Sunday, 9 December 2018

In their prime

Our latest monetary policy targets agreement requires policy to "contribute to supporting maximum sustainable employment within the economy", and the Reserve Bank now spends a fair bit of each Monetary Policy Statement reporting on where we are relative to the maximum sustainable level, using a suite of different labour market indicators.

In the latest Statement, the Bank said that "employment is near its maximum sustainable level" (p22). It might be above it: "Evidence reported by employers suggests the labour market is currently tight, and that employment is above its maximum sustainable level" (p22). Or it might be below it: "some other indicators of the labour market suggest that employment may still be below its maximum sustainable level. One example is the job-finding rate" (p23). But overall we look to be there or thereabouts.

While the Bank deploys a whole battery of perspectives on the state of the labour market, one line of attack that doesn't appear is what is happening to what the Americans call the "prime age labour force", those aged 25 to 54. They're the bedrock of the labour force - they're typically out of education and not yet contemplating retirement - and the argument is that it's the state of the core  labour force that matters most for things like wages growth.

Overseas what's happening to the prime age labour force consequently gets quite a bit of air time: here, for example, is the Wall Street Journal's graph explaining the November US jobs report (from 'Did the Job Market Slow in November? Here’s How It Compares', if you've got access).

Interestingly, despite the long post-GFC expansion in the US, neither the participation rate nor the employment rate for prime age people have got back to where they were just before the GFC, and there is a mix of structural and cyclical trends going on: there looks to have been a gentle trend downwards in participation even before the GFC hit.

The corresponding numbers for New Zealand don't get much focus at all (they weren't mentioned, for example, in Stats' news release on our latest employment data), so in the spirit of inquiry I went and dug them out to see what they might be able to tell us (they're easily calculated from the data in Infoshare). Here are the headline unemployment results.

The unemployment rate for prime age people is, as you'd expect, markedly lower than for the labour force as a whole. And it's certainly signalling a tight market: the latest unemployment rate (2.0%) is getting close to its all-time low (1.5% in late 2007). You'd imagine that a fair chunk of this low rate is frictional unemployment, and that there's precious little cyclical unemployment left.

Here is the participation rate picture. It's harder to interpret: we're in uncharted territory, as the prime age participation rate has been hitting record highs. Can it keep on rising? Is there still a large reserve of people who could be tickled out into employment? Who knows, but you'd guess that the reservoir must be getting lower. We're down to only 14% of prime age people who are not in the labour force, and who are doing things like looking after young or elderly family.

The prime age participation rate is usefully splitabble into male and female participation rates, and here they are.

The overall rise to record levels of prime age participation is largely driven by a sharp and ongoing rise in female prime age participation, and like in the US there are surely both structural and cyclical things going on. That drop in the male rate over 1986-2000, for example, may well reflect the post-Rogernomics shrinking of traditionally male-dominated activities like meat processing. Changing social attitudes about (for example) who should stay at home and look after the kids will be in there, too. So it's very hard to unpick the purely cyclical component. I don't have any good feel at all for where the prime age female participation rate might peak.

Overall, the data don't give any huge overlooked insights into where we are relative to maximum unsustainable employment, mostly because the grand sweep of history and the changing attitudes to who works, and works at what, overlap the more cyclical aspects you'd like to isolate. If there is one useful extra bit of data, it's the prime age unemployment rate, which is confirming the RBNZ's "there or thereabouts" assessment.

Monday, 26 November 2018

The wheels are back on

"The goss", I said a while back, "is that the Commission stands a good chance of having Lodge overturned in the Court of Appeal, but stranger things have happened", Lodge being the High Court case involving price-fixing amongst Hamilton real estate agents.

The Commission had rather unexpectedly lost it - "...and then the wheels came off" - but now the Court of Appeal has put the wheels back on, tightened the nuts, and banged the hubcaps into place.

In the High Court, Justice Jagose had said that the estate agents had come to a collective agreement (their agencies would stop absorbing the cost of Trade Me real estate listings and instead start charging the house sellers for it), and had given effect to it (part of it, for example, was a collective withdrawal of listings on Trade Me, which duly occurred).  But - and this was the surprise bit - the arrangement didn't breach s30 of the Commerce Act. If the seller wanted a Trade Me listing, it was still open to individual real estate agents to offer a discount or indeed carry the cost themselves if they badly wanted the listing. If the ad cost was still negotiable, then it couldn't be said that the collective agreement had controlled the price.

