Interest rates in Australia have just been reduced by 0.5% in the hope that this will stimulate the economy. Will it work? Uncertain. But will politicians say it will work in the coming federal budget? Almost undoubtedly.

Perhaps displays of optimism are not such a bad thing, even if they are unwarranted.

In a study that just came out, we (myself, David Johnston at Monash and Gigi Foster at UNSW) found that optimistic expectations are key to making  people happy with their lot in life. People are much less affected by regret than previously thought, nor do they tell themselves things will be bad in the future so that the present will be a pleasant surprise: people systematically over-estimate how rosy the future should be and this is crucial for their well-being.

Our study, of which the working paper version is here and the on-line article is here (for those with access) has the following highlights:

1. In a sample of over 10,000 Australians followed for 9 years (the HILDA), it turns out that people’s expected future health has about 1/6^th the effect on current happiness as their actual current health, with any difference between the health that was expected and that eventuated having very little effect.
2. Future imagined health was more important to Australians over 35 and to women than to men and those under 35, for whom future imagined health was not important for happiness.
3. As a result, we concur with the medical literature that has long argued that hope is important in itself for health, as witnessed by the strong placebo effect. In the medical literature hope has now become the default standard for new medicines in that new medicines have to be better than placebos if they are deemed to be of real use. Our advise is also to err on the side of optimism whenever possible.

Now, to classically trained economists, the fact that hope itself is a consumption good quite apart from realised consumption may be surprising, but in the reality of economic policy the big lesson from this kind of finding has been incorporated long ago: always pretend the economy will keep going strong or will soon improve unless there are really strong indications to the contrary. Hang on to see many an overly optimistic statement in the Federal budget next week …. and rightly so.

For more information on the study, see here.

(note to self)

For many years now, it has been clear to the insiders that there is no hope in achieving serious reductions to greenhouse gas emission by means of international co-operation: the incentives to free ride on the efforts of others is too great and none of the big players is willing to subjugate themselves to a world police that would enforce a deal. So whilst we have all been happily increasing our consumption of fossil fuels year-on-year, the smart money was always on finding some technological fix to global warming that did not require near-unanimous international agreement, whilst simply adapting to the problem in the meantime. That fix could be geo-engineering or a renewable energy source becoming economically competitive with fossil fuels.

So, where are we currently when it comes to geo-engineering and renewables? In terms of geo-engineering the likes of Bill Gates, Richard Branson, the UK Royal Society, and a whole set of EU-US based institutions have been pouring money and time into looking at what can be done. In terms of renewables, the big movers have been Chinese companies and a glut of new ideas that are leading to much cheaper forms of solar power.

To start with solar power first, according to the Bloomberg New Energy Finance’ Solar Value Chain Index the costs per Kilowatt-hour of solar has reduced around 50% in the last 3 years alone, with various new technologies that have the potential of going down much further. They are talking about printing off solar cells, using iron guns to produce them, making solar panels out of a spray-on paint, and various others ideas. One needs to be an expert at this to judge whether it will actually work, which I am not, but the clear reduction in costs that was achieved recently is there for all to see.

So how close is solar to being competitive to fossil fuels in terms of producing for the electricity grid?

Continue reading →

We are in the middle of the electoral cycle, which seems a good time to give advice on which policies make good economics in the sense of being in the interest of the long-run welfare of Australia. My top 5 of do-able economic policies, some big and some small, that a government from either side could implement:

1. Have an independent Medicine Procurement Authority. We should pay much less for our medicines, both patented and generic medicine, by increasing the distance between politics and medicine pricing. As my colleague Philip Clarke keeps pointing out, Australia pays way too much for its medicine. Whilst we spend about 1% of our GDP on subsidised medicine, we should probably spend no more than half that. And the main reason we spend too much is political, i.e. the minister for health is put under direct pressure to hand out favours to big Pharmaceutical companies (such as via this fairly scandalous Memorandum of Understanding that commits Australia to uncompetitively high prices for generic medicines). An independent medicine procurement authority would have a budget fixed by parliament, revised every so often, with the single task of deciding what to buy for the allocated money. That fixed-budget constraint would force us to constantly review which medicines we still subsidise and what price we pay for them, getting us out of the lazy equilibrium whereby Pharmaceutical companies (invariably foreign) are getting rich because politicians are kept under direct pressure not to put the screws on the pharmaceuticals.
2. Set up a Long-term Leasing Office charged with auctioning off the right to run public services, coupled with an ex-post regulation regime. I am here for instance thinking of inviting foreign universities to bid for the right to run existing inner-city universities, whereby the foreign bidders would get a long-term lease (say, 30 years) on the community land on which a current university stands, together with a regulatory requirement to deliver certain services (i.e. the land cant be used for other purposes) whilst also guaranteeing regular access to government student subsidy schemes and the like. Long-term leases are also a possibility for things like primary and secondary schools, hospitals, airports, prisons, and residential care. In all cases, we would be talking about outside organisations getting access to existing land and facilities with associated obligations to provide services and access to subsidies and the like. Whilst implementing this wholesale would be fairly revolutionary and difficult, any government could experiment with setting this up for a smaller set of current public service providers. It would not merely be a question of private providers taking over public tasks from public providers: public providers could bid to take over other public providers too. It is primarily a means to reduce overhead and encourage real competition.
3. (One of Nick Gruen’s favourites) Set up an independent national budget office with the statutory obligation to calculate the long-run effects of major changes in the tax and spending plans of the government, including the vetting of major infrastructure projects like the National Broadband Network. Such institutions already exist in many major economies, witness the Congressional Budget Office in the US or the Rekenkamer in the Netherlands. The great advantage of such an institution is that it gives much greater confidence in projections of major changes and would replace the fairly dodgy current practise of having private consultancy firms give dubious projections on the impact of major changes in taxes. Such a budget office is a fairly low-cost institution and would partially serve as a training ground for fiscally-knowledgeable politicians and civil servants.
4. A real mining tax. There is little doubt that Ken Henry’s long-run tax reform advice is basically sound: as a country we should reduce taxes on activities with close economic substitutes (such as small business incomes) and increase taxes on things that cannot run away, most notably the minerals we own in the ground. The companies that mine it currently are 85% foreign owned meaning the huge price increases in the international mineral markets are lining the coffers of New York and London stock traders, not Australian households. And yet, minerals cant run away and taxes on their profits have little (if any) deadweight loss, particularly given how few Australians actually work in the mining industry anyway. A 50% or higher profit tax on resources would clearly be in our interest. I would personally also favour putting the proceeds in a future fund that invests the revenue in the world stock markets, which reduces the impact of the mining boom on our exchange rate and thus doesn’t kill off other industries. As an aside, the mining tax we have now is clearly worse than nothing since it indirectly entails the duty of the federal government to prevent the states from increasing their royalties, co-opting our commonwealth government into doing the bidding of foreign-owned companies. One estimate is that this deal cost us 6 billion a year, but complicated tax-offset rules probably mean it is much more. A more realistic figure is that Gillard’s deal cost the country in the order of 50 million a day in lost revenue.
5. (in the category small) Reduce the budget of the Australian Bureau of Statistics by about 90%, reducing it to merely being in charge of running the Census, and instead commission private providers of statistics to generate surveys of Australian businesses and the population. This would involve a quick reduction of around 300 million a year in expenses and would immediately improve the data available for economic decision making. The rational for cutting off the ABS is that it is completely secretive about the data it gathers: only ABS officials are trusted with using the full data by the ABS, not other government departments or Australian researchers. We are thus in the fairly ridiculous situation that those who devise the Australian budget in the Treasury do not have access to all the data gathered on the finances of individual industries. The ABS hides behind laws promising confidentiality to prevent anyone else from using its data, but similar laws on secrecy exist in other countries that have not been interpreted as ‘only people in our statistics organisation can be trusted’. Quite simply, the ABS has turned into a secretive rent-seeking organisation that draws huge subsidies but does not feel obliged to share its products with its paymasters. Why then should the Australian public pay for data that is not used to improve our knowledge of Australia? It might as well not exist and if it didn’t exist, the community would be free to buy data from other sources that are more consumer-friendly.

