Is there a house price bubble in Australia?

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

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

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

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

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

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

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

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

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

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

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

Why can't we have a realistic basis for optimism?

In his book, ‘Flourish’, Martin Seligman writes:

‘I am all for realism when there is a knowable reality out there that is not influenced by your expectations. When your expectations influence reality, realism sucks’ (p 236-7).

I have been thinking about the sentiments in that paragraph at various times over the last couple of days. My initial reaction was that it was wise as well as well written. The problem I now have with the passage is that in the context in which it is written it seems to imply that a realistic frame of mind is inconsistent with optimism. It seems to me that if we are realistic about the right things this can provide us with a stronger basis for optimism. (As an aside, the grammar check in Microsoft Word doesn’t agree with me that the passage was well written. It calls the second sentence a fragment and suggests that it be re-written. Robots have a tendency to be pedantic!)

I will give an example to explain why I think a realistic frame of mind can be optimistic and then consider the broad context in which the paragraph was written. A prime example of expectations influencing reality is in relation to our own behaviour e.g. in playing a sport. If you decide to be realistic about how you will respond to a given situation in future you might think that the most likely outcome is that you will perform in much the same way as you have in similar situations in the past. That might make tend to make you pessimistic about your prospects for improvement. Yet, when you think about it more deeply, a realistic frame of mind could enable you to make use of your inside knowledge of your own potential and your intentions in developing your expectations of your future performance. Your inside knowledge might thus provide you with a realistic basis for more optimistic expectations.

The context in which Seligman’s paragraph appears is in a discussion of the influence of expectations on capital markets and individual health outcomes. The evidence that he presents that expectations can influence individual health outcomes seems to me to be fairly strong. It may be worse that useless, however, for well-meaning people to use this knowledge to tell pessimists not to be so pessimistic. In my view if we want to help people we should give them plausible reasons for hope. My view on this are not be worth much, but Marty Seligman certainly doesn’t support happiness police urging people to fake positive emotion.

I can claim some professional knowledge about the effects of expectations on capital markets. Seligman’s comments on this topic were prompted by a claim by Barbara Ehrenreich that positive thinking destroyed the economy. According to her view, motivational gurus and executive coaches espousing positive thinking – using scientific props provided by academics like Martin Seligman – caused the recent global financial crisis and subsequent recession by infecting CEOs with viral optimism about economic prospects. Seligman responds that it is vacuous to suggest that the meltdown was caused by excessive optimism. Optimism causes markets to go up. Pessimism causes them to go down.

Ehrenreich is presumably suggesting that the bubble wouldn’t have burst if we didn’t have a bubble in the first place. Well, economists are still arguing about whether we did have an asset price bubble, and I don’t think many of those who think we had a bubble would lay the blame on positive psychology. In looking for the cause of the crisis we need to look for reasons why normally prudent financial institutions took on extraordinary risks. I don’t think it is necessary to look any further than the policies that central banks had pursued in the past that encouraged major financial institutions to believe that they were too big to be allowed to fail. The financial crisis occurred when the Fed decided to break with that policy and let one of the big gamblers go to the wall.

Seligman goes on to discuss asset pricing and the views of George Soros about reflexive reality. In my view he manages to make those views more comprehendible than Soros does. (My difficulty in understanding Soros was evident in this post.) According to Seligman, reality is reflexive if it ‘is influenced and sometimes even determined by expectations and perceptions’.

Economists have known for a long time that the market price of an asset is determined largely by expectations about future earnings from that asset and associated risks (reflected in discount rates). So, wealth can be considered to be a form of reflexive reality because it depends on expectations. As well as expectations about future earnings, the expectations that influence market prices at any time may include expectations that investors form about the optimism or pessimism of other investors – i.e. whether they are too optimistic or too pessimistic and how long they are likely to remain in that state.

From the perspective of the individual investor, however, the expectations of other investors are part of external reality that can be speculated about on the basis of their market behaviour, even though it isn’t knowable with any certainty. Her views about the expectations of other investors may influence her decisions to buy and sell, but her actions will have a negligible effect on market outcomes (unless she is a major player in the markets). Thus, even though asset values are determined by the combined expectations of investors, it doesn’t make sense for an individual investor to view her own expectations as influencing reality.

It seems to me that in personal investment, as in other aspects of life, it is good to have a realistic basis for optimism about the strategy one adopts. For example, consider the following advice that Warren Buffett offered retail investors. His basic message is optimistic: ‘Stocks are the things to own over time. Productivity will increase and stocks will increase with it’. Then he provides some realistic advice about how to avoid buying and selling at the wrong time and how to avoid paying high fees. This leads to even more realism: ‘Be greedy when others are fearful, and fearful when others are greedy, but don’t think you can outsmart the market’. He ends up combining realism with optimism: ‘If a cross-section of American industry is going to do well over time, then why try to pick the little beauties and think you can do better? Very few people should be active investors’. (Comments by Warren Buffett in Spring 2008, quoted in Alice Schroeder, ‘The Snowball’, 2008, p 825.)

