Star Wars and Economics

Is The Last Jedi actually the capitalist utopia?

**POTENTIAL SPOILERS AHEAD**

I've had arguments with people over economics and politics before. But never have I properly thrown my hat into the ring of popular culture. Well here goes.

THE STORY

One of Luke Skywalker's most significant lines in the new Star Wars movie, The Last Jedi, is "it's time for the Jedi to end".

I interpreted his reasoning to be that the force must remain in balance. Like all good stories, there's a balance between good and evil, chaos and control, light and dark. Superman has Lex Luthor, Thor has Loki, and the Jedi have the dark side.

Unfortunately, this 'balance' in the Star Wars universe involves a lot of war and a lot of casualties.

Maybe Luke had finally realised that the Jedi were part of the problem. The more powerful they became, the more the force had to balance them out with an equally powerful counterpart:

·         The Jedi Council at its peak gave rise to the Sith;

·         The Sith, after eliminating the Jedi and creating the Empire, gave rise to Luke and Leia and the Rebellion;

·         Luke, upon destroying the Empire and creating his own Jedi Academy, gave rise to Kylo Ren and the First Order; and

·         Kylo Ren, having been trained as a Jedi to become far more powerful than just some kid with the force, required the force to more greatly empower Rey.

Rey herself says "something inside me has always been there, but now it's awake", i.e. her power "awakening" was the force's response to Kylo Ren and his destruction of Luke's Academy. Even Snoke seemed to know of this balance, at one point saying “darkness rises and light to meet it. I warned my young apprentice that as he grew stronger, his equal in the light would rise”.

Every time one side grows, the force gives greater power to the other side to balance things out. But the mantra of both the Jedi and the Sith essentially seems to be "peace through superior firepower" (yes, that's a quote from Point Break), so it keeps resulting in war, not peace.

Whereas if there were no Jedi Academy, the force would have given both Kylo and Rey only moderate abilities that wouldn't create galactic war.

Which means the Jedi – the ones we thought were the good guys – were actually part of the problem. Luke says “to say that if the Jedi die, the light dies, is vanity”. So if the Jedi were to disappear, the light and dark side would still exist, but they would remain in balance at a much smaller scale. Individuals would undertake their own personal battles with light and dark but it would never escalate to galactic war – the force wouldn't allow it (until one side attempted to tip the scales by starting their own Council or Empire or Academy or Order).

And even though Luke ends with the line “I will not be the last Jedi”, I think this was just a reference to the fact that he wouldn’t be the last to wield the force for the light (otherwise he’s kinda contradicting his whole preceding message). But he would be the last one to attempt to institutionalise the force for the light. Consequently, it'll just be individuals wielding the force, not institutions. Because any attempt by the Jedi to 'regulate' the force actually made things worse.

THE ECONOMICS

You can see where I'm going with this ... 'big government' on either side creates more problems than it solves.

Is this not a capitalist's dream? Get rid of big government and let the magic of the force (the free market) create balance and fairness.

In the real world, this doesn’t seem to work. Whatever powerful force you believe exists, you have to concede it doesn't intervene well enough to ensure balance and fairness in human affairs. Without at least some regulation, there would be chaos, or at the very least, the inequality between the powerful and the powerless would be infinitely worse. Hence the need for government.

But in the Star Wars universe, there is an all-powerful force that actively intervenes in the galaxy to ensure balance is achieved. So any attempts by the Jedi/dark side to control that force end up failing.

Yes, the Star Wars prequels, especially Revenge of the Sith, are arguably a huge commentary on the Bush-era USA PATRIOT Act and seizing power through fear. So that side of politics is unambiguously portrayed as bad. But even the prequels seemed to suggest the Jedi were overly cold and dogmatic too.

So now the new trilogy seems to be suggesting the galaxy would be better off without any of them.

Ayn Rand would be so proud.

Merry Christmas, rebel scum!

How do you achieve a government that is both big and efficient?

Without the government.

Politicians should get wings clipped on infrastructure

I think this idea has merit. An independent fiscal authority to complement the Reserve Bank - Infrastructure Australia if you will, but with teeth. This will improve the quality of chosen infrastructure projects, basing them on economic value, not political convenience. It could also encourage fiscal stimulus during a downturn when monetary policy approaches its limits. Not only is this something over which monetary authorities have been pleading with government since the GFC, but by helping monetary policy normalise faster, it can also help avoid unintended consequences such as housing and stock market bubbles.

But this is still a democracy, after all. So to keep these independent bodies accountable to the public, elected officials can still determine the bodies' objectives. In the case of the RBA, the government determined in the Reserve Bank Act 1959 that their 'charter' should be to maintain a stable currency, full employment, and the economic prosperity and welfare of the people of Australia. The Act also requires them to maintain the stability - and manage the risks - of the financial system. But achieving those objectives must be within the scope, power and authority of the body itself, with minimal interference from government, in order to maintain their credibility.

Many people want the government to do more for society, but don't trust it to do it properly. Well this is one way to achieve big government - without the government.

Critics of globalisation revisited.

I came across an interesting passage in the New York Times by Dani Rodrik recently. His point was to draw attention to Donald Trump’s fake populism – his posing as a supporter of the common man, but his actions on trade, tax and health policies that would do the exact opposite, supporting special interests rather than workers.

But Rodrik was also very much in line with my writings about the need to make globalisation work through effective tax policy, not by unwinding globalisation itself (as Trump seems to want to do with, among other things, his attempts to renegotiate NAFTA).

