Wednesday, 11 December 2019

Give that man a DB

Everybody from blind Freddy upwards has been telling this government, and previous ones, to get on with fixing New Zealand's gross infrastructural deficiencies.

"We should pull finger and get the hell on with it while the going is still pretty good", I wrote just over three years ago. "Roll out the infrastructure we need, and pull finger about it while you're at it", I said over two years ago. And apart from an unfortunate predilection for 'pulling finger', I was right, as was everyone else who has been banging on about it.

So all credit to Grant Robertson, who at today's Half Yearly Economic and Fiscal Update ('HYEFU') has done precisely that: an extra $12 billion into infrastructure. It was, from an economic perspective, completely correct: we need the choke points fixed, borrowing costs are at historical lows, and monetary policy has been driven into ever more grotesque distortions because fiscal policy wasn't carrying its share of the inflation-boosting load. Show me someone who disagrees with this boost, and I've a better than average chance of showing you a nutter.

To be clear, I'd say well done to whoever held the portfolio: I try to be non-partisan, and I'll give credit where it's due. In this case the economics said, go for it, and he did. Robertson also ran a bit of a political risk: "you can trust us with the public purse" was an electoral asset, and he's been prepared to face the "you promised a fiscal surplus and you blew it" flak (you'll have seen it's already flying) for the greater good. Good call.

There are practicalities that might intrude. With this spend-up, there is are risks that any old vanity project will get a green light. There are probably capacity constraints, meaning good intentions won't translate into diggers on sites, and hence and otherwise you'd want to see some thought given to (say) apprenticeships in the engineering and construction trades. There could be other constraints: it's a wild guess, and probably totally unrelated to whatever might be the Commerce Commission's next market study, but I wonder what are your chances of buying construction materials at a reasonable price, if  you were minded to buy a lot more of them? And the infrastructure spend-up is going to make overall expenditure control trickier: "you could find $12 billion for roads, but you can't find money for [insert allegedly deserving cause here]". For all that, it's still a good plan.

The other interesting thing from today's HYEFU was the update on whether fiscal policy is likely to boost or brake the economy. Yes, I know I go on about this, but for good reason. Most of the fiscal coverage is from a vested interest point of view - will my pretties get their share of the lollies - and the overall national interest doesn't get enough of a look in. But we all need to know whether on balance, overall, the government is on an austerity tack or whether it's adding to the national spend-up.

The answer to that question - and when I say 'answer', I have to confess it's the best we've got, rather than an outright humdinger of a clearcut answer - is given by Treasury's estimates of the 'fiscal impulse'. Here they are. Bars above the line say that fiscal policy is supportive, below the line it's contractionary. The blue bar is the best one to look at.

Treasury's commentary (p16 here) says that
Compared to Budget Update [last May], the fiscal impulse in 2019/20 and 2020/21 is now more positive (0.9% and 0.3% respectively, up from 0.0% and -0.2% previously). The change in the 2019/20 impulse largely reflects operating spending shifting from 2018/19 to 2019/20. The change in the 2020/21 impulse reflects increased capital spending.
I don't blame you if you're wondering what's being said here. Unpacked, there's good news and bad news.

The good news is that fiscal policy is going to be more helpful over the next year or two than originally planned, which, given that the current preponderance of risks in the global economy is tilted to the downside, is a good precautionary move, as well as taking the heat off the Reserve Bank and starting to chip at our infrastructural problems.

The bad news is that $12 billion of extra infrastructure spend, which you'd think would make quite an impact, will take forever to kick in. Here's the profile (from p13 here).

Some of this is inherent in the nature of infrastructure spending: you can't go out tomorrow and start hacking away at Transmission Gully or a second Auckland Harbour crossing. Some of it is down to unnecessarily complex and slow planning processes. Some of it is down to governments not being ready (from a cyclical management point of view) with the proverbial 'shovel ready' projects or (from a longer term investment perspective) not having a coherent portfolio of projects thought through well ahead of time.

But however you parse it, you can announce $12 billion today, but only $3.7 billion is actually going to be spent over the next three and a half years. So while Treasury talks about increased capital spending contributing to a fiscal boost in 2020/21, the effect is quite small because infrastructure is harder to get moving than a teenager with an attitude.