It is good to be optimistic, but even better to have a realistic basis for optimism.

………

My preceding post was also about Martin Seligman’s book, ‘Flourish’.

Is there a crisis of capitalist democracy?

Richard Posner’s recent book, ‘The Crisis of Capitalist Democracy’, is mainly about the global financial crisis, how it came about in the US, the lessons that the author thinks we should have learned from it and what governments should do to prevent similar crises in future. According to this distinguished author the crisis came about because of lax regulation; we have learned from it that the financial system is inherently fragile and that Keynes is still relevant; and the way to avoid similar crises in future is to introduce regulatory reform in the financial sector.


To be fair, Posner condemns some of the knee jerk responses of governments introducing tighter financial regulation and acknowledges that he is not entirely happy with his own suggestions for regulatory reform. He views the only ambitious proposal that he discussed sympathetically – the separation of commercial banking from other forms of financial intermediation – as ‘fraught with problems’ (p.362).

It is arguable that the global financial crisis was a crisis of capitalism. A milder financial crisis might still have occurred if central banks had not previously acted in ways that led major financial institutions to expect that they would be bailed out if their excessive risk-taking resulted in major losses. It is even possible to entertain the idea (as I did here) that the financial crisis has highlighted a fundamental problem in that laws governing the financial system currently permit financial intermediaries to make promises that they can’t always keep. But why view this economic crisis as a crisis of democracy?

The title of the book arises from Posner’s view that while the American political system can react promptly and effectively to an emergency, it ‘tends to be ineffectual’ in dealing with longer term challenges:

‘The financial collapse and the ensuing depression (as I insist we must call it) have both underscored and amplified grave problems of American public finance that will not yield to the populist solutions that command political and public support. The problems include the enormous public debt created by the decline of tax revenues in the depression, the enormous expenses incurred by government in fighting the depression, and the boost the depression has given to expanding the government’s role in the economy. These developments, interacting with a seeming inability of government to cut existing spending programs (however foolish), to insist that costly new programs be funded, to limit the growth of entitlement programs, or to raise taxes, constitute the crisis of American-style capitalist democracy’ (p.387-8).

Unfortunately, the quoted passage appears in the final paragraph in the book rather than the introduction. There is not much discussion in this book about this supposed weakness of the US democratic system. The author implies that it is largely a problem of political culture. Republicans favour low taxes but they have been reluctant to reduce government spending. Democrats favour high levels of government spending but they have been reluctant to raise taxes. As a result:

‘From the standpoint of economic policy we have only one party, and it is the party of profligacy’ (p.384).

As a person living in a democratic country in which a large part of the electorate has come to equate responsible economic management with budget surpluses and minimal public debt (to the dismay of some left wing economists who would like to see more public sector investment) I find it difficult to take seriously the idea that the current political culture in the United States involves a crisis of capitalist democracy. I am confident that before too long Americans will insist that their governments balance their books in order to avoid the problems currently being experienced in Greece and other European countries.

However, the picture might look a lot different from within the US. Before a change in political culture can occur in the US it will be necessary for a lot more Americans to become concerned about the future implications of current fiscal policies. Richard Posner claims that he has no idea how to solve the problem of America’s political culture (p.385) but I think he is contributing to the solution by merely raising awareness of the problem.

How much prudential regulation do we need?

It was a few weeks since I had seen Jim, so I made the mistake of asking him what he had been doing. He replied that he had been thinking about bankruptcy.

I said that I didn’t know his financial situation was that bad. Jim replied that he wasn’t having too much trouble paying his own bills at this stage, but he had been thinking about bankruptcy as an institution and about the role of government in bankruptcy. While he was saying that I was thinking that Jim was not the kind of person who would ever have too much trouble paying his bills. I heard him ask: “What do you think about bankruptcy?”

I said that I thought modern bankruptcy laws that wiped the slate clean when debtors had no hope of meeting their obligations were a huge advance on traditional practices such as virtual enslavement or imprisonment of people who could not pay their debts. I added that in my view there had to be a role for government in this process because you can’t allow people to hire muscle to pressure people to pay their debts. Since we have to rely ultimately on the coercive power of government to enforce contracts then we have to rely on government to devise rules about the conditions under which contracts cannot be enforced.

Jim nodded. He then asked: “What do you think about limited liability?” I said that I thought the contribution of limited liability to economic growth was often overstated because liability insurance could have arisen to serve a similar purpose in enabling individual investors to limit their liability when in investing in companies. I added, however, that I couldn’t see a problem in the owners of a firm declaring that their liability was limited to the amounts they had invested. In my view transparency is the important issue: people who lend money to the firm or provide good on credit should be aware that if the firm goes bust the liability of the owners is limited.