Not so, said the Court of Appeal. The estate agents had collectively agreed to remove State of the World A (the agencies wore the cost) and replace it with State of the World B (the vendor probably paid, but maybe twisted the arm of the agent and got it for free). That's not on: at [89]
We agree with Mr Dixon’s [John Dixon QC, for the Commission] submission that all of those vendors after January 2014 who chose not to list on Trade Me when faced with having to pay for it, and indeed those who did pay the fee, lost the opportunity to be offered a price which had been set for an agency operating in response to working competitive market forces ... Plainly the agreement in principle to withdraw from agency-paid Trade Me advertising would affect price; if the vendor did not have a Trade Me advertisement it had lost an allowance or credit that had been previously provided. The price for the real estate agencies’ services was correspondingly more.
And the Court gave a homely but useful example: at [88]
By way of example, if the retailers of motor vehicles in a street all agreed on an asking price for a certain model, aware that this was the asking price only and the end price after negotiation could be quite different, that would have an anti-competitive effect in the way discussed in Plymouth Dealers’ Association [an American case from 1960]. The starting point for one side of a negotiation about price would undoubtedly affect the end price, even if it may be possible or even likely the end price would be different from the starting point.
I could see Justice Jagose's point, but the Court of Appeal has put us both right. It's clearly the better take, and I'd be mightily surprised if the Hamilton agents press on to the Supreme Court.

Getting back onto the safer ground of economics, there was a side issue of whether economic evidence about what the real estate agents were likely to have done in any event was admissible. The High Court had said no; the Court of Appeal agreed.

And there's a lesson there for businesses in the real world. It's a recurring theme: some sort of shock happens - in this case, Trade Me tried on an enormous rise in its listing fees, in the air cargo cases airlines got whacked with new security charges - and the question arises, what to do? Chances are, in a competitive market, you're going to have to pass them on to the ultimate customer. All of you in the real estate or air freight game may have independently come to the same conclusion.

But you mustn't get together and collectively agree to do it, even if the two outcomes don't look very different. "It would have happened anyway" will be no defence. At [112] the Court of Appeal agreed with the High Court which had said at [238] that
in principle, s 30 type conduct does not avail of a competition analysis. Constraints on price-setting are deemed in breach of s 27. That the same price may have arisen in the counterfactual (ie, absent constraint) does not respond to the presence of constraint in the factual. The proposed [economics] evidence was irrelevant
So there have been twists and turns in the story, but the end point for businesses is still as I put it after the High Court: "it remains highly dangerous to go near any discussion of price or pricing models with your competitors ... How much of a cost to absorb, and how much to pass on, needs to be your own independent decision".

Thursday, 22 November 2018

Double or quits?

Last month Australia's High Court told Japanese company Yazaki that no, it couldn't appeal against the record A$46 million cartel fine it had copped in Australia's Full Federal Court in May.

Now that the legal race is run, we can sit back and learn some lessons from the whole affair. Mostly, unfortunately, they're lessons about what not to do, though on the positive side they are guides to avoiding future heffalump traps.

First up in the catalogue of mistakes was Yazaki's disastrous decision to keep on fighting both conviction and penalty through the courts. Yazaki was bang to rights from the off: Yazaki and a bunch of other companies had already been convicted and fined in the US and Europe for price-fixing, bid rigging and market allocation in the market for "wire harnesses", which are things that link up the electrical components in a car. Yazaki had, for example, worn most (€125 million) of the €142 million penalty the European Commission had imposed in July 2013 for a cartel that had been ripping off Honda, Nissan, Toyota and Renault.

Sure, Yazaki had every right to claim it hadn't been ripping off Toyota in Australia (though it had). And to make the ACCC prove its case (it did). And to dispute the penalty imposed (originally A$9.5 million). But the proverbial snowball in hell had a better chance of beating the rap. Apart from the evidence in other jurisdictions of Yazaki being up to its eyeballs in wire harness rorts, Sumitomo Electric, Yazaki's comrade in cartel crime, had ratted Yazaki out both overseas and in Australia under the cartel leniency regime. Yazaki was always going to get its collar felt.

The sensible thing to have done was fold your hand as gracefully as you could. And you'd like to think Yazaki, or any New Zealand company in the same pickle, would send out for some independent economic and legal advice on the realistic chances of beating the rap and on the likely penalty (very low, and rather high, would have been the answers). But no: Yazaki appealed the original conviction in the Federal Court and the A$9.5 million penalty; the ACCC cross-appealed; and Yazaki scored one of the bigger corporate own goals of recent times, and got its fine quintupled to A$46 million.

