carniani

So even if the capital-raising is successful there is likely to be a shortfall of several billion euros. The question then is what happens next. The government will certainly not let this historic institution fail, despite a national debt in excess of 130% of GDP – among the highest in the world.

Failure to resolve the problems would compound financial market jitters surrounding Italian banks. That could lead to widespread failure and the export of similar problems, due to a collapse of confidence, to other fragile eurozone countries.

To unlock an injection of state funds the Bank of Italy would therefore need to decide whether to follow the EU rules and risk the wrath of the retail bondholders with a bail-in – and/or provide guarantees to cover their losses. Ironically, the ECB would then potentially have to provide guarantees, liquidity injections and capital support to maintain confidence in the Italian system.

Meanwhile, all eyes will be on the UniCredit capital-raising to see if it fares any better. It should do: UniCredit’s proposed rights issue requires market credibility that Monte dei Paschi does not have at present. Were it to hit difficulties, however, this crisis will move from major to monumental. Either way, it looks likely to be some time before the problems in Italian banking even begin to look like being resolved.

Author: Philip Molyneux, Professor of Banking and Finance, Bangor University

Yellen’s Fed faces a tricky rates dilemma in 2017 that may end up tripping up Trump

From The Conversation.

Editor’s note: The Federal Reserve’s policy-setting committee raised its target interest rate a quarter-point to a range of 0.5 percent to 0.75 percent, only the second such move in eight years. In the widely anticipated decision, the Fed signaled it anticipates raising rates another 0.75 percentage point in 2017 – likely in three quarter-point hikes – a faster pace of tightening than previously expected. We asked two experts to analyze what this will mean for the not too distant future.

Between a rate hike and a hard place

Steven Pressman, Colorado State University

As almost everyone expected, the Fed raised interest rates, and banks will now pass their higher costs on to companies and consumers, leading to higher borrowing rates throughout the economy.

The bigger issue, however, concerns likely increases in 2017. Here the message was somewhat ambiguous. While indicating that three 0.25 percentage point increases were possible in 2017, compared with the previous guidance that only two rate hikes were likely next year, Janet Yellen stressed in her press conference that any changes would be small and remain highly uncertain. She continually noted that the Federal Reserve would have to adjust its thinking in 2017 based on actual economic circumstances.

The Federal Open Market Committee press release was likewise rather ambiguous. It indicated that monetary policy “remains accommodative” and that future adjustments will depend on the “economic outlook” and “incoming data.”

The important takeaway from all this is that it is really not clear what the Fed will do next year. The reason for this is that the Fed is damned if they raise interest rates considerably in 2017 and damned if they don’t.

On the one hand, debt remains a Damocles sword hanging over the U.S. economy, and a rise in rates could cut the thread. Household debt is approaching levels reached before the 2008 financial crisis, which suggests that households may be approaching the point at which they cannot repay their loans – something that can bring down banks and the U.S. economy. And real median household income remains US$1,000 below pre-Great Recession levels and $1,500 below its all-time peak in the 1990s. U.S. households, responsible for 70 percent of all spending in our economy, face a double squeeze that cannot continue.

Worse still, many households remain underwater on their mortgages. Others are slightly above water, unable to come up with the realtor commissions and moving expenses that would let them sell their home and find a more affordable place to live. Higher interest rates will worsen this problem by reducing home affordability and prices.

On the other hand, at some point, perhaps soon, the U.S. economy will enter another recession. If the tax cuts and spending increases proposed by President-elect Trump get enacted, a ballooning budget deficit (made worse by the onset of a recession) will hinder the ability of fiscal policy to create jobs. Interest rate cuts then become our only viable policy tool.

So with rates already near zero, central banks cannot lower them very much. For this reason, they want to load up on ammunition, and push them up some. At the same, time they fear the consequences of doing this. Today’s Fed guidance was ambiguous for a good reason – they are caught on the horns of a nasty dilemma.