Jim said: “Hmm, so you are saying that if I form a company to engage in speculation there should be no limit on the amount of debt that the company can incur? Are you saying that I should be allowed to gamble with other people’s money secure in the knowledge that if the gamble doesn’t pay off then my own liability is limited to the extent of my own investment in the company?” I insisted that transparency was the important issue. If people are prepared to take the risks involved in lending money to speculators, good luck to them.

Jim said: “People who take those risks need all the luck they can get. What about systemic risks? It is one thing to accept that a few people will lose their life savings whenever some highly leveraged property speculator goes bust, but isn’t it something quite different when confidence in the whole financial system is threatened because of excessive leverage in major financial institutions?” I did my best to put the argument that the current financial crisis arose at the end of last year because central banks in major economies hadn’t established a credible commitment to maintaining a stable rate of nominal GDP growth. I suggested that the best way to deal with the deleveraging and associated decline in the velocity of circulation would have been by maintaining a monetary policy that would promote expectations of a stable rate of growth in nominal GDP.

I could see Jim’s eyes glaze over as I spoke. He said: “If you were making government policy decisions in the aftermath of the current financial crisis wouldn’t you be looking to see what could be done to avoid re-emergence of systemic risk in major financial institutions? I had to admit that if I was making government policy decisions I would probably be looking for policy levers relating to capital adequacy and things like that.

Jim said: “Ah, you sound just like one of those neo-socialists who advocates more financial regulation in order to save the capitalist system. Rather than interfering in the financial management of healthy companies, wouldn’t it be better for governments to focus on improving laws to minimize the adverse effects on the wider economy that can occur when some companies become insolvent. For example, why can’t the ownership of insolvent companies be quickly transferred to creditors?”

Jim seems to like asking me questions that I can’t answer.

What is the role of animal spirits in the political sphere in producing economic crises?

“Conventional economic theories exclude the changing thought patterns and modes of doing business that bring on a crisis. They even exclude the loss of trust and confidence. They exclude the sense of fairness that inhibits the wage and price flexibility that could possibly stabilize an economy. They exclude the role of corruption and the sale of bad products in booms, and the role of their revelation when the bubbles burst. They also exclude the role of stories that interpret the economy. All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led up to the current crisis” (George Akerlof and Robert Shiller, “Animal Spirits”, 2009, p 167).

I don’t have many problems with the argument of Akerlof and Shiller (A & S) that animal spirits play an important role in economic crises. I think they attempt to carry their argument too far; it seems to me that the economic system tends to be self-equilibrating despite notions of fairness and money illusion. But I accept that when there is high leverage in the system (i.e. high levels of debt relative to equity) it is a lot more vulnerable to economic crises than when there is low leverage. I also accept that changes in confidence help explain why leverage fluctuates. Stories that interpret the economy seem to have a big role in determining confidence. A few years ago it was common to hear the story that the risks involved in lending on housing were minimal – even “as safe as houses”. Now the story we hear is that investment in government-backed securities offers “a safe harbour”.

The main problem I have with this book is its failure to recognize that animal spirits also play a role in politics. In fact, as Arnold Kling and Clive Crook have pointed out, A & S fail to mention public choice theory. Instead, their model of government is what Kling describes as the “shockingly naive metaphor of a parent”. In their preface, A & S write:

“The proper role of the government, like the proper role of the advice-book parent, is to...give full rein to the creativity of capitalism. But it should also countervail the excesses that occur because of our animal spirits.”

Crook writes: “This is an unappealing analogy. I would sooner take up arms against a government that saw me as a child than vote for it.”

It seems to me that the most important animal spirit that Akerlof and Shiller fail to mention is the anti-market bias, stemming from an excessive desire for security and stability, which comes to the surface whenever a financial crisis threatens to occur. Rather than allowing the normal process of liquidation to occur when large financial institutions fail, the animal spirits that rule the political domain say that everything must be done to “keep the first domino from falling” (as A & S advocate on page 85).

When viewed in isolation, the bail-out of each institution seems like cheap insurance to government policy advisors. The problem is that a series of bail-outs tends to generate excessive confidence in central banks and governments. If you are lending money to a company that you expect to be backed by government, then you are not going to be too worried if the salary packages of the executives of that company give them incentives to take excessive risks. Creditors might not be surprised if the company gets into financial difficulty, but they will be shocked if it isn’t rescued by government.

From the A & S perspective the current crisis occurred not because parents encouraged the kids to act unwisely by incurring gambling debts , but because the parents decided to let one of their wayward children file for bankruptcy. That unsettled the creditors, so the parents lost their nerve and decided to pay all the kids’ debts. At this stage the lesson that the parents seem to have learned from this is that the kids need more parental supervision to make sure that their animal spirits don’t ever get out of control again. How will the kids respond? Will they leave home to get away from this parental supervision? Or will their animal spirits lead them to pretend to be good for a while in order to re-establish cosy relationships with their parents?