The whole article is worth a read, but here is a snippet:

 “… A truly fairer globalisation would start at home, with a reconstruction of the social compact that binds the corporate elite and the wealthy to labour and the middle class. Every society that opens itself up to the world economy needs social transfers, labour-training programs and regional policies that take care of the adversely affected workers and communities. Our domestic approach, over-reliant on underfunded and ineffective trade-adjustment assistance policies, has not worked and needs to be replaced by more extensive safety nets.

These must be complemented with more progressive income taxation, employment-generating policies such as infrastructure investment and political reforms that reduce the role of money in politics. Mr. Trump and the Republicans want to take us in exactly the opposite direction, with a tax reform that will benefit the wealthy first and foremost.

The problem with Mr. Trump’s economic nationalism is not his avowed belief that trade should serve the national interest. When we economists teach the theory of trade, we emphasise that free trade is desirable because it expands the domestic economic pie — not because it confers gains to other nations. The problem is that he is deeply averse to the domestic policies that would allow American workers a piece of the added pie.

… Mr. Trump’s failure to distance himself from special-interest globalisation is perhaps not surprising. But it exposes the vacuity of his brand of populism. Despite all his talk about fairness and the need to stand up for ordinary working people, he has little to offer his core constituency. He will exacerbate, rather than mend, the grievances that made his presidency possible.”

Corporate taxes revisited.

Trump is either exaggerating, ignorant or lying.

Corporate tax cuts won’t cause a foreign investment boom, especially not in the US. They will blow out the budget and worsen inequality, thereby actually hindering economic growth. The only gains will be higher corporate profits, not wages.

But even if it did drive foreign investment, most of the returns would accrue to foreigners, and it would still blow out the budget and/or hurt manufacturers – the very people Trump promised to help.

THE HISTORY OF TAX CHANGES IS HARDLY FAVOURABLE TO REPUBLICANS

Paul Krugman has written extensively on the current Trump/Republican tax plan to cut corporate taxes in the US. I wrote a couple of blogs about the general idea too (here and here).

The supposed justification for cutting corporate taxes that the Republicans are using (as well as Australia and the UK, who are also pushing for cuts) is that it will lead to a big increase in foreign investment, spurring economic growth, wage growth and tax revenue, thereby paying for themselves.

Republicans have liked claiming these supposed benefits of tax cuts for a long time – at least since Ronald Reagan. But a simple comparison of how tax changes have affected growth in the past makes this reasoning debateable:

·         The notion that Reagan’s tax cuts were the driving force behind the 3%+ p.a. growth over his tenure is debateable, given the role that Paul Volcker and the Federal Reserve also had in both the recession and subsequent recovery. Also, the government deficit got worse, not better, in the face of these tax cuts;

·         Clinton increased taxes amid panic from the other side that it would cripple the economy – Clinton actually presided over a boom larger than Reagan (not entirely his doing, but it does suggest tax decreases aren’t necessary or sufficient for economic growth);

·         Bush Jr cut taxes and presided over only lacklustre economic performance (which ended in the GFC, though I’m not entirely blaming him for that);

·         Obama increased taxes on the rich in 2013, but the economic recovery following the GFC still continued;

·         Sam Brownback slashed taxes in Kansas, creating a fiscal crisis and no discernible broad economic benefits; and

·         Jerry Brown raised taxes in California, but the economy boomed.

So this idea that tax cuts will drive growth (much less pay for themselves) is at best, very debateable.

AN ACCOUNTING CERTAINTY – THE TRADE DEFICIT WILL EXPAND

However, regardless of these debates on tax cuts, if cutting corporate taxes drives foreign investment, it will also appreciate the US dollar, squeezing exporters (including manufacturers – you know, the group Trump so passionately promised to help) and stimulating imports, thereby expanding the trade deficit. Specifically, Krugman estimates 2.5m out of the US’s 12.5m manufacturing jobs would be lost, blowing out the trade deficit by $6.5t (yes, trillion) over the coming decade. There would be other jobs created elsewhere, just not the jobs Trump promised to deliver.

Furthermore, as Krugman humorously put it, “foreigners aren’t investing in America for their health”. All that foreign investment[1] would imply returns paid to foreigners, not Americans. So any gains that do come from foreign investment will mostly go to foreigners.

This is not just some abstract economic hypothesis – it’s a mathematical and accounting certainty. In economic terms, a country’s Capital Account must precisely offset its Current Account. When foreign capital flows into a country, this represents a Capital Account Surplus. And it is precisely offset by a consequent Current Account Deficit – a combination of more imports/less exports due to a higher local currency (a trade deficit) and/or increasing interest payments to foreigners for the investments they make in the country. It simply must balance.

And this isn’t even to mention the impact these cuts are expected to have on the budget deficit – an estimated $1.4t over the decade. And given the amount of US assets already owned by foreigners, about $500b (35%) of that will be returns to those existing foreign investors.

The benefits to the US (if any) would be that these new investments (as a result of lower taxes) may initiate a construction boom, stimulating the economy in the short term, and drive economic productivity more broadly over the longer term.

But this is all assuming that lowering corporate taxes would indeed spur foreign investment – as I discuss below, that is actually doubtful.

THERE WON’T BE A FOREIGN INVESTMENT BOOM

Specifically – and particularly hurtful to the US case for corporate tax cuts – the US is not a ‘small open economy’. Trump’s argument actually makes more sense for a country like Australia, not a country like the US that is large enough to affect world markets. In Australia, we are small enough that us dropping corporate taxes wouldn’t affect global rates of return. So after-tax rates of return in Australia would rise relative to the rest of the world, thereby attracting foreign investment until pre-tax rates of return in Australia fall enough to offset the benefits of lower corporate tax rates.