How higher rates will hurt Mexico and tie up Trump

Wesley Widmaier, Griffith University

Donald Trump has promised to build a wall and make Mexico pay. But the Fed’s decision to continue raising rates higher – known as tighter monetary policy – may push Trump to send money abroad, even to Mexico, a common target of his scorn on the campaign trail.

History shows that monetary policy decisions can have complex effects.

With a U.S. recovery continuing, the Fed’s tightening is raising fears of a reaction similar to the 1994 Mexican peso crisis. If this happens, the Trump administration may face hard choices.

Just like today, early 1994 saw then-Fed Chair Alan Greenspan move from an easy money stance and resume raising rates. Greenspan argued that the stock market was flirting with a bubble, bank earnings were low and inflation might revive. Raising interest rates was seen as the solution to ease the market bubble, pull money back from emerging markets and tamp down on a return of inflation.

However, the Fed’s moves back then had unexpected effects. Like many middle-income countries today, Mexico had issued dollar-denominated tesobonos to insure against exchange rate risk. But as the Fed raised rates over 1994, Mexico found it harder to make payments on the bonds, prompting a run on the peso.

The U.S. responded with a $50 billion rescue. Dollars had to flow south – or a Mexican collapse might send immigrants north.

Of course, this is not a dynamic unique to Mexico. As Fed moves raise the cost of servicing dollar-denominated debts, increased debt-servicing costs could have global repercussions.

However, Mexico’s economy has been a subject of some recent concern. If Fed restraint heightens those concerns, Trump may need to forget the wall – and pay Mexico instead.

‘Big government’ hurts growth? It’s not as simple as that

From The Conversation.

Since the late 1970s it has largely been the consensus that “big government” is detrimental to growth. This manifested after the financial crisis when countries, including previously fiscally-comfortable countries like Germany and the UK, adopted austerity programs, ostensibly to spur growth by cutting government expenditure.

But our research shows the story is not so simple. We found that studies tend to reflect selection bias. Findings that indicate a negative association between government size and growth are more likely to be published than those that show either a positive or no association.

Our research also found that the affect of the size of government is different between developed and developing countries and that there is a lot we don’t know about the optimal size of government, and whether some parts of government should be smaller than others.

The existing research is inconclusive

The existing research on the effect of the size of government on economic growth is actually contradictory, with some researchers asserting that a bigger government enhances growth, and others arguing that it hurts growth.

The arguments for a positive impact of a big government rely on examples like the potential of infrastructure development to create jobs, or intervening when there is a market failure (e.g. taking over banks during the GFC). Some of the negative affects of a large government are thought to be felt through the excess burden of distortionary taxes, and government inefficiency.

But the research is ambiguous and inconclusive. A survey of the academic literature suggests the conflicting results could be a result of the decisions researchers make. About what measurement of government size is used, for instance, or the type of countries studied – developed or less-developed, rich or poor.

Our research

Our research considered these distinctions, and so we sought to account for these variations when examining the relationship between government size and growth.

We did this through meta-analysis – statistically analysing 799 estimates reported in 87 existing studies, looking at the relationship between government size and economic growth. We looked at the different measures of government size (e.g. total government expenditures and government consumption) and different levels of development (developed and less developed countries).

We found only partial support for the idea that the size of government has an effect on economic growth. Specifically, our research suggests that the effect of government size on economic growth is negative in developed countries but insignificant in less developed countries (LDCs).

Put differently, while we find evidence of a negative effect of government size on economic growth in developed countries, we find no effect in the case of LDCs. This is the case irrespective of whether government size is measured as the share of total expenditure or consumption expenditure in GDP. It also suggests that big government is usually bad for growth in developed countries but not in LDCs.

What this means

There are a couple of things to take away from our research.

For starters, as has been hypothesised previously, a small government can enhance economic growth by providing the minimum for investment and growth – the rule of law and protection of property rights etc. But when an economy becomes richer, the size of the government tends to grow beyond its efficient level, so a further rise in government size would reduce economic growth.