Does fractional reserve banking have to be a scam?

“To some extent, commercial bankers lend out their own capital and money acquired by CDs (certificates of deposit). But most commercial banking is "deposit banking" based on a gigantic scam: the idea, which most depositors believe, that their money is down at the bank, ready to be redeemed in cash at any time. If Jim has a checking account of $1,000 at a local bank, Jim knows that this is a "demand deposit," that is, that the bank pledges to pay him $1,000 in cash, on demand, anytime he wishes to "get his money out." Naturally, the Jims of this world are convinced that their money is safely there, in the bank, for them to take out at any time.” Murray N Rothbard, ‘Fractional Reserve Banking’.

When my friend Jim asked my reaction to this quote, I said that I didn’t know that he knew Murray Rothbard. Jim replied: “I didn’t know that he knew me, but I think he is making a good point.”

I asked Jim whether he thought most people really believed that banks were like warehouses that kept the money deposited with them until people wanted to withdraw it. Jim said: “Most people know that banks lend the funds deposited with them to other people, but the point is that banks do promise to repay deposits on demand. They know that they can’t keep this promise if everyone wants their money back at the same time. Banks shouldn’t be allowed to make promises they can’t keep.”

I tried to argue that the financial system generally works well even though exceptional circumstances can arise where financial intermediaries make promises that they cannot keep. I suggested that it is very rare for situations to arise when a high proportion of borrowers do not meet their commitments and the value of the security held by banks falls below the value of loans outstanding.

Jim said: “Look, you can’t pretend that these situations where banks can’t keep their promises occur so infrequently that they should be ignored. Democratic governments don’t just look the other way when banks go bust. Do you think that the best solution for this problem is for governments to get involved by offering deposit insurance, guarantees that banks will not be allowed to fail and close supervision and regulation to ensure that such guarantee do not result in irresponsible behaviour? Don’t you see that this government intervention has arisen because banks are allowed to make promises that they can’t keep.”

I asked Jim whether he was suggesting that instead of promising to repay deposits on demand, banks should convert themselves into unit trusts. That would mean that the amount that investors could get back on demand would vary according to the market value of the financial institution’s loan portfolio.

Jim replied: “I don’t think many people would view that system as a good substitute for conventional bank deposits that are repayable on demand. What I have in mind is that a bank would specify in its agreement with depositors that in the event that it could not meet its promise to repay deposits in full within, say, a month of the request being made, then equity holdings in the bank would immediately be cancelled and re-issued to depositors in proportion to the nominal value of their deposits. The former depositors could decide whether they wanted to liquidate these equity holdings immediately by selling them on the stock market, or to hold on in the hope that the bank’s financial situation would improve.”

I have been thinking about Jim’s proposal. I do not imagine that the conversion of deposits in a troubled bank into equity holdings would be as quick and simple as Jim envisages. Nevertheless his proposal seems to me to be preferable to the current shambles that has arisen as government regulators have sought to substitute their assurances for dodgy promises that financial institutions are not able to keep.

What is the best analogy to help us understand the financial crisis?

In attempting to understand the current financial crisis I don’t have the benefit of a great deal of knowledge of macroeconomics. Nevertheless, I can understand only too well what many macroeconomists are saying about fiscal stimulus and multipliers because they are using Keynesian language that I learned in my first year at university 45 years ago.

During the 1970s nearly all macroeconomists seemed to abandon the crude Keynesianism that I learned about at university. Why have so many reverted to it at this time? The answer might have more to do with the desire for a comfort blanket in times of uncertainty than with the merits of Keynes’ approach. The Keynesian remedy does not seem to me to be much more relevant to the current situation than it was to the stagflation of the 1970s. It suggests that when you wake up with a debt-induced hangover, then you will soon feel better if you get the government to take on some more debt on your behalf. That doesn’t sound to me like a recipe for a more healthy world economy.

So I have been looking for articles which will help me to understand why the world is in recession and what can be done about it. The best aid to understanding that I have found so far is John Cochrane’s refinery analogy:

“Imagine by analogy that several major refineries had blown up. There would be tankers full of oil sitting in the harbor, and oil prices would be low, yet little gasoline would be available and gas prices would be high. Stimulating people to drive around would not revive gas sales. Borrowing gasoline and using it on infrastructure projects would be worse. The right policy action would obviously be to run whatever government or military refineries could be cobbled together on short notice at full speed, and focus on rebuilding the private ones.” John H Cochrane, ‘Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies’.