Continue reading →

Public debts in Southern Europe only grew in 2011, and they were already unsustainable in 2010. Worse, the interest rates these countries have to pay on their debts has grown as all the long-term rolled-over debt held by these countries now carries a 7% upwards interest rate.

Greece is the worst affected, with a government debt to GDP ratio of about 160% and getting worse. It is clearly now on the other part of the Laffer curve and further tax increases will not lead to more tax revenue, but less tax revenue. Whilst for other countries, an ECB bailout is the most likely scenario, Greece is on a collision course with an official default that it can no longer turn away from. No one seriously believes the Greeks are going to pay their loans back. Greece is drifting irrevocably into the situation whereby it will officially default and simply not be able to pay the wages of its civil servants, the pensions of its elderly, and have Greek banks collapsing around them as well, unless the ECB bails them out completely, which now seems unlikely. Re-introducing a Greek currency would mainly add huge capital flight to the woes and solve nothing in the short run. It really is looking rather bleak for Greece at the moment, whether it manages to trick the rest of Europe into another stay of execution or not.

Here, I want to point to particularly interesting political processes that have locked Greece into a default death spiral: political paralysis, civil service paralysis, and population paralysis. And at the heart of them are the special interest groups that dominate Greece.

What do I mean by special interest groups and their hold on Greek society? Iannis Carras wrote a hilarious and informative piece on how it works in Greece. Iannis relates the story of how a particular set of rent-seekers conspired to divert water from Western Greece to Thessaly by means of large construction projects. Diverting this water via large dams and reservoirs was done against the wishes of local residents, against EU planning rules, and against the ruling of the Greek high court judging it to be illegal. How did the rent-seekers get round this? They nominally broke the project of water diversion from one region to another into several smaller ones and simply kept going. And what drove this project? European cotton subsidies! Cotton is very thirsty and so water was diverted to the area more suited for cotton. Who drove it? Construction companies, Thessaly major farmers, and Greek politicians, all happily flaunting Greek law. Worse, it turned many a Greek politician and former farmer into a pure rent-seeker. And once they got into that game, they kept going. A favourite means of extorting money out of their own government is now for Greek farmers to simply block the roads until someone gives them money!

Other examples abound. Greece is now full of museums, ports, and roads which no-one uses, paid by the European Union and spawning groups of entrepreneurs everywhere whose main income in life comes from lobbying either the EU or any other major institution. Indeed, in a quite cruel illustration of the increased power of vested interests in these times, Carras notes that the only real reforms being implemented in Greece are all in favour of the construction industry. The most recent such example is the removal of environmental obstacles to build houses, effectively allowing large-scale theft of government natural reserve land by private companies,  which in turn makes a mockery of the intended sale of that same government land. A sale which was hoped to reduce the government deficit!

Iannis Carras’s sobering conclusion is that ‘EU aid has strengthened the position of intermediaries and rent-seeking elements in the Greek economy.’

Then the issue of paralysis, whereby the main thing to say at the outset is that paralysis mattered because it prevented structural reforms from happening.

Importantly, structural reforms could have tilted the balance of whether default was inevitable, but it has turned out to be impossible to legislate and enact structural reforms. By structural reforms, I mean tackling tax evasion, opening the economy up by means of labour market reform, and dismantling the legal apparatus supporting strong special interest groups that paralyse the professional service sectors and the civil service. Such structural reform was needed to get economic growth going, has been advocated by virtually all intelligent observers inside and outside of Greece, and initially would have involved pretty simple off-the-shelf legislation. Yet, it has not been done and it now clearly wont be done, even though the consequence is a disaster for the country.