This is explained by Wagner’s Law, which suggests that when a country becomes industrialised and richer, it will be accompanied by an increased share of public expenditure. But while there are certain forms of government spending which are necessary to sustain a functioning economy, spending beyond a specific level can bring more costs than benefits.

But the existing literature does not explain much about the optimum government size. Theoretically, there is a point beyond which increases in government size lead to a decline in economic performance. But empirical work is limited and inconclusive in this area, and thus it is not clear what this point is.

The distinction between developed and LDCs is also very important. Caution needs to be taken when generalising the effects of government size on growth.

There’s a lot that we don’t know in this space. Further research is needed on the relationship between the size of particular parts of the government, and economic growth. Such studies are more likely to produce policy-relevant findings compared to studies that focus on total measures of government size.

This would help policymakers determine how big governments should be and which components of government to cut in the context of tight government budget constraints and excessive government expenditures.

Authors: Sefa Awaworyi Churchill, Casual Academic, RMIT University; Mehmet Ugur, Professor of Economics and Institutions, University of Greenwich; Siew Ling Yew, Lecturer, Monash University

‘Fake news’ – why people believe it and what can be done to counter it

From The Conversation.

Barack Obama believes “fake news” is a threat to democracy. The outgoing US president said he was worried about the way that “so much active misinformation” can be “packaged very well” and presented as fact on people’s social media feeds. He told a recent conference in Germany:

If we are not serious about facts and what’s true and what’s not, if we can’t discriminate between serious arguments and propaganda, then we have problems.

But how do we distinguish between facts, legitimate debate and propaganda? Since the Brexit vote and the Donald Trump victory a huge amount of journalists’ ink has been used up discussing the impact of social media and the spread of “fake news” on political discourse, the functioning of democracy and on journalism. Detailed social science research is yet to emerge, though a lot can be learnt from existing studies of online and offline behaviour.

Matter of trust

Let’s start with a broad definition of “fake news” as information distributed via a medium – often for the benefit of specific social actors – that then proves unverifiable or materially incorrect. As has been noted, “fake news” used to be called propaganda. And there is an extensive social science literature on propaganda, its history, function and links to the state – both democratic and dictatorial.

British poster from World War I attacking German atrocities in Belgium.

In fact, as the investigations in the US and Italy show, one of the major sources of fake news is Russia. Full Fact, a site in the UK, is dedicated to rooting out media stories that play fast and loose with the truth – and there is no shortage.

An argument could be made that as the “mainstream” media have become seen as less trustworthy (rightly or wrongly) in the eyes of their audiences, it makes it hard to distinguish between those who have supposedly got a vested interest in telling the truth and those that don’t necessarily share the same ethical foundation. How does mainstream journalism that is also clearly politically biased – on all sides – claim the moral high ground? This problem certainly predates digital technology.

Bubbles and echo chambers

This leaves us with the question of whether social media makes it worse? Almost as much ink has been used up talking about social media “bubbles” – how we all tend to talk with people who share our outlook – something, again, which is not necessarily unique to the digital age. This operates in two distinct ways.

Bubbles are a product of class and cultural position. A recent UK study on social class pointed this out. An important subtlety here is that though those with higher “social status” may congregate, they are also likely to have more socially diverse acquaintance networks than those in lower income and status groups. They are also likely to have a greater diversity of media, especially internet usage patterns. Not all bubbles are the same size nor as monochromatic and our social media bubbles reflect our everyday “offline” bubbles.

In fact social media bubbles may be very pertinent to journalist-politician interactions as one of the best-defined Twitter bubbles is the one that surrounds politicians and journalists.

This brings back into focus older models of media effects such as the two-step flow model where key “opinion leaders” – influential nodes in our social networks – have an impact on our consumption of media. Analyses of a “fake news story” appears to point – not to social media per se – but to how stories moving through social media can be picked up by leading sites and actors with many followers and become amplified.

The false assumption in a tweet from an individual becomes a “fake news” story on an ideologically-driven news site or becomes a tweet from the president-elect and becomes a “fact” for many. And we panic more about this as social media make both the message and how it moves very visible.