The “major refineries” correspond to the banks that have loaded themselves with toxic assets. The oil tankers sitting in the harbour correspond to the savings that are going to government securities paying low interest rates and the high gas prices correspond to the high price of credit to businesses and consumers (in many countries). The running of government and military refineries at full speed corresponds to the government raising funds by issuing debt and lending it to businesses and consumers.

Cochrane recognizes that this analogy does not give a complete picture of the current situation. He explains that if we just had a shock to the supply of credit (blown up refineries) we would expect to see stagflation – lower quantities of goods and services sold, but upward pressure on prices. Instead we are seeing lower quantities sold and lower inflation. So, we are also seeing a demand shock as a result of people becoming much more averse to holding risks. (The refinery analogy could possibly be stretched to accommodate this. If several major refineries were blown up then investors could be expected to seek to reduce the exposure of their portfolios to other firms that might also be at risk of “blowing up”.)

Would the situation be resolved if the central banks were to target a specific rate of growth in nominal GDP (as I discussed in an earlier post)? The answer might depend on what assets the central banks purchase from the public in pursuit of this objective. If they buy government bonds this will help satisfy the increased demand for money, but not address the supply shock in the credit market. It is possible that the market could take care of this problem e.g. major firms may be able to by-pass the damaged banks by raising funds directly from the public. However, when central banks buy newly-issued commercial paper and securitized debt they are acting directly in place of the injured banks.

As a stop-gap measure this kind of by-pass intervention has the important merit of being a lot easier to unwind than alternative approaches. If central banks confine their purchases to quality assets they will not have any difficulty selling them when inflation begins to rise and people get tired of holding so much money. The effects of fiscal stimulus involving cash splashes by governments are likely to be much more difficult to unwind without a decade or more of high-tax and low-growth stagflation.

It seems to me that current debates about the effectiveness of stimulus packages in lifting aggregate demand tend to miss a more important point about consequences beyond the immediate short term (i.e. long before Keynes’ long run when we will all be dead). John Cochrane makes the point as follows in relation to the U.S. economy:

“If the resources are not there to unwind our current operations, to quickly retire ... newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.”

Can the perceptions of participants influence market fundamentals?

“Reflexivity can be interpreted as a circularity, or two way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation ... and changes in the situation are liable to change their perceptions ... . The two functions operate concurrently, not sequentially” (George Soros, “The New Paradigm for Financial Markets”, 2008, p 10).

“Many critics of reflexivity claimed that I was merely belabouring the obvious, namely that the participants’ biased expectations influence market prices. But the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets are always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process” (Soros, op cit, p 57-8).

Does George Soros know what he is talking about? The fact that he has operated successfully in financial markets for a long time suggests to me that he might have a few clues about how they work. But I struggle to understand him.

As is the case with many other problems of understanding, I think my problem in this instance relates to definition of terms. What does Soros mean by fundamentals? If a process is eventually self-defeating then it seems to me that this means that it is inconsistent with the fundamentals of the real world – i.e. it is inconsistent with what we know to be true about such things as resource availability, technology or human nature.

When Soros suggests that market prices can influence the fundamentals he may have something less fundamental in mind such as widely accepted perceptions of investors and credit providers about particular markets or the wider economic situation. It seems plausible that a widespread view that housing was a very safe investment, for example, could be reinforced if house prices began to increase more rapidly and if credit providers perceived that this made lending more secure. Under some circumstances that might, perhaps, result in a self-reinforcing process of increases in house prices that would eventually become self-defeating, for example because increasing numbers of people might decide that they would be better off renting rather than owning a house.

If this is what Soros means by reflexivity, does it help to explain the current financial turmoil? In explaining his super-bubble hypothesis Soros writes:

“The belief that markets tend toward equilibrium is directly responsible for the current turmoil; it encouraged the regulators to ... rely on the market mechanism to correct its own excesses. The idea that prices, although they may take random walks, tend to revert to the mean served as the guiding principle for the synthetic financial instruments and investment practices which are currently unravelling” (Soros, op cit, p 102).

It seems to me that the second part of that statement, relating to synthetic financial instruments, may help to explain the current financial turmoil. With the benefit of hindsight it is apparent that the world economy is suffering from, among other things, the development of a self-reinforcing belief system which led many financial firms to over-value synthetic financial instruments.

However, the first part of Soros’ statement doesn’t make sense. Regulators have not relied on the market mechanism to correct its own excesses. The current turmoil is partly a consequence of a history of financial firms being bailed out by regulators on the grounds that they were too big to be allowed to fail. George Soros is on much firmer ground when he recognises that most reflexive processes involve an interplay between market participants and regulators (p77).

Hopefully, the regulatory environment that emerges from the current turmoil will recognise that participants in financial markets are human. It should not surprise anyone that when financiers are given incentives to behave imprudently they tend to act accordingly.

What will it take to get sustainable recovery?