The first and probably most important lock-in process is the civil service: the need for quick spending cuts meant that the public sector had to reduce in size and freeze wages. What do you think happens inside the ministries when this occurs? That the lesser-paid remaining employees are going to do their utmost for their country by devising and enacting radical reform legislation, or that those who remain will be the weaker ones who couldn’t get decent jobs elsewhere and whose principle worry is not to rock the boat and retain their job? The right answer is the latter.

As a result of this paralysis of the civil service, the sheer capacity for structural reform has been strongly eroded, as was nicely illustrated in this excellent piece on the impossibility of reforms. Greece, and to some extent also Spain and Italy, is now less able to legislate and support structural reform than 2 years ago. All that remains is austerity packages, which are technically easy: bit less money here, slight increase in tax rate there. Nothing new has to be set up or thought through.

Continue reading →

About 8 months ago, I had a look at what was then happening in the Arab world and made predictions about what was going to happen next. Time to see what really happened and update the forecast.

A minor prediction I was making was that Libya would again succumb to the resource course, making democracy impossible there, an article taken over by the Congressional Quarterly in the US (December edition). So far I am looking good for that prediction, with individual cities maintaining their own prisons and militias, as well as open fights about the division of the oil spoils.

The main prediction I was making concerned Egypt where I predicted the regime would re-constitute itself, coopting deal makers in agricultural and slum areas. I predicted that the urban youth which was driving the protests would lose out.

This is indeed exactly what has now happened: the army has put the torture chambers on full throttle in order to intimidate the urban youth. The elections have clearly shown that the largely uneducated and agricultural population has no appetite for supporting intellectuals in cities, and has gone for what they know, which is the muslim brotherhood, more radical muslims, the army, or some regional politician. The muslim brotherhood, which over the years has become so infiltrated by the regime that it was amongst the first to condemn the original protests against Mubarak, has about 40% of the preliminary vote and the reform parties have merely 15%. The radical Islamists get 25% and more regional parties make up the rest. Given that the army has already decided to simply give itself some seats in parliament if it needs them, as well as several more months of systematic torture of any opposition before parliament is even convened, one is already seeing a grand bargain between the Muslim brotherhood and the regime: a further move towards religious austerity in exchange for no challenge to the economic parasitism of the army. Egypt will become a very dull place indeed.

Continue reading →

Last month, I talked about the route that Mario Monti should take with Italy if he truly wanted to get it back to a higher-growth path. My advice was to take on the rent-seekers in blitz-reforms, whilst keeping the population in a state of great anxiety about the economy in order to reduce political opposition. Freeing the Italian economy from the many rent-seeking groups that stifle it was in my opinion needed to get long-term growth. I questioned whether Mario, the ultimate financial insider, was up to that kind of job.

How did he do?

Well, I would say he went one-third on the mapped route. As advised, he moved with lightning speed, bringing forward a set of reform packages by December 4^th, less than a month after taking power. Also, as advised, he went for some quick hits on existing vested interests. His increased tax on property and his taxing of funds owned up to after a tax-amnesty make up the majority of his tax increases and are visible forms of taxing the wealthy. He went for welfare reductions by removing the indexation of pensions for a few years (exempting the poorest) and a general tax increase via more GST.