Outing fake news

What fuels this and can we address it? First, the economics of social media favour gossip, novelty, speed and “shareability”. They mistake sociability for social value. There is evidence that “fake news” that plays to existing prejudice is more likely to be “liked” and so generate more revenue for the creators. This is no different than “celebrity” magazines. Well researched and documented news is far less likely to be widely shared.

The other key point here is that – as Obama noted – it becomes hard to distinguish fake from fact, and there is evidence that many struggle to do this. As my colleagues and I argued nearly 20 years ago, digital media make it harder to distinguish the veracity of content simply by the physical format it comes in (broadsheet newspaper, high-quality news broadcast, textbook or tabloid story). Online news is harder to distinguish.

The next problem is that retracting “fake news” on social media is currently poorly supported by the technology. Though posts can be deleted, this is a passive act, less impactful than even the single-paragraph retractions in newspapers. In order to have an impact, it would be necessary not simply to delete posts but to highlight and require users to see and acknowledge items removed as “fake news”.

So whether or not fake news is a manifestation of the digital and social media age, it seems likely that social media is able to amplify the spread of misinformation. Their economics favour shareability over veracity and distribution over retraction. These are not technology “requirements” but choices – by the systems’ designers and their regulators (where there are any). And mainstream media may have tarnished their own reputation through “fake” and visibly ideological news coverage, opening the door to other news sources.

Understanding this complex mix of factors is the job of the social sciences. But maybe the real message here is that we as societies and individuals have questions to answer about educating people to read the news, about our choice not to regulate social media (as we do TV and print) and in our own behaviour – ask yourself, how often do you fact-check a story before reposting it?

Author: Simeon Yates, Director Institute of Cultural Capital, University of Liverpool

It’s not just a drop in GDP that should worry us

From The Conversation.

It seems like we haven’t had much good economic news lately. This was neatly summarised in the drop in national output (GDP) of 0.5% due to weak investment, both private and public.

Private investment is unexpectedly weak across most categories. New building investment fell by 11.5%, construction investment fell by 3.6%, while mining investment fell for the 12th consecutive quarter.

This was all reflected in a drop in business confidence and business conditions in the September quarter.

This is not what’s meant to happen when you have interest rates at record lows. Last week the RBA held the cash rate at the lowest ever rate of 1.5%.

The cash rate has been falling steadily from 4.75% since October 2011 – it has not risen once during this time. Falling interest rates are supposed to stimulate business investment and also consumer spending, yet this is weak too, growing at below trend.

Mining and non-mining investment

Mining and non-mining investment. Australian Bureau of Statistics

The puzzle can be explained. When interest rates get very low they start to have the opposite to their intended effect on both households and businesses.

Households that are either in or approaching retirement have to save more to achieve their target nest egg of savings. This depresses consumption spending. No other than the RBA governor at the time, Glenn Stevens, acknowledged in a speech in April that low interest rates were a big problem for savers.

The arithmetic is simple. If you as a couple want to generate a comfortable income of $60,000 in retirement, you will need about $900,000 at an annual net return of 5% (after fees), if you are willing to run your capital down to zero after 25 years. You would obviously need more than that if you want to leave some capital at the end.

But 5% annual return is now looking very unlikely on a sustainable basis, given a low-risk asset allocation and a world of ultra low interest rates. About 3% (net) is more likely. In that case you will need roughly $1.1 million even if you are prepared to run your capital down to zero in 25 years. This isn’t even including any extras like a short overseas holiday once a year.

People understand this and are saving more to build a bigger nest egg, given such low returns. Other households that are building their wealth are tending to use lower interest rates to borrow in order to buy property.

Their consumption spending is more in the form of interest payments on their debts, rather than purchases of goods and services. The ratio of housing debt to household income has increased over the past three years from 166% to 186%.

And lower interest rates keep the Australian dollar lower than it would otherwise be. That makes overseas purchases more expensive, such as holidays and cars.