As readers of this blog will know already, Jim often asks me questions that I can’t answer. This morning he asked me how long it will take for the Australian economy to get back on a sustainable growth path. I was not able to answer directly. I suggested that what happens to economic growth in Australia will depend on what happens in the rest of the world. I added that if the U.S. starts to grow again in 2010 then that will have a positive impact on growth prospects for Japan and China and for commodity exporters like Australia.

Jim asked: “How confident are you about the U.S. starting to grow in 2010?” I started making excuses about my lack of knowledge of the U.S. economy and my poor knowledge of short term macroeconomics. That was when Jim said: “You know that political leaders all over the world have been saying that they will do what it takes to restore confidence and get sustainable recovery.” I nodded as Jim went on: “What they seem to be implying is that they will just keep increasing government spending until people become more confident. Does that make you feel confident?”. I shook my head. Jim then asked: “So what will it take to restore investor and consumer confidence and get sustained recovery?”

I told Jim that was a very good question. That only bought me about a second to gather my thoughts. The only sensible answer that I could think of was that restoring confidence was a matter of establishing a general expectation in the U.S. (and other major economies) that GDP would grow at about the same rate as the trend rate of growth in their productive capacity.

Jim interrupted: “That means boosting aggregate demand. Isn’t that what governments are trying to do now?” My response was that our focus should be on establishing the expectation of sustainable growth in the monetary aggregates rather than just a short-term boost in aggregate demand, with the expectation of a subsequent contraction as soon as inflation raises its ugly head again.

Jim interrupted again: “Next you will be telling me that Milton Friedman was right and what we need is a rule requiring the monetary authority to maintain a specified rate of growth in the stock of money.” I admitted that I still thought Friedman was on the right track, but technical difficulties involved in targeting the money supply would make it more sensible to target growth in nominal GDP (i.e. PY rather than M).

Jim said: “So what you are saying is that if the U.S. central bank were to announce a target rate of growth of nominal GDP and start making appropriate adjustments in monetary policy to achieve that target, then this would restore confidence and promote a sustainable recovery.”

I wish I had sufficient confidence to tell Jim that he had hit the nail on the head. Instead I suggested that rather than trying to put words in my mouth he should take a look at Scott Sumner’s blog: TheMoneyIllusion.

Postscript:
I particularly liked the following posts on Sumner's blog: Why did monetary policy fail?; and The Economics Babel.

What do we mean by market efficiency?

I ran into Jim again yesterday. Actually it would be more true to say that he ambushed me. I turned a corner and there he was. After the way he treated me in our first discussion (reported here) I was not particularly looking forward to talking to him again.

Jim said: “I enjoyed our last discussion”. I nodded agreement as I wondered why I wasn’t shaking my head the other way. Meanwhile, Jim was saying: “I heard that you wrote up our last discussion on your blog”. I must have looked a bit concerned because Jim said: “That’s OK. I don’t mind helping you with your blog, as long as you are accurate in reporting what I say and don’t make me look stupid”. I told Jim that might not be easy, but I could tell from the way he was looking that he obviously didn’t think it would be a joking matter if I made him look stupid - even though I wasn’t using his correct name on my blog. So I added that I was not going to report his expletives. Jim said that was OK. He claimed that he didn’t swear in any case, but if I wanted to I could use some bleeps now and then just to add emphasis. He said: “I won’t mind if you use a bit of poetic licence now and then, as long as you don’t make me look stupid”.

After he had bought me a beer Jim said that wanted to ask me something else. He said: “You believe that free markets are perfect don’t you?” I responded that I wasn’t quite sure what he was getting at. I told him that in my view all markets are imperfect, but when governments try to regulate them they often make matters worse. Jim said: “No, that’s not what I mean. I’m talking about capital markets – share prices and bond prices. Do you think those markets are close to perfect?”

At that point I explained to Jim that what he was talking about was the efficient markets hypothesis that prices always reflect all relevant information. I said it seemed to me that investors have the strongest possible incentive to make informed decisions because their personal wealth is at stake – and equity prices reflect the information on which investors base their decisions.

Jim said: “I’m not sure I understand. Are you saying that individual investors all have the same expectations about future prospects of particular firms?” I acknowledged that individuals have a lot of different views about the future. I suggested that even though a lot of investors think they can beat the market, the market averages out these different expectations, so those who do better than the market tend to be balanced by those who do worse than the market.

Jim nodded for me to continue. I explained that people who invest in funds with low management fees, whose weightings of individual shares in their portfolio are similar to a share market index, often do better than those who pay high management fees to funds that undertake a lot of research.

Jim said: “I suppose if someone has just lost half their capital on the share market they will not feel so bad if the value of their portfolio has fallen in proportion to the index and they have been paying low management fees.” I agreed.