I'm not the first to say this, but there is a ever stronger case building for a non-partisan agreement on a core programme of infrastructure spending. We shouldn't be in a position where overdue investment happens only when cyclically opportune; we shouldn't be in a position where one government's 'holiday highway' is the next government's 'road of national significance'; we shouldn't be reacting, after the event, to stresses that have become evident because we haven't had the wit to preempt them. And on the supply side, we won't have the range of contractors we'd like to have to build the projects we need, unless they get the comfort of a pre-announced schedule of potential contracts. We risk being hostage to the big few who can ride out the dry years.

But enough of the quibbles. Did fiscal policy step up to the plate? Yes. Did we get more real about infrastructure? Yes. Does that man deserve a DB? Yes.

Monday, 9 December 2019

This doesn't help

The OECD came out the other day with its latest PISA results - "the Programme for International Student Assessment (PISA) examines what students know in reading, mathematics and science, and what they can do with what they know. It provides the most comprehensive and rigorous international assessment of student learning outcomes to date". Here's how New Zealand students have been doing over the history of the PISA tests. We used to be clearly better than the OECD average across reading, maths and science, but the results have been deteriorating in all three areas.

We're not alone in this. Here are Australia's PISA results. Almost exactly the same.

You could, I suppose, take some comfort from the fact that our performance levels (even if steadily declining) are still not that shabby by international standards. Here are the top 30 countries (I'm using countries loosely here to include for example the consolidated results from four regions in China producing quality-meeting PISA scores), when ranked by reading scores. We're still 12th, Australia's 16th. But self-evidently we'll get eaten if, for example, the rapidly developing economies of eastern Europe up their game and we continue to slide.

I'll leave the bunfight over the reasons for our (and Australia's) recent PISA declines to others. What bothers me about these trends is the contribution they may be making to our long-standing productivity problems, where for any given degree of effort and resources we seem to produce less than the higher-income OECD countries. Australia's also hit a productivity wall: its latest official estimates showed that "market sector multifactor productivity (MFP) fell 0.4% in 2018–19, the first decline since 2010–11 ... Labour productivity fell 0.2% in 2018–19, the first recorded negative for the sixteen industry market sector aggregate (since the beginning of the time series in 1994–95)".

A wee while back I wrote a column for the Australia and New Zealand accountants' magazine Acuity, documenting New Zealand's and Australia's productivity problems and canvassing some of the usual suspects ('Is there any scope for multifactor productivity growth?'). I didn't include falling skill levels for new entrants to the workforce - a fall of some 4.7% across all three areas since 2000 - but maybe I should have. Normally you'd expect each entrant cohort to the labour force to be bringing higher, not lower, levels of skills to the productivity party: it gets a lot harder to make progress when your starting point is going backwards. In the context of productivity growth, where small changes matter a lot over the longer term, a drop in entrant skills of approaching 5% in two decades is a big thing. This is a ball and chain we don't need.

Thursday, 5 December 2019

Our first market study

The petrol market study came out a short while ago, and if you haven't caught up with where it landed, the Commerce Commission has an infographic on its main findings, another one on its recommendations, the media presentation this morning, an executive summary, plus the whole report.

From a regulatory policy point of view I like where it has gone. There's been an almost unthinking reach for heavier-handed forms of sectoral regulation in recent years, and it's good to see a lighter-touch approach favoured for petrol. The two main recommendations are a terminal gate pricing wholesale market, and less restrictive contractual arrangements between petrol wholesalers and petrol retailers, both overseen by an industry code of conduct.

There is the threat of tougher regulation in the background if these arrangements don't do what they're meant to, which is fair enough, but the key element is a "more market" one, with a currently ineffective wholesale petrol market getting a kick start towards greater liquidity and relevance. And that's as it should be: the intervention required should be the minimum required to get a result, and if we can get an effective market-based solution satisfactorily supervised by the industry itself, we're done.

These are of course only recommendations to the government, and who knows how a three-headed cat will jump, but hopefully the proposals will get the tick. At least we know we will get a response, as the very excellent s51(e) of the Commerce Act requires that "The Minister must respond to the final competition report within a reasonable time after the report is made publicly available".