New building investment

New building investment. Australian Bureau of Statistics

As for businesses, why should they feel more confident about future sales revenue when the RBA thinks the economy needs stimulating, and when they see weak household consumption and other businesses reluctant to invest?

The apparently good news to come from the September quarter national accounts is actually dangerous. Australia’s terms of trade rose by 4.5%, due to mineral price rises such as iron ore. This feeds into export income and in turn eventually into company profits and tax revenue. Therein lies the danger.

The last terms-of-trade boom, from 2000 to 2010, released rivers of tax revenue. This is not what Australia needs right now because it will not last. It will only allow our politicians to postpone the necessary long-term cuts in government spending. Even worse, it might encourage them to hardbake new spending programs that we can’t afford in the long run.

Instead, we need to remember what Nobel-prize-winning economist Paul Krugman famously said:

“Productivity isn’t everything, but in the long run it is almost everything.”

Sustained improvements in average living standards can only come from improvements in productivity. We know how to improve productivity, we just can’t muster the political will to do it.

We have become far too concerned with how to share a national economic pie that is in danger of shrinking, particularly in per capita terms, than in growing the pie.

Author: Ross Guest, Professor of Economics and National Senior Teaching Fellow, Griffith University

Affordable housing is an increasing worry for age pensioners

From The Conversation.

The average housing costs of older (65-plus) outright homeowners in lone-person households were A$38 a week in 2013-14, the Australian Bureau of Statistics calculated, compared to $103 for older social housing tenants and $232 for older private renters.

Fortunately, over the last several decades almost all Australians who depend on the age pension for their income have been outright homeowners, and their housing costs have thus usually represented a small proportion of their pension. However, this situation is changing and the significance of this is profound.

As a result, many older households are hitting a brick wall… the numbers of vulnerable older people are rising.

Drawing on 125 in-depth interviews conducted in Sydney and regional New South Wales (discussed in detail in my book, The Australian Dream: Housing Experiences of Older Australians), it is evident that these substantial differences in housing costs combined with differing levels of tenure security have a fundamental impact on the capacity of Australians dependent solely or primarily on the age pension to lead a decent life.

The interviews I conducted with the older homeowners, particularly with couple households, indicated that provided they did not have extraordinary expenses (high medical bills, excessive smoking and or drinking, having to look after a child etc), they managed reasonably well on the age pension. They could run a car, engage in modest leisure activities, travel and even save.

Margaret, who lived by herself, was content:

Well I can [and] I do participate. I don’t go to the opera because that’s too expensive … I don’t go to live shows because they’re too expensive, but that’s okay. I do other things. I’m a very busy person.

Although the housing costs of older social housing tenants are high relative to homeowners, the fact that their rent is pegged at 25% of their income means they have a fair amount of disposable income after paying for their accommodation.

Betty, a social housing tenant, summed up their situation:

In public housing you see, even if they’ve only got the old age pension, nothing else, because their rent is only a quarter [of their income], they manage, most of them quite well. People who don’t manage are the ones who drink, smoke a lot … or who have an illness that requires heavy expenditure on medication.

In addition, historically, older social housing tenants have had guaranteed security of tenure. John spoke of the enormous benefits of this security:

When you know your accommodation is right, this is especially when you’re older, you can pursue other interests. You’re more relaxed and I do feel, I really feel you’re in for a longer life you know … I’m quite content and I think it’s just wonderful that the government does supply these houses.

Private renters live with insecurity

Many older private renters live in a state of perpetual insecurity as they can be told to leave at any time. Lopolo from www.shutterstock.com

The third group, older private renters dependent on the age pension for their income, are in a completely different position. A large proportion of them are having to use a large proportion of their income to pay for their rent.

Also, once their lease ends they can be asked to leave at any time – no grounds have to be given. The resulting perpetual insecurity combined with the cost of their housing is the basis for enormous anxiety and distress.