Then Jim asked: “What do you think of Warren Buffett’s view that it is possible to beat the market because people are often irrational – they let greed take over and then they panic when fear takes over”. I said that I like Buffett’s approach to investing, but I wasn’t too keen on his politics.

Jim ignored the latter remark and asked: “So what advice do you think the Oracle of Omaha would give to novice investors about where to put their money?” I said that I imagined that he would tell them to put their money into Berkshire Hathaway. Jim replied: “Well, you don’t know everything! Buffett says that novice investors should stick with low-cost index funds.”

Postscript:
I checked to see whether or not Jim had just made this up. Warren Buffett actually gave this advice in April this year (reported here).

Can budget deficits cure the debt problem?

When I first met Jim (that is not his real name) a few days ago he seemed like a fairly harmless businessman. But when he heard that I was an economist, he said that there was something he wanted to ask me.

I had the feeling that I would not like Jim’s question, so I mentioned that I had retired. Jim pretended not to hear. He said: “The current financial crisis was caused by too much debt wasn’t it? Before I could respond, he had added: “So, tell me how the world’s governments are going to solve the problem by having bigger budget deficits and more debt?”

I tried to get out of answering by saying that I didn’t know much about short-term macro-economic management. That response didn’t satisfy Jim. He said: “Come on, you must have some idea about what governments are trying to achieve.”

I started my explanation by going back to the cause of the problem. Making my explanation as simple as possible, I said that the problem had arisen basically because lending institutions in the U.S. thought that it was safe to lend a high proportion of the value of houses because they felt that house prices would continue to rise. This meant that when the bubble burst and house prices fell, a lot of borrowers had debts that were greater than the value of their houses. So defaults started to increase and that created big problems for banks.

At that point Jim interrupted. “I know all that”, he said, “what I don’t understand is why the governments didn’t just let the rotten banks fail”. I explained that the financial system had become like a house of cards, built on the expectation that some financial institutions were too big to fail. When the U.S. government let one bank collapse, this led to a crisis of confidence in the whole financial system.

Jim looked skeptical. “You still haven’t answered my question”, he said. “How can governments solve the problem by creating budget deficits? Doesn’t this just make the problem worse for countries that have been living beyond their means. Shouldn’t they be living within their means rather than going further into debt?”

I told Jim that I thought that was a good point, but the problem was how to get from where we are now to where we want to be. I suggested that the idea behind what governments were attempting to do was not stupid because they were trying to restore confidence and to avoid increased unemployment. I said that if you look at an economy and see a lot of people becoming unemployed and a lot of spare capacity emerging, this suggests that consumer demand is too low, not too high. I also explained that governments don’t actually have to go into debt to fund their deficits. They have the power to create the additional money that they spend.

Jim then looked alarmed. “Do you mean that they might use the printing presses like Robert Mugabe does? So we could end up with hyperinflation like in Zimbabwe?”

I tried to calm Jim down by telling him that at the moment a lot of economists – those who know about these things - seem to be more worried about deflation than inflation. They are worried that we might get stuck in a situation like that in Japan in the 1990s, with falling prices and economic stagnation. I said that the policy aim was to give economies just enough of a boost to restore economic growth without inflation.

Jim seemed to understand. He said: “So what these economists are trying to do is a bit like getting a satellite into the right orbit – they just want to give the economy the right amount of thrust?” I acknowledged that the policy problem could be a bit like that.

Jim smiled before he added: “Yeah, well I reckon that’s the problem with you economists. You think you are f***ing rocket scientists!”

What is the rate of economic growth implied by current equity prices?

There is a standard joke among economists that equity markets have predicted about 10 of the last 5 recessions. As the joke acknowledges, equity prices embody predictions of future earnings and this implies that they also embody predictions of economic growth rates.

So, what is the rate of economic growth implied by current equity prices?

A good way to think about this is to consider why there is a difference between the current average dividend yield (annual dividends per share as a percentage of the current share price) and the real bond yield (bond yield minus expected inflation rate). This difference is required to cover two elements: the equity risk premium and the expected future rate of growth in dividends. If it is reasonable to assume that the expected rate of growth in dividends will be equal to the rate of economic growth over the longer term, the market’s expected rate of economic growth is given by:

y = (r – p) + x – d

where: y = expected real GDP growth rate;
(r – p) = real long term bond yield;
x = the equity risk premium; and
d = dividend yield.

So, it is a simple matter to calculate y if we know r, p, x and d. Unfortunately, however, there are a couple of thorny issues that need to be considered regarding appropriate numbers to use for the real bond yield and the equity risk premium.

When I last looked at this question (about five years ago) I decided that it would be more appropriate to use a long term average real bond yield than a current real bond yield. If the current bond yield is used, the results seem to become unduly sensitive to current monetary policy settings. In my calculations for Australia I used a real bond yield of 4.5 percent.