The thing I was most mulling about, in the interval between the draft report back in August (which I wrote about here) and this morning, was what had happened to all those arguments about the real problem being tacit retail price collusion, which had cropped up in (for example) the MBIE petrol market study and in the Commission's own Z / Chevron decision. The answer to that is in para 7.97 of today's report, where the Commission says coordination is still a risk, but one that will be made harder (and any effects would be less) if the proposed wholesale market gets up and running:
most of the market features that made retail markets vulnerable to tacit  coordination when we considered the Z/Chevron merger in 2015/16 remain today although some market features have changed to make the markets more vulnerable to tacit coordination and others less so. We consider that retail fuel markets are vulnerable to some level of tacit coordination. We welcome Z Energy removing the MPP from its website. However, we consider that tacit coordination has been and may remain at least a contributing factor to the margins that we observe. We consider that measures to improve competition at wholesale and retail levels of the fuel supply chain, opening up those markets to new suppliers, will reduce their vulnerability to accommodating behaviour as well the potential effect of any such behaviour that does occur.
Out of vanity I looked up what had happened to my own little submission on the draft: I'd said that a chart showing New Zealand with amongst the world's highest post-tax petrol prices should have been on a purchasing power parity basis, rather than at market exchange rates, since market rates at one point in time can wobble all over the place, and what looks expensive in New Zealand today might look cheap tomorrow. I'll call it a draw: at 3.88-89 the Commission agrees that a point-in-time comparison isn't the best, and they've included longer-term paths which show our petrol prices are indeed among the developed world's most expensive (possibly for good reason, eg transport costs to a small isolated country), but the Commission remains wedded to spot rates. Over longer periods the Commission says spot rates will average out the volatility.

The other thing to take away is that we've now seen the first final output from the new market studies powers. Self-evidently, despite the critics and sceptics, the sky has not fallen. It's been done at reasonable cost, in reasonable time, with a good degree of balance - in the media presentation, the chair Anna Rawlings pointed out a range of consumer-benefiting innovations in the petrol business, for example - and with sensible-looking recommendations tailored to the diagnosis. Good day's work all round.

Who'll be next, I wonder? The goss has been that the government in principle recognises that the Commission can initiate its own studies (s50 of the Act) but in practice will fund only one a year, and will be picking another one toot sweet to pre-empt which one it'll be. I've heard rumours, but let's not spoil anyone's Christmas.

Friday, 29 November 2019

The good old days. Not

Marilyn Waring's interesting memoir The Political Years is an eye-opener on New Zealand in the late 1970s and early 1980s. While she has a particular perspective to emphasise, there's no doubt that the casual sexism, racism and conservatism of the day that she recalls do not square with the "we've always been progressive since women got the vote in 1893" story we like to tell ourselves.

From an economic policy point of view, it's also a reminder to those who put 'Rogernomics' and 'Ruthanasia' in the 'awful neoliberalism experiment' basket that reform was needed. Even Waring, down the left end of the political spectrum, concludes (p46) that
Within just a few months [of first being elected in 1975], I was getting a picture of incredible inefficiencies. Tariff structures were a nightmare, and were still in hangover mode from the Second World War. Licensing was a mess: those who had import and transport licences ran small fiefdoms. Transportation regulations intended to protect the railways restricted truck movements without a special licence, adding significant costs. Vast amounts of primary production were subsidised. Far too much discretionary power rested in the hands of ministers. Certainly, that meant I might lobby for gains for my constituents, but the process needed a wholesale clean-out.
She gives examples (pp45-6) of the kind of lobbying involved: letters to ministers with "requests for relief of import duty on a sports cup for presentation at the local high school and for a licence to import woven woolen fabric for the Te Awamutu and District Pipe Band".

Mercifully most of that nonsense went overboard after trade liberalisations, but it's doubtful whether our chronic propensity for micromanagement is permanently buried at a crossroads with a stake through its heart. It's not that long ago that a government minister's approval was required for a Tourette's Syndrome sufferer to have access to a medical cannabis product. And in my own narrow neck of the woods, the Commerce Commission's "cease and desist" powers - designed to provide a timely interim stop to anti-competitive conduct until the substantive issues got litigated later - were so hedged about with preconditions and provisos that they were eventually abandoned as useless.