But the US is so large that lowering corporate taxes there wouldn’t just raise their rates of return – it would raise global rates of return too. So it wouldn’t take that much foreign investment flows to bring US and global rates of return back into equilibrium. Moreover, not all goods and services in the US are tradeable internationally. So the rest of the world’s inability to benefit from everything that could be produced because of the capital flowing into the US means US corporate tax cuts won’t even cause capital inflows to the full extent in the first place (except maybe in the very long term – decades). So much for the idea of a foreign investment ‘boom’. This might be good in terms of not causing too much pain to exporters, but it won’t lead to a foreign investment boom or higher wages, and will still blow out the budget.

CEOS DON’T EVEN WANT THE MONEY!

I can see only one scenario right now were corporate tax cuts – even if they damaged exports and the budget – could be justified. If business and industry wanted to make significant productive investments – more productive than the government would do – but couldn’t as a result of overly burdensome tax rates. But this is not the case. At a panel discussion, US CEOs themselves – in front of White House Economic Policy Adviser Gary Cohn – said they probably wouldn’t use corporate tax cuts to increase investment. And in Australia, Treasurer Scott Morrison has even had to encourage CEOs to publicly support their proposed corporate tax cuts – something he surely wouldn’t have to do if they really needed tax cuts. And as I mentioned in my previous blog, according to RBA Governor Philip Lowe, corporate taxes are not the most significant determinant of investment decisions in Australia either. So any foreign investment that is attracted by cutting corporate taxes in Australia may not deliver much in the way of economic benefit either if local companies don’t have any greater desire to invest just because taxes fell.

The Tax Policy Centre supports this notion that there will be virtually no economic growth benefits and a worsening of the budget, as do the economists of a recent survey:

“Of the 42 ideologically diverse economists surveyed by the University of Chicago on the impact of Republican tax plans, only one agreed that they would lead to substantial economic growth, while none disagreed with the proposition that they would substantially increase US debt.”

This is why in my previous blog I preferred government infrastructure investment as an economic kick-starter, rather than corporate tax cuts. Corporate tax cuts were only a second-best alternative in my mind, because I saw them worsening income inequality as larger companies would be less likely to invest from the windfall[2], and more likely to just pocket it[3] (somewhat undermining the whole ‘stimulating worker wages’ argument). Governments would also have less tax revenue for income redistribution. And in the US, their corporate tax cuts were at least somewhat dependent on withdrawing funding from Obamacare[4], which no doubt would worsen economic inequality.

And this is even more true when you factor in the notion that income tax cuts proposed for the middle classes expire by 2027 and actually become tax increases (as is required by Senate rules to show that it won’t worsen the budget deficit after a decade), leaving only the wealthy with enduring tax cuts. And even if you believed Republican claims that Congress would eventually extend these middle-class tax cuts beyond 2027, that would imply additional revenue needed from elsewhere to balance the budget. And knowing Republicans, this is more likely to come from further cuts to health care and social security than from tax increases on the wealthy. How can inequality not worsen under these plans?

Furthermore, given that the US and Australia probably won’t be the only countries to lower their corporate tax rates, it will at best prevent a country from losing their international share of the pie, not necessarily help grow the pie.

INFRASTRUCTURE, NOT TAX CUTS

There is no shortage however, of productive government infrastructure investment opportunities in the US, or in Australia for that matter (some transport projects are already underway or in the pipeline). And while these too may require foreign investment, drive up the local currency, and hurt manufacturers and other exporters, we would actually know that these investments were happening (unlike corporate tax cuts which could just end up in company profits and executive bonuses), so they would have a greater chance than corporate tax cuts of raising wages and reducing inequality, thereby stimulating growth and helping the government budget.

TRUMP IS EXAGGERATING, IGNORANT OR LYING

So lowering corporate taxes won’t likely stimulate foreign investment that much, if at all, in Australia, much less the US. It’ll just be pocketed by companies in the form of profits not wages, punch a hole in the government budget, and worsen economic inequality, thereby actually worsening economic growth.

And even if it did cause a foreign investment boom, the benefits to America would be far less than Trump indicates. And  many of his supporters – manufacturers and other exporters – would actually suffer.

When it comes to the benefits of corporate tax cuts, Trump – and the Republicans – are either exaggerating, ignorant or lying.

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[1] It would have to be foreign investment, because there is nothing in Republican plans that would cause Americans to consume less and save more. In fact, a decrease in domestic savings is actually more likely.

[2] One of the arguments Krugman uses to this extent is that lowering corporate taxes on large companies with significant market power (e.g. Google, Apple) doesn’t cause them to invest and hire more workers/pay higher wages, because they’re not under that much of a competition threat. So lowering taxes on them is just a revenue loss for the government, a profit gain for the company, and a worsening of inequality, not a gain for workers or the broader economy. So maintaining corporate taxes in industries of concentrated market power is actually more important than ever.

Maybe there is potential to just offer corporate tax cuts for small businesses (like Australia has), because (among other things) small businesses, unlike big ones, arguably have a harder time obtaining private sector finance, even for worthy investments, because they have fewer assets that can be used as collateral. This makes them a riskier loan prospect for a bank. So a little government tax break may actually go a long way to facilitating productive investments for small businesses (and consequent broad economic benefits), rather than big businesses that should be able to obtain the finance other ways.

Alternatively, government could offer tax concessions only for desirable investments/activities. However, this could involve a lot of bureaucracy in terms of administration and enforcement, and opens up the potential for loopholes where undesirable activities (not genuine investments) are able to exploit these tax concessions, and/or distorting other activities that aren’t eligible for these tax concessions. Furthermore, if the government really wants to control how tax cuts/concessions are invested, why not just choose their own infrastructure projects? But there are certainly other options worthy of debate.