Maggie, a private renter in Sydney, said:

It [the age pension] is unrealistic. I mean I thank God for it because I’d never make ends meet otherwise. I really thank God for it, but it’s unrealistic. You cannot live on that. I mean what would you live on? It’s a joke. I was lucky that I had the income from working on the side … I couldn’t have lived like that without working a bit …

Helen painted a bleak picture. Even though she was drawing the couple pension she was clearly suffering enormous psychological distress:

Sometimes I think I’m too old for this. Maybe I’ll be dead in a year’s time and we wouldn’t have to worry about it. All the stress … I said to my doctor, ‘Why keep us alive when there’s nothing there for us?’ I said, ‘There’s no help for us,’ and she agreed with me … I told her we couldn’t get into a retirement village or even buy a caravan, or mobile home. We couldn’t even buy that. So we have a little bit of money but we can’t do anything with it. It’s not enough to help us.

When I asked Janet, who had been a private renter for a long time, how she responded when she heard that she had been accepted for social housing, she said:

I was absolutely, well, I sat down and cried. I literally sat down and cried because I felt like, well, at least I had the protection of the Department of Housing whereas before of course I didn’t have any of that. I had no protection whatsoever … My children were having children so they couldn’t [take care of me]. They’re just working-class people and so they couldn’t care for me … So consequently I couldn’t see any future at all until I got the word from Housing that I have got somewhere.

Numbers of vulnerable older people are rising

The power of affordable and secure housing to create a foundation for a decent life for people dependent on the age pension is clear.

However, there is no doubt that an increasing proportion of older Australians on the age pension will be dependent on the private rental sector in coming decades. This is because of the housing affordability crisis and increasing divorce in later life, combined with the virtual stagnation of the social housing sector.

In 2013-14, 4.8% of couples aged 65-plus and 9.5% of people living by themselves were private renters. Among 55-to-64-year-olds, these proportions were almost double: 8.4% of couples and 20.7% of lone-person households in this age cohort were private renters. Almost all of these households will still be private renters when they become dependent on the age pension, so the prospects for this group are grim.

Author: Alan Morris, Chair Professor, University of Technology Sydney

How the Fed joined the fight against climate change

From The Conversation.

The Federal Reserve’s policy committee is expected to lift its target interest rate a quarter-point – to a range of 0.5 percent to 0.75 percent – at its final meeting of 2016.

The main reasons the Fed has kept rates near zero for eight years have been to restore economic growth and lower unemployment – goals that have been largely achieved. But doing so has had an important, if little noticed – and probably unintended – side effect: It has been promoting efforts to curb global warming.

Solar projects like this one in Pueblo, Colorado, become more attractive when rates are very low. Rick Wilking/Reuters

That is, the ultra-low interest rates have favored sustainable projects like wind farms and corporate solar installations, the kind that are necessary if the world is to transition to a low-carbon future in line with the Paris climate accord. At the same time, they have discouraged unsustainable, high-carbon projects like coal power plants that appear cheap but become unprofitable over time when you factor in the cost of carbon.

Government policy, without help from the Fed, could nudge businesses and consumers to reduce carbon emissions. But, as my research shows, governments walk a fine line when setting carbon policies. They may fail to adequately address climate risks with policies that are too lenient or come too late or they may create systemic instability and financial crises with policies that are too harsh or aggressive.

So one way to reduce these risks is for the business sector to voluntarily and swiftly proceed with the transition to a low-carbon, “green” economy. And thanks to the Fed, the low-interest rate environment is supporting just that.

Opportunity costs

Under the Paris Agreement, more than 190 countries agreed to limit the global temperature increase to below 2 degrees Celsius.

Just last month, the agreement entered into force after countries representing 55 percent of global emissions ratified it.

But the accord doesn’t actually force countries to do anything to live up to their pledges, and many companies have long been resistant to the kinds of policies, like carbon taxes and cap-and-trade systems, that would achieve those aims. Furthermore, U.S. President-elect Donald Trump has vowed to exit the accord.

So how can we reach those goals?

My own research suggests one way to get there is through the widespread adoption of capital budgeting techniques – the process of determining the viability of long-term investments – that take into account the opportunity costs of both financial capital and carbon dioxide.