Another bad habit not fully kicked is unnecessary secrecy. In Waring's day, Robert Muldoon would not even share Treasury's analyses with his own MPs: on p256 she recounts how
Ruth Richardson, one of six new MPs in caucus [after the 1981 election], wasted no time in asking to see the Treasury reports on the state of the economy. Muldoon replied they were confidential, amd Hugh Templeton added that the secrecy gave Treasury the 'freedom to report'. The PM noted that the reports referred to high interest rates, devaluation, running down cash balances and internal liquidity under pressure. There was no cause for alarm, he said.
You can see why the Labour government of 1984-90 brought in the Public Finance Act to require a step change in transparency.

The same dubious "freedom to report" rationale was invoked to keep the proceedings of the Public Expenditure Committee secret. The Committee - which I'd guess was a forerunner of today's Finance and Expenditure Select Committee - was charged with "examining the Annual Reports and Accounts, and the Estimates of Expenditure, for every government ministry, department and agency" (p56), a highly important accountability role, especially given the limited other avenues at the time for scrutiny of the executive. Waring, appointed to the Committee and later its chair, questioned the secrecy and was told by the Clerk of the House (p56) that
Official papers prepared at the request of the Committee have always been regarded as confidential, and the assurance of confidentiality has been fundamental to the willingness of departments to supply frank and detailed examination.
We have, thankfully, largely moved on. But even today s9(2)(f)(iv) of our Official Information Act includes, as a valid reason for withholding information, "the withholding of the information is necessary to ... maintain the constitutional conventions for the time being which protect ... the confidentiality of advice tendered by Ministers of the Crown and officials" or under s9(2)(g)(i) to "maintain the effective conduct of public affairs through — (i) the free and frank expression of opinions by or between or to Ministers of the Crown or members of an organisation or officers and employees of any department or organisation in the course of their duty".

There may be genuine occasions when these confidentiality provisions need to apply, but a few minutes on Twitter will tell you that some entirely responsible and proper 'citizen journalists' will be wondering, after bumping heads with the OIA, exactly how far we've progressed from the Sir Humphrey Applebys of Waring's day.

Friday, 22 November 2019

RBB Economics draws a crowd

A record number of attendees braved the smoky air of Sydney yesterday to attend RBB Economics' ninth annual competition conference. If you're in the competition law trade and you haven't been, have a word with them: it's a good event. This year's was on the general theme, "What's next for competition law in Australia?"

We started off with the traditional opening keynote by Rod Sims, chair of the ACCC (his speech is here). As it happened two of his points - the potential role of consumer law in enhancing competition and productivity, and a potential need for strengthened merger laws - got developed in a lot more detail in later sessions. Like a lot of people in the competition game I've tended to relegate consumer law to poor cousin status, and (let's face it) largely on intellectual snobbery grounds: where's the challenge in reading an ad to see if it's misleading or deceptive, compared with the subtleties of economic theory? But Rod, and subsequent speakers, made a good fist of arguing that consumer law helps buttress the workings of workably competitive markets.

Jacqueline Downes, a partner at Allens, spoke in reply. The main points I took away were that the ACCC's concerns about merger laws not being effective in blocking anti-competitive mergers were not supported by the data: the few cases that go right through the courts and go against the ACCC are only a tiny unrepresentative fraction of mergers. The vast majority of potentially iffy ones get knocked back either by the firms' advisers, or in informal discussions with the ACCC. The system works. She also wondered about the number of market studies being undertaken (not that the ACCC has any choice about doing some of them) and their potential for politicised policy responses.

The next session was 'What would a new unfair trading prohibition look like?', led off by ACCC commissioner Sarah Court. She had recently changed her view and now thinks an 'unfair' trading prohibition would be a useful tool, in part because of recent difficulty in making the existing 'unconscionable conduct' offence stick: you'll find a good entry point to the Kobelt case that caused the grief here. In reply barrister Robert Yezerski also commented on the Aussie courts' struggle to get their heads around the statutory formulation of  'unconscionability' as opposed to the common law equitability jurisprudence they had learned at their elders' knees. In Robert's view, the key concept in the statutory formulation is, essentially, immorality - something that is so at odds with society's moral norms as to deserve condemnation.