[3] These profits may benefit shareholders too, but 80% of all shares in the US are owned by the wealthiest 10% of people (40% by the wealthiest 1%) – so this will still worsen inequality.

[4] While outright repeal didn’t work, Republicans are still working to repeal the individual mandate that requires people to sign up. This will result in premiums increasing an estimated 10% per year over the next decade, and about 13 million people losing health insurance, saving the government money on subsides that they can then use for corporate tax cuts.

No faith

Did Australia ever really believe in itself?

Stan and Bert Kelly

A couple of weeks ago (I know, falling behind schedule again), I attended the Stan Kelly lecture at the University of Melbourne, presented by Assistant Governor (Economic) of the RBA, Luci Ellis. But on the same day that it was announced Australia, in a moment for the history books, had voted in favour of marriage equality, the lecture’s significance was somewhat overshadowed.

The lecture was named by Bert Kelly, former Member of Parliament and commentator, for his father, Stan. Both men were strong free trade and open economy advocates. Even though Stan actually sat on the Commonwealth Tariff Board, he opposed the broad use of tariffs. Not only did tariffs hinder economic performance, they were inherently unfair, supporting not the most deserving sectors or the sectors that provided the best products or customer service, but the sectors with the loudest lobbyists.

The lecture was quite technical, but Luci linked it all together with a good story about Australia’s journey from a protectionist, inward-looking, low growth, high inflation economy with lagging living standards of the late 1950s (when Bert Kelly first entered Australian Parliament) to the prosperous and internationally open economy of the modern day. And this journey was thanks in no small part to the actions of both Bert and Stan.

What has filled the void left by the mining and resources sector? Housing, public infrastructure, and participation.

Then the lecture turned to the challenges of the modern day, and the topic of the lecture itself – where is growth going to come from? Since the mining and resources boom ended, Australia has searched for a new ‘engine of growth’ – a single sector that will fill the void left by the mining and resources sector and drag the rest of the economy with it.

Initially, it was residential housing construction. But even at its peak, it only contributed to the economy about a third of the growth that the mining and resources boom had at its peak. And with the housing market reaching dangerous heights, APRA and the RBA enacted a series of macro-prudential measures to reign it in, lest it get too overheated and crash, dragging the rest of the economy with it (a downside of having single drivers of growth – they can also be the drivers of recession if they crash). And these measures appear to be working.

Public infrastructure investment (the kind I've been advocating for a while as an economic kick-starter) is now taking on some of the burden, especially transport infrastructure. This would appear a sensible transition sector, being a similar activity – and using similar skills – to the mining and resources construction boom. It also directly drives private sector activity and helps boost productivity broadly across the economy. But this kind of boom, like the mining and resources investment boom, and indeed a housing construction boom, is inherently temporary. Over-investment is a potential risk, so we can’t rely on this as the main engine of growth indefinitely.

Similarly, the rise in labour force participation rates since the GFC (particularly women and older people) that has driven growth is also only a once-off boost – you can’t re-join the labour force more than once without first leaving it.

So where is growth going to come from next? Well according to Luci, in a word, everywhere.

Firstly, remember that the mining and resources investment boom gave way to a subsequent boom in mining and resources exports, which is still growing as more projects come on line.

In fact, as the Australian dollar falls, all export sectors should benefit, not just mining and resources. Manufacturing, tourism and agriculture (sectors that suffered under the high exchange rate of the mining and resources boom) will pick up again. Also services exports like education and health, which Luci argues is not taken seriously enough as a real and sustainable engine of growth. Maybe because it’s not a physical product like iron ore, wheat or wool. Or maybe it’s seen as driven by government activity, and therefore isn’t ‘real’ growth from the ‘real’ economy. Or simply because productivity in services is so much harder to measure, therefore it’s not real. But Luci disagrees.

“There's a hint of the eighteenth century physiocrats in this mindset, but with manufacturing and business investment taking the place of agriculture in the firmament of virtuous activities … Do people genuinely think it’s not really production if you can’t drop it on your foot?” Luci Ellis

Services are a very real, sustainable and potentially prosperous sector. Not only do sectors like health, education and child care generate benefits in their own right, they also foster productivity and innovation in other sectors, and help drive participation rates and workforce longevity (as we've recently seen above).

Then Luci pointed to immigration fostering growth – immigration of generally younger, more highly education individuals driving productivity and living standards, not just the raw size of the economy. And as most of this immigration concentrates in cities, economies of scale will drive activities and efficiencies that could only happen in large cities.

“There are some sorts of industry, even of the lowest kind, which can be carried on nowhere but in a great town. A porter, for example, can find employment and subsistence in no other place. A village is by much too narrow a sphere for him; even an ordinary market town is scarce large enough to afford him constant occupation.” Adam Smith

And so it is with management consultants, medical specialists, and all manner of activity that can only occur in cities.

Luci also highlighted R&D investment and rates of technology adoption – recently at relatively low levels in Australia – as potential drivers of growth in the future.

We still don’t believe in ourselves.

So Luci takes issue with the idea that Australia needs a single engine of growth – an external factor, like a Chinese-driven commodities boom or foreign investment in our housing market, or government infrastructure investment. When in reality, growth can come from everywhere and it can be through our own productivity and innovation, not some external factor beyond our control.