The opportunity cost of financial capital is simply the rate of return the company could have earned on its next best investment alternative. If a project cannot return at least that, it should not be funded.

On the other hand, atmospheric capital, as measured by carbon dioxide emissions, is not privately owned, making its opportunity cost much harder to measure. This cost includes the benefits we forgo when emitting carbon dioxide into the atmosphere, such as more stable agricultural yields, reduced losses from less violent weather, greater biodiversity, etc. If a project cannot generate a return on carbon that is at least commensurate with the benefits we give up as a result of the project’s carbon emissions, the project should be rejected.

Estimates of the social cost of carbon for the next 35 years have been produced by the U.S. Interagency Working Group on Social Cost of Carbon and other organizations, such as Stanford University. Estimates from these two sources range from approximately US$37 to about $220 per ton of carbon dioxide, while many companies report internal carbon prices at or below the lower end of this range.

Historically, companies creating these costs haven’t borne the brunt of it, but that is changing as countries, states, provinces and cities are imposing or planning to impose various carbon pricing mechanisms. Examples include China, the European Union, California, Canada and U.S. states in the Northeast and Middle Atlantic region.

Since the planning horizon for long-term capital budgeting projects like power plants and solar installations often extends out 10 to 20 years or more, that carbon cost is likely to grow quite a bit, and more of it will be billed to the companies doing the polluting, meaning carbon-intensive projects will become increasingly expensive.

While the Fed does not influence the opportunity cost of carbon – and whether companies account for it – it does influence the opportunity cost of financial capital. Specifically, the Fed influences the time value of money by setting interest rates.

Patient investors

The time value of money is the compensation borrowers pay investors for their patience.

If the interest rate is high, people are very impatient and prefer cash flows now, perhaps leading them to prefer to invest in a polluting power plant that pays out right away rather than an expensive windmill farm. If the interest rate is very low, on the other hand, people have easy access to funding and can wait a long time for cash flows that come much later. That makes longer-term, riskier projects like that windmill farm more attractive because their value will grow as governments punish carbon emitters – and investors will be rewarded for their patience.

It is the Fed’s manipulation of the time value of money that affects the choice of high-carbon versus low-carbon projects, especially when an expected rising opportunity cost of carbon is included in the analysis. So with rates hovering at unprecedented lows for nearly a decade, today’s investors can afford to be patient.

Investments in the green economy that initially may seem expensive but pay off over the long term are favorably viewed when rates are low because positive cash flows in the more distant future are barely discounted. That is, their present value equivalents (the current worth of a future sum of money) are almost the same as the future amounts because so little interest would be earned were they invested elsewhere. That means the positive future cash flows are more likely to outweigh the initial costs of green projects.

In fact, there has been a solid 57 percent increase in renewable energy capacity in the U.S. since 2008, while dirtier power sources – though still dominant – have waned.

Coal, for example, made up 21.5 percent of energy production in 2015, down from 34 percent in 2008. Renewables, meanwhile, climbed to 11.5 percent from 10.2 percent in the same period. Actual consumption tells a similar story, with coal-making up 16 percent of all energy consumed in 2015, compared with 22.6 percent in 2008. Consumption of renewable energy climbed to 9.8 percent from 7.3 percent.

The expansion of the renewable energy sector was driven by a number of factors including cost reductions associated with technological improvements as well as policy support in the form of tax breaks, but the low-interest rate environment undoubtedly contributed to the acceleration of the low-carbon transition.

Will the music stop?

The Fed has been able to keep the time value of money at record low levels for so long thanks to persistently low inflation. If inflation begins to accelerate as economic growth increases, the Fed no longer has that ability, and the upcoming rate rise will be just the beginning. That will begin to shift the valuations of high- and low-carbon projects, making the former a bit more attractive, the latter a bit less so.