Good. It's about time something disrupted the cynical calculus of appeals. Recall that in both Australia and New Zealand one way of setting cartel penalties is three times the profit gained from the cartel, the idea being that it acts as a disincentive to absorb cartel fines as a cost of doing business (provided the perceived chance of being detected and convicted is higher than one in three). But there's nothing equivalent deterring companies from clogging up the courts with doomed nuisance appeals. A $10 million fine? A 30% chance of getting it reduced to $5 million? A legal bill of $1 million? See you in the Court of Appeal, is the line of reasoning. This time it's fallen flat on its face, and I'm not sorry.

And it's not as if the courts are in any good place to absorb the dead weight of these nuisances. The ACCC first laid charges in December 2012. The Federal Court's liability judgement came out in November 2015 The original penalty judgement appeared in May 2017. The Full Federal Court  ramped up the fine in May 2018. The High Court finally drew two lines under the affair in October. That's nearly six years from go to whoa. I'd guess a similar timetable would have played out here in New Zealand. It's too slow. If 'hard core' cartelists like Yazaki think twice in the future before clogging up already slow courts, it'll be a good outcome.

Another lesson is that if you are in a cartel, or discover you've been in one, do not walk, do not amble, do not pause to think you're well hidden in the undergrowth and they'll never find you, RUN for the protection of the cartel leniency programme. So far Yazaki has copped well in excess of $1 billion globally, while Sumitomo Electric is home free, at least with the criminal enforcers (private class actions can't be fended off in the same way).

That was always good advice, but even more so now given the reasoning behind the Full Federal Court's whacking up the fine, and which I'd expect the New Zealand courts will be looking at. For one thing, it took the view that there were more contraventions than the Federal Court had identified (five, rather than the primary court's two, namely an overarching scheme plus a giving effect). For another, it said Yazaki's whole corporate income in Australia would go into the calculation of the maximum penalty (it ended up being a penalty based on turnover rather than on three times profits).

Yazaki wriggled: its argument was that the rest of its Australian business (which didn't even know about the cartel fix being in) shouldn't be swept into the maximum penalty calculation for what happened in one little corner. The Full Federal Court wasn't having a bar of it: at [198]
We also do not accept the respondents’ [Yazaki's] submission that the construction for which they contend is to be preferred by considering the position of a tiny subsidiary of a major Australian corporation, carrying on some very incidental and discrete part of the corporate group’s business, and engaging in cartel conduct, in circumstances where no other company in the corporate group had any knowledge of what was going on. If the consequence is that all of the values of the supplies made by every company in the corporate group were brought in, irrespective of their connection with the conduct of the contravening subsidiary corporation, we would not regard that as an absurd consequence, that is, a consequence obviously unintended by the Parliament.
One final learning is that, yet again, the primary victims of this cartel were other businesses: industrial inputs like wire harnesses are a common target for cartel operators. When it comes to debating cartel enforcement policy, it's fine for the business community to have reservations about criminalising cartels and sending ringleaders to prison, and to worry about pro-competitive collaborative activity being mistakenly characterised as anti-competitive cartels. But that's as far as concern or business solidarity should go: more businesses should realise they're the prime prey for these conspiracies, and should be supporting throwing the book at the Yazakis of this world.

Wednesday, 7 November 2018

Two sides to the story

You might think the ugly process of nominating US Supreme Court judges and the predictably  5 - 4 conservative/liberal votes in many of the Court's decisions wouldn't matter a hoot to us humble toilers in the vineyard of New Zealand competition and regulation. But you'd be wrong.

The US Supreme Court, in the Amex case, said something important in June about two-sided markets: formally it's Ohio. v American Express Co. and even has its own Wikipedia entry if you'd like a quick recap of what went on. Two-sided and multiple-sided markets and platforms are everywhere these days - I'm writing this post on one - and even if US jurisprudence doesn't always get a lot of traction in our Anglosphere courts, sooner or later the latest American anti-trust thinking tends to find its way through to us too, not least because the same economic experts front up here.