And the key insight I found from her lecture was her conclusion as to why Australia thinks like this – because we still don’t believe in ourselves. Just like the late 1950s and the Kellys’ time when Australia didn’t think its industries could compete against international competition without government tariff and subsidies support, let alone be good enough to actually export, Australia still believes we don’t have the capacity to be universally productive and innovative enough without a single outstanding and exogenously-driven industry to keep us going.

While we have come a long way, liberalising our trade policies since the 1970s, opening up our manufacturing and agricultural sectors to the world, and floating our currency in 1983, consequently discovering – to the surprise of many – that we actually had an incredible ability to compete internationally (manufacturing exports skyrocketed in the 1980s and 90s in response to this), we still seem to hang on to that mid-20^th century insecurity that says we can’t do it ourselves.

There will always be some sectors – for whatever reasons – that grow faster than others, but that doesn’t mean we need them to drive the rest of us.

So to paraphrase Luci herself:

When someone asks you where growth is going to come from, tell them … everywhere.

Economics and quantum physics

A short but very amusing blog post by Paul Krugman, where he compares the current Republican tax plan to Schrodinger's cat.

https://mobile.nytimes.com/blogs/krugman/2017/11/24/schroedingers-tax-hike/?referer=https://www.google.com.au/

Did Donald Trump just make a sensible decision?

Janet Yellen should have been re-confirmed. But the choice of replacement could have been so much worse.

Donald Trump recently announced the new Chair of the Federal Reserve to replace Janet Yellen – Fed Governor Jerome Powell. And the collective economists’ reaction appears to be one of relief. Not because it was the best possible choice, but because the choice could have been so much worse.

To be honest, there doesn’t seem to be any reason why Janet Yellen couldn’t have been confirmed for a second term. In fact, Fed Chairs in recent history have served at least two consecutive terms. And Yellen, by all accounts, has done a great job. She has continued the process of normalising interest rates in the US – faster than some, including Nobel Prize winning economist and New York Times columnist Paul Krugman, would have deemed ideal, but not drastically so. And she has laid the path for the future normalisation of the Fed’s enormous balance sheet.

Yellen was chosen by Obama, and was the first woman to Chair the Fed, but I’m sure these facts had no bearing on Trump’s decision to replace her.

So the choice to replace her at all didn’t seem ideal. But the choice of Jerome Powell was such a relief because of the other candidates that were in the running.

Both former Fed Governor Kevin Warsh and academic economist John Taylor were two such candidates. Taylor you may recognise as the name behind the famous ‘Taylor’s Rule’ of interest rates – a formula he devised in 1993 using data relating to unemployment, inflation and potential output to generate an estimate of the current interest rate that the Fed should be targeting. The Fed didn’t follow this rule explicitly but, during normal times, this formula functioned quite well.

During the GFC however, Taylor’s formula seemed to suggest that Fed Chair at the time Ben Bernanke and Co. had dropped interest rates too far and flooded the market with too much liquidity. Many very influential and supposedly learned people, including John Taylor, all proclaimed in their now infamous 2010 open letter that the Fed’s actions would result in runaway inflation and the debasement of the US currency. Warsh made similar claims. Claims they maintained year upon year, and which never materialised. Bloomberg tracked down all these signatories in 2014 and still none of them conceded that they were wrong – that during a crisis like the GFC, extreme liquidity measures are indeed required, and will not produce runaway inflation or the debasement of the currency.

For the last decade, inflation has, in fact, remained stubbornly below the Fed’s 2% target. This is because, as mentioned in one of my previous blogs, this liquidity was not being spent/absorbed by the system – it was simply acting as a floor through which the system couldn’t keep spiralling. This is the nature of a ‘liquidity trap’, where a Central Bank can create the floor, but not the recovery – that requires fiscal support.

Were either of these two to become the new Fed Chair (or worse, had they become the Chair during the GFC), they very likely could have withdrawn liquidity from the system and raised interest rates in the face of these false prophesies, and in so doing, driven the fragile US economy properly into Depression 2.0. And I do not believe I am exaggerating in this assertion. Nor did I think that the Federal Reserve – perhaps the most powerful economic agency in the world and one of the last (at least quazi-) independent bastions of intellectual rigor and competence in the US – was immune to being, as Paul Krugman put it, “Trumpified”.

Then came the relief – Jerome Powell. Powell has been a faithful supporter of Yellen’s policies on interest rates and financial regulation over the last few years, and is likely to be a steady hand in the future. And while I would have liked to see Yellen for another four years, we can take comfort in the fact that Powell is not likely to normalise interest rates or the Fed balance sheet faster than the economy can handle, and that the Fed is in the hands of an experienced Chair who hasn’t been consistently wrong about monetary policy for the last decade.

Every cloud …

IMF World Economic Outlook - Part 2

As a general interest follow-up to the IMF World Economic Outlook, I decided to test the IMF’s hypothesis in Australia specifically.



PART-TIME EMPLOYMENT IS SLOWING INFLATION

One of the key findings of the IMF was that the modern proliferation of part-time employment is hindering wage growth and making it harder for Central Banks around the advanced world to achieve their inflation targets[1], even a decade after the GFC.

Well, a simple comparison between Australia’s inflation rate over time, and the share of the labour force that is full-time employed, seems to support that notion. Australia’s full-time share of employment has fallen from 85% in 1978 to 68% most recently in September 2017, with the remainder being part-time workers. And correspondingly, Australia’s inflation rate has fallen from commonly over 8% per annum up to 1990, to an average of 2.5% since March 1993.

Over this period, the R-squared between these two variables is 0.63 – a fairly strong relationship, where the increasing proliferation of part-time work does seem to be associated with falling inflation.