Even if Kobelt fell over from a regulator's point of view (the financial regulator ASIC in that case, not the ACCC), it may have been one of those finely balanced facts-based cases that don't count for much in the longer-term. Which is just as well, as we in New Zealand will be looking to the Aussie jurisprudence when we adopt unconscionability, as we are now likely to do. As for bringing in 'unfair' in Australia, I could sympathise with Sarah's point that the wording would likely need to be linked to 'significant consumer harm', but I'm not sure (and I don't think the audience was either, going from the Q&A) that there is going to be any easy way of formulating a workably effective form of words.

After lunch we had 'Do we need to strengthen Australia's merger laws?'. Rod had felt that the courts were letting uncompetitive mergers through, partly because they were not properly taking into account how the post-merger commercial incentives changed  for the managers of the merged entity: he'd felt that the ACCC's submissions on changed incentives were being dismissed as speculative theorising. Jennifer Orr, principal economist in the ACCC's Economic Group, took a different line about arguably too-lax merger under-enforcement: she pointed to growing empirical evidence (in academic journals, mainly, and mostly US-focused) that industry concentration had been (wrongly) allowed to develop to the point that more powerful incumbents were anti-competitively enabled to raise price or give less. Had the prevailing 'Chicago School' approach to anti-trust missed something that older-fashioned analyses, which gave more weight to structural conditions like HHIs, had been more alert to?

In reply King & Wood Mallesons partner Lisa Huett and RBB Economics' own George Siolis pushed back. Lisa argued that "If it ain't broke, don't fix it", and provided the numbers to back Jacqueline Downes' earlier point about the vast majority of potentially problematic mergers getting flagged away. She wasn't enamoured either of the potential 'solutions' (like reversing the onus of proof, or introducing rebuttable presumptions of harm if say a proposed merger took an HHI over 2500). And she pointed out that in any event there had been a fair amount of other law reform (the 'effects' test for abuse of market power, 'concerted practices') to deal to any mischief a lax merger approval might have facilitated. George traversed the history of the evolution of anti-trust thinking which, for good reason, had arrived where it is today. He preferred that competition authorities should stay the course, use all the tools available to check for (say) potential post-merger coordination effects, and "get dirty", meaning immerse themselves fully in the facts of the case and the industry.

This session got the audience going. One chap bristled at the idea that merger parties should have to prove anything: the shoe should be on the other foot, and the ACCC should be positively required to prove harm, rather than hide behind a "not satisfied there wouldn't be" criterion. In general there was quite a bit of support for the idea that Type 2 errors (letting anti-competitive mergers through) aren't welcome, but equally (and for some in the audience, more importantly) Type 1 errors (blocking efficiency-improving mergers) weren't getting enough of a look-in.

Personally I was left in a bit of a quandary (maybe you are too), and said so in a question to the panel. On the one hand, I've been involved in mergers that went from 3 to 2: where, for example, the #2 and #3 players, merged, would make a more effective competitor to the #1 incumbent. I had no trouble sleeping at night afterwards, never mind what the post-merger HHI said. On the other hand you can't go around ignoring the evidence that Jennifer mentioned, either.

Even if you don't quite know what to think, though, one place you land is the need for post-merger reviews to see what is actually happening. In my notes I've written "ACCC not resourced, no powers" to do post-merger reviews: I can't remember whether one of the panellists said it, or someone mentioned it over coffee, or where it came from. But if so, it needs to be fixed, and the same applies to our own Commerce Commission (which in the past has had at least an indicative go at seeing how post-merger events played out). We need to know.

And so into the final session, 'How can the ACCC's competition concerns get more traction before Australian courts?'.

A Brit, a Scot and a Kiwi go into a bar ... aka Simon Bishop (RBB Economics), Dr Ruth Higgins SC, and Dr Mark Berry as they put the finishing touches to their thoughts on how to get traction in court on competition cases

One for the lawyers, but also some useful insights for those of us on the economics side of the house. Our own Mark Berry pointed to the value of the New Zealand 'hot tub' style of testing expert evidence and its ability to expose errors (on all sides of an argument). And he wondered if New Zealand and Australia were actually moving things along too quickly, by comparison with the times taken to rule on merger clearances or authorisation overseas: are we missing a chance to look deeper and harder at the issues involved? Ruth Higgins emphasised the primacy of the facts, quoting Thomas Huxley's "The great tragedy of science - the slaying of a beautiful hypothesis by an ugly fact", and argued that economic arguments are better when they integrate the apparently inconvenient facts. She also said that the big contribution from economists can come from establishing an overall framework within which the court can advance, rather than leaping to judgements themselves. And RBB's Simon Bishop said that the ACCC shouldn't necessarily be dismayed by the odd loss in court: it is not compelling evidence of wider underenforcement (they are always the marginal could-go-either-way cases), and echoed Ruth's points about economists showing restraint, focus, and a respect and care for the facts.