What rate of equity risk premium is appropriate? The equity risk premium is one of the few topics for which it could actually be reasonable to claim that if you laid all economists end to end, they still would not reach a conclusion. To cut a long story very short, I used the average equity risk premium implied by the relationship between GDP growth rates, average real bond yields and average dividend yields in Australia over the previous 20 years. This implied an equity risk premium of about 3.3 percent. (I am prepared to make available an unpublished paper discussing the methodology to anyone requesting it by email.)

When I did the arithmetic with the dividend yield prevailing in August 2003 (4.3 percent), I came to the conclusion that the expected real GDP growth rate for Australia implied by then current equity prices was 3.5 percent per annum. Since this was only marginally above the average growth rate for the previous 20 years, it did not seem to me to be unduly optimistic.

When I do this arithmetic now, with the current average dividend yield (6.6 percent on 18 November, 2008), it suggests that the expected real GDP growth rate for Australia implied by current equity prices is 1.2 percent per annum. That seems to me to imply that current share prices in Australia embody an unduly pessimistic view of longer term economic growth prospects.

Health warning:
There is a rumour going around among former work colleagues that when I was living off my earnings as an economic consultant I was heard to say, more than once, that free economic advice was not worth much. That rumour is true, but I have since changed my opinion. There is no truth at all in the rumour that I have been heard expressing the view that there are three kinds of economists: those who can count and those who can’t. I tried to say that once, but I ended up saying that I didn’t know whether I should be considered to be in the first or second category.

Why is economic growth interrupted by periods of stagnation?

In his book, "The moral consequences of economic growth", Benjamin Friedman argues persuasively that economic growth has important spill-over benefits – movement towards more openness, tolerance, mobility, fairness and democracy. Arguably, these consequences are all consistent with development of institutions – rules of the game – that would encourage further economic growth. So why has economic growth been interrupted by periods of economic stagnation?

Friedman doesn’t address this question in his book. It might be unreasonable to expected him to do so - the book is highly ambitious as it stands. As I read the accounts of stagnation during the 1970s and 1980s, however, I could not help thinking that this stagnation was at least in part a consequence of the way governments had responded to the preceding period of economic growth during the 1950s and 1960s.

I found myself thinking that the book could have been better if the author had spent more time discussing the ideas of Joseph Schumpeter – in particular, Kondratieff cycles. Building on these ideas, and those of Mancur Olson, Wolfgang Kasper has suggested that contradictions and obstacles tend to build up in fast-growing economies after a generation of accelerated growth (“Building Prosperity”, The Centre for Independent Studies, 2000, pp 6-11). These obstacles can include bottlenecks in supply of raw materials and labour (a decrease in elasticity of supply) and increased use of market power to squeeze profits. If monetary policy is used to expand demand, the result is little real growth and much inflation. As growth stalls, the prevalent social mood shifts from can-do optimism to defence of existing positions. Politicians increasingly side with established interest groups against emerging competitors.

According to this Kondratieff – Schumpeter – Kasper cycle theory, downturns eventually become periods of rejuvenation in which past economic difficulties trigger economic reforms that make institutions more market-friendly. Periods of accelerated growth are triggered by low and stable real interest rates, secure supplies of raw materials at relatively low prices and a low degree of industrial relations conflict. This enables investors to plan ahead and anticipate strong profitability.

I think it is important to make the point that there is nothing inevitable about these long cycles. It is possible for a country to remain stuck in a downturn, or even to go into secular decline, while the rest of the world returns to prosperity. It is possible for a country to avoid the worst consequences of a period of stagnation in the world economy if it maintains a set of institutions that enable it to adjust quickly to the changed environment. It may also be possible for the world economy to grow indefinitely if leading economies can avoid the contradictions and obstacles that would otherwise lead to recession.

Finally, I think it is also important to note that in some countries the contradictions that lead to prolonged recession may have more to do with attitudes encouraged by governments and central banks than with specific government interventions (eg regulations or taxes). For example, the lax responses of central banks to inflationary pressures in the 1960s conditioned people to expect that increases in inflation (such as those resulting from oil price shocks) would tend to persist. Thus the economic stagnation experienced in the 1970s may be attributed, in part, to contradiction between the expectations of the public that increases in inflation would persist and the lower inflation outcomes that restrictive monetary policies were intended to produce. (See: Athanasios Orphanides and John Williams, ‘Imperfect knowledge, inflation expectations and monetary policy, 2002.)

During the 1960s it was commonly believed that governments could sustain economic growth at close to full employment – all that was required was political will and the judicious use of monetary and fiscal policies. These unrealistic expectations were shown to be unsustainable when it became necessary for economies to adjust to increases in energy prices in the early 1970s and early 1980s. Let us hope that faith in governments never again returns to the levels experienced in many countries during the 1960s.