So the IMF appears to be on to something.

Note that I’m using headline consumer price index (CPI) inflation above, instead of core CPI inflation. Headline CPI inflation is an estimate of the rate at which the goods and services purchased by the average household are increasing in price. Core CPI inflation excludes items such as food and fuel which, due to the volatility of their prices, distract from the underlying trend. So core CPI inflation is arguably a better measure of inflation, but I used headline CPI inflation above because the data provides a longer time series.

But even when using the shorter core CPI inflation time series (since March 1983), the whole period still returns an R-squared value of 0.59 – fairly strong still. But what using core CPI inflation does reveal – in further support of the IMF’s findings – is that the relationship between inflation and the full-time employment share has become even stronger since the GFC (an R-squared of 0.72 since March 2008).

That is, the modern proliferation of part-time work really does seem to be increasingly associated with lower inflation.



CORRELATION VS. CAUSATION

Now, I’m an economist, so I understand the risks of assuming causation from correlation. As the meme below rather humorously suggests, you could just as easily conclude that there is causation between Nicolas Cage movies and pool drownings.

But even if these Nicolas-Cage-pool-drownings numbers are correct (I admittedly haven’t check), there’s no reason – short of subliminal messaging – that would lead us to conclude that Nicolas Cage movies are causing pool drownings (or the other way around).

But there is logic behind the IMF’s theory. Part-time workers arguably have less bargaining power to demand higher wages than their full-time counterparts – quite simply because an employer risks losing more labour hours if they don’t meet the needs of a full-time worker. Think of it like one person asking for a raise under the implicit threat of quitting, versus two workers asking for a raise. Who’s more likely to get the raise? The two workers because together, they have more labour hours with which to bargain. It’s the same logic behind trade unions improving worker bargaining power by acting on their collective behalf, rather than individually.

So the IMF’s logic does go beyond mere correlation.

But there are a few points to consider.



THE BALANCE BETWEEN HIGH AND LOW INFLATION

First, we don’t want inflation to be as high or as volatile as it was before the 1990s. True, inflation that is too low is a risk because the closer it gets to negative territory, the greater the chances of a self-fulfilling deflation-led Depression where households, businesses and even government indefinitely delay their major expenditures and investments in the expectation that these expenditures and investments will be cheaper in the future, thereby creating a self-fulfilling prophecy and causing the economy to crash. Deflation also increases the real burden of debt, by putting downward pressure on household wages, business revenue, and government tax revenue while the absolute level of debt remains constant. As Keynes observed, high inflation can cause problems, too, but at least it encourages spending, while the expectation of deflation can “inhibit the productive process altogether”. Some Central Banks are even considering increasing their inflation targets to around 4% to provide them with a greater buffer from zero, given how close inflation rates around the advanced world have been/are to the dreaded negative territory.

But we also don’t want inflation to be too high. High inflation isn’t necessarily bad, per se, as long as it’s predictably high. If we know that inflation is going to be 10% (say 9.5-10.5%) with as much confidence as we used to expect it to be between 2% and 3%, then that’s probably okay. Everyone will simply adjust their expectations and behaviour to account for 10% inflation. Theoretically, a million per cent inflation would be fine, as long as it’s consistently a million per cent (even though there’s no reason we’d want it that high). Remember, inflation shouldn’t have any real consequences if its predictable – they’re just numbers[2].

Unfortunately, high inflation can be (and historically has been) also very volatile. And that’s a problem. Wage contracts are harder to negotiate because it’s harder to predict the future cost of living, resulting in either excessive wages, reduced business profits and increased unemployment, or insufficient wages, rising inequality and slower economic growth. Businesses have a harder time justifying major investments in property, machinery, labour, etc. because they don’t know what the price of their goods or services will be in the future. The finance industry also has a harder time lending money if it doesn’t know what interest rate to charge to offset future inflation[3]. Even governments need to do cost-benefit analyses on their investments, which becomes harder when future prices are unpredictable. But even if high inflation weren’t also volatile, we still wouldn’t need it to be too high to be a safe distance from negative territory.

So while we want a little inflation, if worker bargaining power is the key, we may not want to push it too far.



THE RESERVE BANK AND AUSTRALIA’S AGEING DEMOGRAPHIC ALSO AFFECT INFLATION INDEPENDENTLY OF THE FULL-TIME EMPLOYMENT SHARE

Second, there are definitely other factors at play here. From the early 1990s to the GFC, the correlation between inflation and the full-time employment share virtually disappears. As mentioned above, despite some short-term volatility, inflation was relatively flat around a 2.5% average from March 1993, while the full-time employment share continued to decline. And there’s a reason why this correlation could have weakened during this period. In March 1993, the RBA unofficially adopted what would eventually become it’s official and explicit target of 2-3% inflation over the business cycle. The RBA was also given independence from government to achieve this target with all the tools at its disposal[4]. And to their credit, since March 1993, Australian inflation has averaged precisely 2.5% – not bad! So the RBA became much more effective at controlling inflation, apparently regardless of what the full-time employment share was doing – at least for a while.

Thirdly, Australia’s population continues to age and the workforce as a share of that population continues to shrink. This will be an ongoing drag on economic growth and therefore, probably inflation, and could already be partly responsible for recent sluggish inflation, independent of the rise in part-time employment.

Fourthly and finally, (though these four factors are not by any means exhaustive), as Milton Friedman once said, “inflation is always and everywhere a monetary phenomenon”. While we may like to scapegoat “greedy businessmen, grasping trade unions, spendthrift consumers, Arab sheikhs, bad weather, or anything else that seems remotely plausible” as the cause of inflation, none of these entities can affect ongoing inflation because none of them possess a printing press.