In panel discussion afterwards, there was also general agreement on what economists shouldn't do. There was short shrift given to the economists who can see no weaknesses in their arguments, and no sympathy for spinners of over-complex theories which they can't explain to decisionmakers in a persuasive way. But none of us are in those boxes, are we?

Thursday, 21 November 2019

Small mystery solved

Here is the table from the latest Monetary Policy Statement that shows the Reserve Bank's projection for the official cash rate (the OCR).

There's something odd. If you look at the projection for March '20 through to June '21, you see that the OCR is projected to be 0.9% for six quarters in a row. But how can that be? The RBNZ won't be setting an 0.9% OCR: it might set 0.75%, it might set 1.0%, but it won't be setting 0.9%.

If you're a monetary policy tragic, maybe you already know the answer. But I didn't. So I asked the RBNZ what was going on. And the very helpful Chris McDonald, manager of forecasting at the Bank, enlightened me.

The projection is actually what the Bank thinks, via its modelling, is what the OCR needs to be to achieve 2% inflation. The Monetary Policy Committee will make its own tactical OCR call at each policy decision point, and you'd imagine it wouldn't be a million miles away from the level the Bank's models say is the right level, but the projected path isn't actually a stab today at what those decisions will be.

I gather I'm not the first to wonder what that 'projection' meant. Future tables may well include some footnoted explanation.

Wednesday, 13 November 2019

Good call

We've just had the Reserve Bank Monetary Policy Statement. In the pre-MPS poll that Daniel Dunkley ran for the Good Returns website I'd reckoned that it was a 50:50 call, but on balance (and in the minority who lucked into making a correct forecast) I leaned towards leaving the OCR at 1%. It's the right decision.

I'd been worried that another cut would risk the same counterproductive effect on consumer and business confidence that seems to have followed the Reserve Bank of Australia's latest cut to their cash rate - "if the RBA thinks things are bad, I'd better panic too" - and there were other factors suggesting doing nothing. Local business activity seemed to have bottomed out in the latest ANZ business survey; it could be a good idea to leave some monetary policy ammo in the locker rather than creeping ever closer to zero interest rates; and in any event in current global geopolitical conditions it might pay to wait and see how things unfold.

Plus domestic non-tradables inflation had gone over 3% in the September CPI (as shown below in blue, with the 2010 GST hike taken out): I like to look at it ex housing and housing utilities (in red), but either way it looks as if local inflation is already heading towards where the Bank would like it to go, and has been for two years. So sit on your hands, I thought, made sense for the Bank.

In responding to the survey I forgot to add that the RBNZ itself thought, at its August MPS, that inflation would get back to 2% by late 2021 with the OCR effectively unchanged. The forecast OCR track in August's MPS isn't easy to interpret - there are, for example, three successive quarters where the OCR is shown as 0.9%, and if you can explain the OCR track that gives rise to that pattern you're smarter than I am - but essentially the RBNZ thought we looked to be headed for 2% inflation last time without doing anything much extra.

Since then, two other things have occurred to me. One is that I wonder whether the distortions involved in driving inflation up from its current 1.5% to the target 2.0% are worth it. And the other is whether easing monetary policy further (and in Oz they now appear to be contemplating unconventional tactics as well - 'Reserve Bank gets the money printers ready') would be effective: what if we ventured even further into unknown territory and we still couldn't get a 2% inflation outcome? What would be the point?

On the distortions, I'm leaning towards the view that there is precious little effective difference between a 1.5% and a 2% inflation outcome: both are low enough not to distort economic decisions, but both are high enough to allow that little bit of lubrication that allows relative price changes to take place without some prices having to be cut in absolute terms. I wouldn't therefore invest a lot of effort in pushing 1.5% to 2%, and I note that the Monetary Policy Committee's 'remit' says "a focus on keeping future inflation near the 2 percent mid-point" not "the focus" (my emphasis).