So Amex is relevant to us, and indeed we've traversed this territory ourselves in the past. I was involved at the time, so I'll just refer to the public material on the credit cards 'interchange case' of 2006-09, where an agreed settlement was reached pretty much on the steps of the High Court (the announcement of the Commerce Commission's proceedings in 2006 is here, one of the settlement announcements in 2009 is here)

This latest US case was about whether credit card companies can include 'anti steering' provisions in their contracts with retailers. 'Anti steering' means that a retailer, if it's signed up with Amex, say, can't nudge ('steer') the Amex-card-using shopper to some other means of payment. The retailer will be wont to steer the shopper to use the card system that costs the retailer least. That's usually not Amex: it charges relatively high fees to retailers to fund a relatively generous rewards programme for its cardholders.

Amex would argue that its card brought its (typically higher spending, upmarket) customer into the shop in the first place, and that at least one of the thoughts going through the buyer's mind when they spend up big in the store is the payoff from the Amex rewards programme. It's a swizz, on this reasoning, for the retailer to benefit from the Amex-initiated deal but put it through the till on someone else's card network.

Before reading Amex, I had sympathised with the plaintiffs (the Feds and 17 American states initially, but down to just 11 states at the Supreme Court). Language along the lines of "you mustn't mention there are competing alternatives to this card" doesn't sound good at all, and both Visa and MasterCard had agreed to stop doing it, with only Amex ploughing on all the way through the American courts. My first instincts would have been along the lines of the minority in the Supreme Court, which said
If American Express’ merchant fees are so high that merchants successfully induce their customers to use other cards, American Express can remedy that problem by lowering those fees or by spending more on cardholder rewards so that cardholders decline such requests. What it may not do is demand contractual protection from price competition (p26)
But to my considerable surprise (I didn't ever expect to find myself agreeing with the conservative majority of the current Supreme Court) the 5 - 4 decision in favour of Amex looked the right call.

The majority found that the credit card market is a two-sided market, which you would think is beyond much doubt. The District Court first hearing the Amex case had, however, oddly found separate single markets for retailer and shopper card services. The District Court got put right by the US Court of Appeal, and the Supreme Court affirmed it.

Following on from that market definition, the majority in Amex said that you mustn't draw anti-competitive conclusions from looking at high prices on one side of a two-sided market, a conclusion which is now a commonplace in competition economics but doesn't seem to have been considered by the Supreme Court before (the minority referred to a case from 1953, but that was long before the modern theory of two-sided markets):
Evidence of a price increase on one side of a two-sided transaction platform cannot by itself demonstrate an anticompetitive exercise of market power. To demonstrate anticompetitive effects on the two-sided credit-card market as a whole, the plaintiffs must prove that Amex’s antisteering provisions increased the cost of credit-card transactions above a competitive level, reduced the number of credit-card transactions, or otherwise stifled competition in the credit-card market ... They failed to do so (pp15-6)
The Amex majority pointed to a variety of evidence that showed no anti-competitive detriment: for example
the evidence that does exist cuts against the plaintiffs’ view that Amex’s antisteering provisions are the cause of any increases in merchant fees. Visa and MasterCard’s merchant fees have continued to increase, even at merchant locations where Amex is not accepted and, thus, Amex’s antisteering provisions do not apply ... This suggests that the cause of increased merchant fees is not Amex’s antisteering provisions, but rather increased competition for cardholders and a corresponding market wide adjustment in the relative price charged to merchants (pp16-7)
and they also cited a wide variety of other evidence (on pp18-9) showing ongoing vigorous competition between the card networks, which made the plaintiff's claim of harm rather difficult to sustain.

They also dealt to the "inherently anticompetitive" argument which I would have been attracted to - that it is inherently wrong to forbid retailers to mention the competition. Amex said that the anti-swizz justification ("you can't welcome our customer and then do a switcheroo against us") was okay, or in the majority's words
there is nothing inherently anticompetitive about Amex’s antisteering provisions. These agreements actually stem negative externalities in the credit-card market and promote interbrand competition ... This externality endangers the viability of the entire Amex network. And it undermines the investments that Amex has made to encourage increased cardholder spending, which discourages investments in rewards and ultimately harms both cardholders and merchants (p19)
If you're still sceptical about ultimately harming cardholders, it helps to think of Amex as an agent aggregating the collective purchasing power of its well-heeled membership to wrest what is effectively a larger discount from retailers.