THE COMMON ANCESTOR – DEMAND

Personally, I think both the modern proliferation of part-time work and low inflation, rather than driving each other directly, are both driven by insufficient demand. Simply, I think the solution isn’t going to be Central Bank-driven or monetary policy-driven. It’s going to be demand-driven. As I’ve mentioned before, while Central Banks still have only limited scope to further stimulate their economies with interest rates and liquidity, and while global interest rates are still so low, infrastructure spending by governments should be used. Happily, this should drive both inflation and full-time employment.



THE IMF OFFERS VALUABLE INSIGHT BUT WE MUST PROCEED WITH CAUTION

So no doubt the share of full-time employment isn’t the only factor driving the inflation rate, certainly not for Australia. This is not to say the IMF’s findings were wrong – never would I be so bold[5]. Perhaps the attempts of Central Banks to control inflation independently of the full-time employment share only succeeded temporarily, and recent years have simply seen a return to the long term downward trend. But it is an important lesson in the difference between correlation and causation, and in the risk of applying general findings for the advanced world to specific countries without considering their individual (perhaps unique) circumstances.

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[1] The rate at which the goods and services in an economy are increasing in price which, in Australia, the RBA targets at 2-3% per year.

[2] Though it would still be a hard political sale for a Central Bank, which has spent so much time building up its credibility around a 2-3% inflation target, to suddenly announce that they want 10% inflation.

[3] Also, other countries might get annoyed if they have lent money to a country that is now producing higher inflation and paying back their debt in increasingly worthless currency, without them necessarily being able to charge a higher interest rate to compensate. While decreasing the real value of their debt may be beneficial for the country that is in debt, it risks starting a currency/trade war with the lender country.

[4] Their official objectives under the Reserve Bank Act 1959 are: a stable currency; full employment; and the economic prosperity and welfare of the Australian people over the medium term. And it achieves these three objectives partly through maintaining a low and stable inflation rate.

[5] Until I start talking about their role in Europe’s austerity efforts.

IMF World Economic Outlook, October 2017

Poor wage growth and the hangover from the Great Depression.

Melbourne was very lucky to host this event – it usually only passes through Sydney and Canberra. The presentation was made by Dr Petia Topalova, a very accomplished economist and a great presenter. Dr Topalova was born in the former Yugoslavia, studied at Cambridge, and is now a published writer for the IMF in their Washington, DC. headquarters. Like I said, accomplished.

And this week she was in Australia delivering the IMF’s October 2017 World Economic Outlook. Clearly she’d made this presentation a few times, so it was largely committed to memory. But more importantly, she didn’t miss a single step during the Q&A. Every question was answered clearly and concisely, with no hesitation or uncertainty. The Doctor knew her stuff.

The focus of this presentation was the recent disconnect in advanced economies between economic growth and wage growth. We are starting to see, especially in the US but also in Australia and other advanced economies, economic growth pick up and unemployment rates fall. Economic theory would suggest that as this ‘slack’ is picked up, wages should start to recover also. But they aren’t. In fact, wage growth is still below pre-GFC rates. For the economists amongst us, this means the Phillips Curve is flattening. Why?

Well this recent phenomenon, largely occurring in advanced economies, is supposedly because of the modern proliferation of ‘involuntary part-time work’ – workers (particularly low to medium skill) who would like to work more hours but are restricted to part-time work. Not technically unemployed, but definitely underemployed.

Increasing use of temporary contracts is also part of this trend.

As to be expected, this results in workers have less bargaining power to demand greater wage growth – hence this modern disconnect between economic and wage recovery[1].

An important implication of this is for social safety nets. Modern social safety nets were largely designed after the Great Depression and WWII, when most workers were either full-time employed, or unemployed. And if you were unemployed, you qualified for these social safety nets.

Today, social safety nets need to adapt to increasing part-time work – workers who, while not technically unemployed, are underemployed and therefore, likely in need of greater support than a full-time employed worker, and greater support than current social safety nets are designed to provide.

A side note on Japan:

'Abenomics' (Prime Minister Shinzo Abe's strategy of monetary easing, fiscal stimulus and structural reform) seems to have provided a little boost in terms of some indicators. But inflation rates are still well below target. And their ageing demographic will continue to weigh on activity.

Japan really is a cautionary tale for the rest of the world. During a crisis, Central Banks and governments need to react quickly and strongly, lest inflationary expectations become so ingrained that, three decades later, active policy has virtually no discernible impact on the economy.

Greater openness to skilled immigration would also help.

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[1] Note in commodity countries such as Australia, Canada and Norway, recent declines in commodity prices have also weighed on wage growth.

Interestingly, increasing automation was not a very significant force behind tepid wage growth – not since the early 2000s.

Globalisation requires cooperation

Especially during crises.

Economic multipliers are shrinking

Economists often use input-output modelling to measure the broader economic impacts of a single event. If, for example, a major $100 million construction project is announced, we can insert that $100m into the model, and it tells us how the effect of that construction activity would spread to the rest of the economy.

The difference between this broader impact and the initial construction injection is called the ‘multiplier’.

But in recent years, the assumed multiplier in input-output modelling has been falling, meaning that individual investments by industry and/or government are having smaller and smaller knock-on effects on the broader economy. Why?

Well one explanation lies within globalisation – specifically the globalisation of supply chains. Businesses no longer source all their inputs locally. They can buy machinery from Germany, parts from Bangladesh, technical expertise from the US, even one’s workforce can be sourced from interstate or overseas (just look at Australia’s mining and resources boom, where most of WA’s labour shortfalls were met with international labour, not labour from other states).