In terms of long-term reforms, he went for pension age reform, which is a move that will not have major short-run fiscal benefits because in reality almost no-one works until the official pension age anyway and hence pension age reform should be seen as a long-term reform designed mainly for the civil service that retires early: it takes a long while for the various pension ages to adjust to the official one and for significant groups of people to go through the new system. Perhaps most important for the long term is that Monti is trying to reform the calculation of pensions such that they reflect total contributions rather than the wages of the last few years. Anyone who knows anything about pensions knows that that is a fairly revolutionary change and that it cant be done in the short run. It simply cannot be implemented retrospectively because of missing information about past wages. It is even hard to imagine that the whole stock of current employees close to retirement will be subject to this change, so I can only guess that the fine-print will say that it only applies to pensions from some far future date. It is a good example though of the kind of reform that economists have been calling for for decades (it is a key example in my own co-written econ textbook) but that you need the right moment for in order to push it through politically.

Yet, Mario didnt go for the truly debilitating special interest groups that would open up the economy in the short-run. No tackling of the laws on retrenchment, which is a real problem for hiring. No tackling of the professions (doctors, etc.), which debilitate much of the tertiary sector. He is even promising more unhelpful subsidies for business, like subsidies for eco-friendly building.

Hence, to be brutal, Mario went for the easier targets and didnt do much. Reduced welfare, an indexation freeze on pensions, indirect increases in income tax (i.e. via the states and not the central government), increases in GST, and a couple of obvious long-run reforms that will take decades to come into effect. No concerted effort to go after the tax avoiders and the fat-cats that dominate the political landscape in Italy. No major clashes with the unions either. Indeed, the size of the reform (20 billion Euro more taxation and 10 billion extra spending) is pretty paltry if you consider the problems that Italy faces (with about 2 trillion in debt). There is hence more of the appearance of decisive action, whilst the reality is that of a couple of helpful long-run changes whilst no major interest group has been offended in the short run. Indeed, all the reforms look pretty much off-the-shelf to me, which tells you there is little going on in the background in terms of policy development. Italy is not getting ready for real change.

What does this mean for Italy in the longer run? It most importantly means that there is now a much higher chance that Italy will default on its government debt: the reforms are simply not enough to either pay back the debt nor do they give confidence in medium-term future economic growth that would get rid of the debt.

Mario Monti undoubtedly knows this. So what game is he playing? Is he hoping for a miracle in the form of suddenly returning faith that Italy will always pay its debt and thus a return to 2% bond interest rates? I suspect he is not really hoping for a miracle but consciously has resigned himself to some form of default and meanwhile simply refuses to attempt the politically difficult, which is to take on the major interest groups that paralyse Italy and make it a place you prefer to visit rather than work in.

It is hard to know what Monti’s end game is, or even if he has one. Perhaps he thinks he can have another round of more serious reforms if this one gets through parliament. Perhaps he simply thinks this is the best he can do given the internal political realities of Italy. Perhaps he is trying to put Italy in the position where it could get by if it merely defaulted on the foreign part of the debt, not the domestic part, which in turn would strengthen its bargaining position in a bailout scenario. Whatever the end-game is, with these baby-reforms Monti has proven himself to be a conservative who will not upset the internal status quo. They chose well.

What is the road of least resistance scenario, and thereby the most likely scenario, for the Eurozone financial crisis? To solve this conundrum, we need to map the major elements of high resistance around which the road must navigate and the areas of low-resistance towards which the road will flow. These are:

1. (high resistance) It is actually politically very hard for any country to leave the Euro. If, say, Greece announces it leaves the Euro then one should expect a bank-run overnight with Greece deposit holders cashing in their savings and putting it in foreign Eurozone banks. Moreover, it might easily take a year before Greece could physically re-introduce its own currency, during which time the uncertainties and capital flight accumulate: money-machines have to be changed, accounts have to be converted, export contracts have to be re-written, and a system of converting anything valued originally in Euros into the new currency has to be negotiated. Apart from being a major hassle requiring expertise many countries do not have, it would give all the other countries an immediate excuse to stop paying that country any transfers. Young ambitious Greeks should be expected to shun a defaulting Greece. It is hence quite costly in the short run to step out of the Euro, as well as virtually guaranteeing a severe deepening of the recession overnight. This is equally true for any other country in the Eurozone: leaving the Euro is a bold and courageous step, unlikely to be witnessed any time soon. The road of least resistance therefore does not include any single country leaving the Euro.
2. (low resistance) The political costs to defaulting within the Euro are, when one reflects on it, surprisingly low. Greece has in effect been defaulting for several years now and has been handsomely rewarded with transfers and debt-write-offs. It was certainly the road of least resistance within Greece to steer straight into default. So too will the governments of Italy and Portugal be calculating that any default on their debts is a viable scenario and preferable to major internal upheavals that could be blamed on the government of the day. For what are other countries actually going to do when governments default on their debts? Not much. There is no mechanism via which they can kick countries outside of the Eurozone or the EU, so barring a whole set of richer countries deciding to set up a new EU and abandoning the rest, the Euro countries are stuck with each other. Countries cant kick each other out, nor can they really force any sanctions within the system. If, say, Italy decides to only pay back the government bond loans to its own banks in order to prevent them from going bankrupt but defaults on any loans held by foreigners, then the other countries have no other course of action than to protest and take the hit. They might retaliate by not honouring any loans to Italian banks but, again, apart from a wholesale break-up of the EU, they actually have surprisingly little means to punish any country. This incidentally is true even under the newly proposed stability pacts: if a country simply refuses to pay any fines then there is not much the other countries can do. Hence, defaulting is a low-cost option for individual countries.
3. (high resistance) The political costs for the rich countries to start a new EU of their own, the so-called rump-Europe scenario, is surprisingly high. Think firstly of how the richer countries benefit from the current union: because they suffer less from civil-service-demanded wage growth, their countries are more competitive precisely because they are in a currency-union with countries that do suffer more from civil-service driven wage inflation. This guarantees them higher levels of employment and exports, a brain drain of the less well-organised countries towards them, and very low interest rates at which to borrow, all advantages that would disappear if they cut the ties. Also, cutting the union would not in fact mean that their own banks would no longer be linked to the government bonds of other countries so cutting political ties does not actually stop the financial ties. Hence the economic benefits are neither immediate in the short-run, nor obvious in the long-run. Then think of the politics by thinking of the mechanism involved in breaking away: the countries would have to formally abandon the EU, would have to negotiate their relation with the Eurozone with those remaining in the EU (!!), then set up a new treaty for a new zone and introduce a new currency or convert the Euro into a Euro-plus that would hold for their region. Each step has to go through all the parliaments involved, virtually guaranteeing years of wrangling about the shape of a new treaty. Now, this scenario is certainly imaginable, but would take years to go into effect and hence cannot be sold by any politician as the solution to anything. Hence, a break-away by the rich countries would only be assured to lead to short-term economic loss (the countries being set loose would have to default almost immediately, with all the consequences associated to that) without clear long-term gain. It is therefore not a viable scenario. What rich countries can do is to ensure their own banks and economies are less exposed to those of the high-debt countries, but that is a slow process that takes years.
4. (low resistance) The European Central Bank’s determination not to become a printing press is, probably, brittle. Mario Draghi, the president of the ECB just last week reiterated how countries must help themselves. At the moment hence, the ECB is sticking to the line that it is there for price stability in the Eurozone and is refusing to write blank checks to over-spending governments.  It is quite openly gambling on the current crisis to force governments into tighter spending regulation, with, it might be said, some apparent success. Yet, if the going gets really tough and neither commercial banks nor governments have the cash to pay back their loans to each other and to outsiders, is the ECB really going to refuse to bail out governments and the financial sector by means of printing money? It would seem highly unlikely that the ECB would indeed keep up its refusal for massive capital injections if its back was against the wall because it really is the only institution that can do it. More probably, it would indeed take on the role of the American Fed and simply print money on a massive scale to prevent widespread bankrupcies of governments and banks.

With this contour map in mind, the road of least resistance is starting to come into view. Continue reading →