The minority saw things completely differently, but struggled with their arguments. They persisted with the manifestly uphill notion that there are two separate markets:
the relationship between merchant-related card services and shopper-related card services is primarily that of complements, not substitutes (p11)
Since only substitutes are in the same market, there must must be two markets:
there is no justification for treating shopper-related services and merchant-related services as if they were part of a single market, at least not at step 1 of the "rule of reason" (p12)
The reference to "step 1" is to the 3-step process American jurisprudence follows (plaintiff says anti-competitive harm, defendant can rebut as pro-competitive, plaintiff can respond that it could be achieved less intrusively).

In any event, as a market definition, this looks a somewhat contrived description of what the majority better characterised as two sides of a single transaction. The minority also argued (which they needed to, since their first line of attack was weak), that market definition didn't matter, since evidence of higher prices was enough to establish anti-competitive effect:
The District Court’s findings of actual anticompetitive harm from the nondiscrimination provisions thus showed that, whatever the relevant market might be, American Express had enough power in that market to cause that harm. There is no reason to require a separate showing of market definition and market power under such circumstances. And so the majority’s extensive discussion of market definition is legally unnecessary (p14)
Not convincing at all: if a price increase is sufficient evidence of market power, every business in the country would be in the dock. But when a judgement opens with wrap-me-in-the-flag huffing ("For more than 120 years, the American economy has prospered by charting a middle path between pure laissez-faire and state capitalism") it's a good bet that wrap-me-in-the-logic is in short supply.

The judgment was met with outrage in some quarters. A piece from the Brookings Center on Regulation and Markets reacted with "Why the Supreme Court’s decision in Ohio v. AmEx will fatten the wealthy’s wallet (at the expense of the middle class)", for example, and the Open Markets Institute's Lina Khan wrote on Vox that "The Supreme Court just quietly gutted antitrust law".

I can understand the sentiment: 'anti steering' had initially looked wrong to me, too. But this is now the second time for me in recent months where something that initially looked deeply suspicious from a pro-competition point of view was judged okay (the other one was the Australian Pfizer case). For me, both cases correctly avoided a Type 1 error (wrongly finding anti-competitive detriment). But I'd also accept that in dynamic industries like pharma (Pfizer) and platforms (Amex) the safe path between Type 1 and Type 2 errors is getting harder and harder to spot.

Thursday, 11 October 2018

I've tried to stop...

...writing any more posts about market studies, but events have intervened. The government announced that it's going to fast track the Commerce Amendment Bill, which will give the Commerce Commission the powers to do studies, and also that the first one will be an inquiry into the petrol industry (which was always on the cards anyway).

So I headed smartly to the Transport and Infrastructure Select Committee's website to see where the Bill had got to, and found its final report (published on September 12). Market studies - or "competition studies" as we've elected to call them - have got the tick, though the Committee members divided on party lines on who should be allowed to initiate them. The majority backed either a Minister or the Commission (I'm with them), in line with MBIE's advice in its advisory report on the bill. The National members would have let the Commission initiate only with ministerial approval.

The Committee also went with another good MBIE recommendation. The Committee said (p3):
We consider that it would be appropriate for the legislation to require a government response to the final report. We do not consider it necessary to specify a time frame or process for the response. We recommend inserting new section 51E to require the Minister to respond to the commission’s final report on a competition study within a reasonable time frame.
I was really pleased about this. Of the 15 market studies submitters on the Bill (6 for, 6 broadly neutral, 3 against), only two folks had pushed for it - ASB Bank (submission here, the Ministerial response bit is on p7) and me (ditto, pp18-19). But MBIE thankfully saw enough merit in the idea to run with it. To my mind, it made no sense to set up a studies regime but not address the risk that they would be ignored.

There is also a useful focus (again following MBIE's sound advice) on following up what actually happens after the studies come out. As the Committee put it (p3)
We would like to see evaluations carried out to assess the effectiveness of each study and of the regime as a whole. We do not propose any legislative amendment in this regard. However, we suggest that, as part of the commission’s accountability arrangements with the responsible Minister, one of its performance measures should be to evaluate each competition study and report the results in its annual report.
I also learned from para 20 of MBIE's report to the Committee that "Cabinet has directed MBIE to carry out an evaluation of the competition studies regime after it has been in operation for five years". That's good practice. As I mentioned in a telco context ('Regulation done right'), it's easy to set up regulatory regimes and processes, and then forget to go back and check whether they've done any good or are still needed.

It's a pity in a way that it needed soaring petrol prices to be the catalyst that propelled competition studies up the legislative queue: they deserved a faster track than they'd got up to now. But that's realpolitik, and there's no point being naïve about it. If it took politicians' squirming to get a faster result, let's bank it and get the Commission underway that much quicker.