Consequently, even when money is invested in one area, it ‘leaks’, resulting in smaller and smaller general impacts in the location in which the investment was initially made.

Example – Geraldton

Western Australian regional city, Greater Geraldton, for example, suffers from significant economic ‘leakage’. A project Geografia undertook last year calculated total business ‘leakage’ alone of $1.24b, much of which was from the Manufacturing sector, but also Construction, Mining, Transport, postal and warehousing, and Rental, hiring and real estate services (Figure 1). Returning to our construction project above, $100m here would result in only a $31m direct economic impact and a $65m flow-on impact ($96m total – still smaller than the initial injection). Many of the benefits would be felt elsewhere. Consequently, the broader economic impact was only larger than the initial injection when you include the positive impacts outside Greater Geraldton.

Figure 1: Expenditure Leakage by Source, Greater Geraldton

Source: Geografia, 2016

Not surprisingly, Greater Geraldton residents spend a lot of money outside of Greater Geraldton. A small regional city (Greater Geraldton’s population was less than 40,000 at the 2016 Census) just does not have the goods and services available to meet local need.

Example – Casey

Outer metropolitan municipalities offer a variation on this theme. They are notorious for highly mobile labour forces and therefore, out-commuting. And as residents leave every day to work closer to the city centre, they spend a considerable proportion of their income outside of their home municipality.

Let’s take Casey in outer metropolitan Melbourne. With a population of 300,000 at the 2016 Census, Geografia used bank transaction data in their Spendmapp product to see they spent upwards of $250 million outside their own municipality just in the month of December 2016 (Figure 2). In addition to out-commuting, this may also be due to a lack of appropriate offerings within Casey. As per our construction example above, just $84m in total would be captured locally if the $100m project occurred in Casey.

Figure 2: Resident Expenditure Leakage, Casey

Source: Spendmapp, 2017

More leakage means smaller multipliers and less local impact

This kind of leakage has significant implications for the economic viability of investment projects. A local government is going to have a harder time justifying a project if they can’t demonstrate through input-output modelling that a large proportion of the benefits from such a project will remain in the local area.

There are also implications for economic recovery after crises. The standard Keynesian approach says that during a recession, fiscal multipliers are especially high and therefore, particularly effective at reviving a lagging economy. In the US, those multipliers have indeed been strong in recent years, justifying a stronger fiscal policy response to an economy that was, until recently, underperforming. But the US is an enormous economy, so their domestic supply chains are well-established and diverse, resulting in minimal economic ‘leakage’ and strong fiscal multipliers. But for smaller, internationally open economies such as Australia, fiscal policy may be less and less effective at kick-starting a slumping economy.

And this brings me to the solution – self-sustainability vs. cooperation.

Self-sustainability

In the case of Greater Geraldton, a significant amount of their ‘leakage’ could actually be clawed back (Geografia estimated about $259m of the $1.24b in business leakage). This can be done by identifying industries where the volume of leakage is so high, it demonstrates a large local market that could be used to entice (and support) a new business to invest locally. ‘Buy local’ policies could be used to support these businesses. Equally, population growth will help meet more of the local workforce needs. This increased self-sufficiency would help contain a much larger share of any investment directed at Greater Geraldton. Leakage would be minimised, and multipliers would be higher.

Entire nations have even greater potential to contain leakage by diversifying into more industries along their supply chains, thereby reducing reliance on imported inputs. Investment in education and training can also reduce reliance on foreign skilled labour.

Of course, this kind of self-sustainability is not always possible or advisable. Capital City CBDs for example, are major financial and business hubs – and should remain so. Trying to stimulate their economies by increasing the local resident population, thereby reducing the need to import labour from the rest of the city, will likely detract from its commercial advantages. Yes, it may retain more of its local resident expenditure, but this will reduce floorspace available for commercial use.

And even nationally, it is often not advisable for an economy to try to specialise in everything. Firstly, in a developed country such as Australia, where the private sector hasn’t already developed such activity, this would require the government to ‘pick winners’ – this ‘infant industry argument’ has been successful in the past (sometimes), but it’s a risky option.

Furthermore, often it is just better to import things that other countries are better at doing (like labour-intensive manufacturing from Bangladesh), rather than dedicating resources to an industry in which we will probably never reclaim our competitive advantage (and potentially taking resources away from our real advantages).

Cooperation

Consequently, if self-sufficiency is not possible or advisable, cooperation is needed. If Greater Geraldton needs an economic boost but ‘leakage’ is a concern, fiscal support from the State government is justified. This way, Geraldton benefits from added assistance, Perth will benefit, given many of Geraldton’s inputs would be sourced from Perth, and, in a lovely positive feedback loop, Perth would potentially buy more goods and services from Geraldton. So when a small area is susceptible to leakage, the broader area that benefits from this leakage should also assist.

Nationally, this requires global cooperation. During the post-GFC slump in the developed world, efforts by individual countries to stimulate their economies fiscally (if they existed) would have leaked somewhat, having less impact locally. But through international cooperation, nations could have coordinated their fiscal policy programs, with all nations benefitting from the leakage of other nations, via the modern world’s globalised supply chains.

The verdict

The solution, as is often the case, will require a balance. Places, big and small, should not become so overly specialised that they are vulnerable to external shocks, and virtually unaffected by local fiscal stimulus. But at the same time, the benefits of globalisation should not be unwound by attempting to become completely self-sufficient in areas of competitive/comparative disadvantage.

A global economy requires global cooperation.