But a quarter-point increase won’t change valuations much. For now, the low interest rates will continue to favor long-term sustainable projects that will help us reach the Paris targets, while discouraging unsustainable ones that become unprofitable once budgeting analyses consider the likely future implementation of carbon taxes and new emissions regulations.

If we do reach those targets, we would have the Fed and the markets to thank – and not Congress or Trump – for a successful transition to a low-carbon economy.

Author: Carolin Schellhorn, Assistant Professor of Finance, St. Joseph’s University

As its economy changes, China is starting to export its real estate ideas too

From The Conversation.

When it comes to discussions about Chinese real estate investors, we tend to focus on the idea that they are buying up property in places like Australia, pushing up prices – even if that is somewhat questionable. But it also ignores the other side of the equation. The number of properties built by Chinese developers outside of China has grown significantly, even as residential construction within China slows.

The expansion of Chinese residential development outside China has impacts on a number of levels, from property prices through to regional diplomacy.

The shift to Asia

Country Garden, a property development company based in Guangdong, China, is constructing apartment buildings that would add more than half-a-million homes and house 700,000 people in Johor Bahru, in southern Malaysia. This project goes far beyond constructing apartment buildings, however. It is part of an even bigger project named “Forest City” that Country Garden plans to build on four artificial islands.

The idea is that Forest City will be equipped with schools, shopping malls, parks, hotels, office buildings and banks. All ensconced in rich greenery, clean water and a quiet transportation system.

This grand project is just one example of the recent surge of overseas investment by Chinese property developers. Total investment in the Chinese real estate sector was growing at a rate above 10% until 2014, then dropped to less than 1% in 2015. This indicates a significant shift in Chinese real estate investment.

All the while, Chinese investment in the real estate sector overseas has picked up strongly. It has grown from $US0.6 billion in 2009 to US$30 billion in 2015. Several Chinese property developers have identified overseas investment as their main business growth strategy.

Two reasons for the pivot

Chinese investors have begun looking offshore for a couple of reasons.

Chinese buyer demand for overseas properties is growing. Since China reformed its economy and started growing at a fantastic rate, households have accumulated significant wealth. They now want to diversify their investment portfolios, and so are seeking property elsewhere.

Volatility in domestic housing prices has intensified this trend, despite various government policies aimed at smoothing out price fluctuations. An oversupply of properties in third and fourth-tier cities such as Ordos and Qinhuangdao created “ghost towns” where property isn’t desirable. In first and second-tier cities, however, prices have skyrocketed. House price-to-income ratios of these cities are ranked highest in the world, making it difficult to invest in properties in China.

In recent years there has been a huge expansion of production capacity. In 2015, China produced 51.3% of the cement and 49.5% of the crude steel in the world. As production capacity grows beyond the demand from the domestic market and runs into overcapacity, it is natural that firms will seek returns overseas.

The impact of it all

Taking Country Garden as an example, it is worth noting that the developer is not just building residential property, but designing and constructing the entire infrastructure for a city. Transport, greenery, water and noise control are all being put in place. These are beyond the scope of a conventional property developer.

Therefore, one potential positive impact of this project is to help boost the quality of infrastructure in Johor Bahru and so nurture more business activities in the future. The economic and geographic relationships between Johor Bahru and neighbouring Singapore may develop into one similar to that between Shenzhen and Hong Kong.

It is, however, critical that the local government monitors and enforces strict environmental protection and regulation to ensure the project won’t damage the natural environment or disrupt the local market.

The huge influx of newly built apartments has resulted in the value of residential sales dropping by almost one-third in in Johor Bahru last year. Whether this is a short-run phenomenon and housing prices will rally in the long run depends on whether more business activities and job opportunities can attract population inflow to the city and hence create higher demand for housing. In the short run, the fall in housing prices may lower the cost of living and attract firms and workers into the city.

For the Chinese government, it will be important to nurture more talent with legal and financial expertise to help Chinese property developers go out and invest overseas. This expansion by developers is just one, early facet of China’s new diplomatic efforts to develop infrastructure overseas.

Author: Yixiao Zhou, Lecturer in Economics, Curtin University