At the petrol pump

You don't - for good reason - get much of a chance to quote reams of facts on the radio. So for those of you who were listening to my stint on the National programme's 'The Panel with Jim Mora' on Tuesday, here are the numbers on what's driven the rise in petrol prices this year.

Conclusion - roughly two-thirds of the rise is down to the increased cost of the imported fuel, which has been hit by both a markedly higher world price in US dollars, and a markedly lower New Zealand dollar against the US dollar. It's not down to a big rise in petrol companies' margins, which is the story being used to frighten the children.

Most of the rest is down to taxes, by the way, and even more so in Auckland. The numbers above come from MBIE's weekly petrol price monitoring which as MBIE says "assumes retail petrol price are uniform nationally. Auckland City has recently introduced a regional fuel tax that will increase fuel prices in the Auckland region. Our currently methodology does not accommodate regional prices or regional fuel taxes. We are developing a new methodology ... that will include regional retail price differences". Aucklanders can add 11.5 cents to the increase in taxes, meaning that, for them, tax increases have been of the same order of importance as higher import costs.

The MBIE data are a great resource if you'd like to keep tracking developments for yourself. There was also an excellent explainer on the Newsroom website from Bernard Hickey, 'Q+A: Are petrol retailers profiteering?' which provides a lot of useful background.

Tuesday, 2 October 2018

A good follow-up

The New Zealand Institute of Economic Research has followed up on an idea I threw out here in August, suggesting that somebody ought to ask New Zealand businesses exactly what was bugging them when they reported low levels of business confidence (and thanks for the credit in the latest Quarterly Survey of Business Opinion, guys, it's appreciated).

Here are the answers to the special question the NZIER included this time round.

While it's good to know more precisely what's on businesses' minds, in the event it's not hugely surprising. Most people had suspected that businesses were not enormously enamoured of various current economic policies, and sure enough government policy topped the list. The tightness of labour markets (staff availability, wage pressures) and its impact on profitability, are also right up there, as is profitability more generally.

As NZIER said in the media release, "Profitability continued to worsen, reflecting intensifying cost pressures for many businesses. Businesses remained pessimistic about an improvement in profitability", and the overall results in the QSBO were downbeat. Looking just at the "own activity" results, which track GDP pretty well, "Firms’ own activity for the September quarter and expectations for the next quarter both fell, indicating a slowing in economic growth over the second half of 2018".

Hopefully the support from still very supportive fiscal and monetary policy will carry us through whatever slowdown occurs in coming months: in particular, the lower Kiwi dollar has tilted overall monetary conditions in businesses' favour, even as the RBNZ has stood pat on already low interest rates. And let's trust that the long-running  post-GFC global business expansion will not blow a gasket, despite the best efforts of American tomfoolery to derail it.

That's the upbeat take. But if there's one thing that would give you special pause for thought, it's "consumer confidence" turning up in the graph above as businesses' third most pressing worry. I didn't expect it to rate so highly, but looking at it now, I can see why it's there. I'd finger the petrol price as one big factor: here in Auckland the regional tax, the general rise in fuel excise, the high world price of oil, and the weaker Kiwi dollar have resulted in a litre of 91 costing $2.35 - $2.40, and households aren't in a great place to absorb a thumping great whack like that. I also suspect that housing wealth effects, again maybe more in Auckland than elsewhere, have stalled or even reversed.

So the state of consumer confidence is something I'll be watching a bit more closely. Hopefully rising wages in a tight labour market will alleviate some of the budget pressures from the petrol station forecourt, and the September QSBO result of no rise in employment likely reflected firms' inability to find scarce labour, rather than any cutback in hiring intentions, which remain positive. I certainly wouldn't want to see any job insecurity thrown into the already fragile household mix.

Monday, 1 October 2018

What do devaluations achieve?

Perhaps unwisely, over the week-end I queried a bit of logic I saw on Twitter which had argued that a lower domestic currency makes a trade deficit worse.

The reply that came back to my query said that a lower dollar makes imports more expensive, QED.

And although I tried to point out that other things start happening, too, to my surprise I got further pushback in support of the the lower-dollar-makes-a-deficit-worse theory.

Maybe it's a generational thing. Back when I was starting out in economics, exchange rates were typically fixed or managed, currency changes were an actively deployed policy tactic, and the conventional thinking was that you reached for a devaluation to improve your trade deficit.  These days, exchange rates typically float, and the effects of devaluation as an option have, maybe, been forgotten about.

So here's a numerical example of what I always thought was the orthodox way of looking at it. It starts with New Zealand running a small trade deficit - our export revenue from wine doesn't quite match our import bill for oil - and it traces what happens when the New Zealand dollar drops against the US dollar. For dramatic effect I've made it a big fall, from parity with the US dollar to only 50 US cents.

The first panel is the starting point. The second panel shows the immediate impact of the fall in the Kiwi dollar. As the people on Twitter rightly feel, the first impact is of course to make imports more expensive, and the trade deficit does indeed get worse. What we're seeing at that point is the downward, or worsening, part of what used to be called the 'J curve' effect, and these days would probably be called a 'hockey stick' or 'Nike swoosh' effect - things get worse before they get better.

If that's all that the Twitter people were saying, fair enough, though I get the clear feeling that they also believe that the lower dollar will lead to a permanent worsening of the deficit, and that things won't actually get better later on.

But get better, they do, thanks to two responses to the lower dollar.

Panel three shows adjustment on the import side. Oil used to cost NZ$60; now it costs NZ$120. That's a powerful incentive to use less of it - by car pooling, by trading down to smaller car engines, by putting in solar panels, by using more energy-efficient public transport, whatever.

One respondent on Twitter argued that "How do you propose we "cut back" on imports without local industry to meet the demand? Should we just tell people to have less goods and medicines because they've become more expensive?". Well, the answer to that is that people routinely change their patterns of consumption to big price changes. If tickets to the big match get too pricey, you do something else for the weekend. If avocados are $7 each (as they were), you don't make guacamole. But I'll come back to that behavioural response at the end.

In panel three I've assumed that a variety of energy-saving measures in response to much more expensive oil lead to a reduction in demand from 400 barrels to 300. And we saw precisely that response in the real world to successive jack-ups in prices by OPEC, though it took quite a while for people to reorganise their affairs (eg by junking gas guzzlers and designing more fuel-effective engines).

That alone starts to eat into the initially higher trade deficit, which comes down from NZ$28,000 to NZ$16,000. The exact numbers don't matter: what does matter is that we've started going up the swoosh.

But there's also a response on the export side, which I've shown in the bottom panel. Before, the American buyer of our wine was paying US$200 a case. After the devaluation, he's only paying US$100 - it's a complete steal. He could well increase his order significantly - if he was profitably shifting New Zealand wine at US$200 a case, he'll have them flying off the shelves at US$100.

Or it's possible that the winemakers will raise their prices a bit. In the panel I've assumed they raised the Kiwi dollar price from NZ$200 to NZ$250, which for the US buyer means he's still paying a lot less (US$125) than the US$200 he used to pay. I've assumed that there's a mixture of more wine sold, as they are now a lot cheaper in US$ for US buyers, and a somewhat higher NZ$ price.

And hey presto, the overall outcome after both imports and exports have adjusted is a small trade surplus.

"Hey presto" may get you thinking this is all a sleight of hand, and indeed there is an assumption in the background here that those behavioural responses actually happen, and happen strongly enough, to turn things round. And there's a bit of economics (the 'Marshall-Lerner condition') that's figured out exactly how strong those responses need to be.

If you're what used to be called an 'elasticity pessimist', you don't believe the responses will in fact be large, and maybe that's where my Twitter correspondents are. Maybe, on the import side, we're always going to have to buy those medicines, and we can't skimp; maybe, on the export side, some wowser wine-shunning import monopoly won't order more cases then it used to. There's nothing logically wrong with that line of thinking, and at the end of the day the actual effect will turn on the size of the responses. Me - I'm more of an elasticity optimist, and especially over the longer run.

Before leaving what will be ancient history for some and the bleeding obvious for others, I'd just add that back in the day I was never a great fan of devaluations as a policy option. Can they improve the trade deficit? Yes, over time. But should you go there?

Mostly no. Devaluations can come with unpleasant side effects, including the ever-higher-inflation ever-lower-dollar spiral that New Zealand actually fell into. They can degenerate into tit for tat zero sum games (everybody can't simultaneously devalue against everyone else). And they encourage - or at the very least perpetuate - the idea that price is the best way to compete in world markets. So, at most devaluation makes an expedient policy tactic, but it's a poor economic strategy.