So there's little upside benefit from straining harder for 2%, but there are costs. Current settings are already undermining, for example, much of the rationale for retail investors to invest in term deposits, and market commentary suggests that much of the recent sharemarket price gains reflect Mr and Mrs Bloggs taking money out of the bank and plonking it in dividend-paying equities. I can't say I'm hugely enthused about the incentives on the other side of the ledger, either, for corporate treasurers to tank up on artificially cheap debt.

There has to be some risk of inflating asset or debt bubbles. On Standard & Poor's calculations, the S&P / NZX 50 index at the end of October was trading at 24.8 times expected earnings. That's even more expensive than the U.S. market. Looking at the MPC's remit again, it says at 2(b)(i) that "the MPC shall ... have regard to the efficiency and soundness of the financial system": have any members started asking questions about the allocative efficiency consequences of where we are?

Even if that's a hard question to answer, I think it's pretty clear that whatever the distortionary costs are, they're likely more than deploying fiscal policy would involve. There's plenty of efficiency-improving infrastructural investment (including building the human capital skills of the unemployed and underemployed) that could push on our output gap and generate the desired inflationary pressure.

And can we even be sure, given the state of the rest of the world, that there is any sensible setting for local monetary policy that would actually deliver the 2% target? By sensible I mean a setting that does not have the exchange rate a long way away from purchasing power parity, or interest rates at very high or very low levels in real terms. The assumption has been that all we have to do is push the official cash rate to some non-absurd position on the dial, and 2% inflation will follow in due course. As the old DB ads might say, is that right?

The reason I ask that question is that I think there is some risk of forgetting the fact that we only have a limited control of our own monetary policy destiny. As Friedman's 'trinity' put it, you can have two, and only two, out of the following three: control of your own interest rates, control of your own exchange rate, and control of cross-border money flows. We've opted for our own interest rates, and free capital flows: the exchange rate which we can't control will be whatever it will be. What guarantee is there that the autonomous exchange rate will settle at a level compatible with 2% local inflation? None at all.

Chuck in the fact that we have only partial control of our own interest rates in the first place - we're effectively squeezed into the territory constrained by the zero lower bound and other countries' currently ultra-easy monetary policy settings - and it may well be that our limited room for interest rate manoeuvre (combined with that free-ranging exchange rate) isn't compatible with a 2% outcome. There's room to be sceptical about pushing ever harder on a piece of string.

Friday, 8 November 2019


I don't understand WACC, the Weighted Average Cost of Capital.

No, don't look at me like that - I do understand the mechanics of the thing, and have had my fair share of meetings pinning down appropriate beta comparators, the extent of the market risk premium, Brennan-Lally tax adjustment, and due allowance for the curvature of the earth.

No, what I mean is, I don't understand WACC as a regulatory concept.

Bear with me. I can see WACC as an accounting concept. A firm's balance sheet is made up of  equity and debt, and each comes with a cost: what you have to pay the owner shareholders to invest their risk capital, and what you have to pay lenders to lend. And the overall cost of the whole balance sheet is the weighted average of the two costs, WACC. All good.

But you'll often see a regulated firm described as "earning its WACC" (with subtext, "and no more"). No, it isn't. The firm is earning its return on equity. Its lenders are earning their return on debt. Neither of them is earning WACC.

In fact I can't see why (with one potential exception) regulators take the interest they do in the cost of a firm's debt. The standard regulatory equation in rate of return regulation (certainly as it's been implemented in New Zealand under Part IV of the Commerce Act) is
Allowed revenue minus (efficient) opex minus (efficient) investment minus (economic) depreciation = allowed interest costs plus allowed return on equity
But why do regulators give a fig about the interest costs? They're a cost that the regulated firm has every incentive to minimise: it's paid away to the third-party suppliers of credit, not a return to the firm itself.

The standard formulation makes little sense to me. Why shouldn't the equation be squarely focused on the return to equity:
Allowed revenue minus (efficient) opex minus (efficient) investment minus (economic) depreciation minus actual interest costs = allowed return on equity (ROE)
It's more logical: the only return that matters in a market economy is the ROE. And the rejigged version of the equation is both simpler and less restrictive.

It's simpler, because at the moment rate of return regulation goes through a whole process determining the "appropriate" cost of borrowing for the regulated entity - typically by establishing what a company of similar credit standing in that industry would pay, for debt of a maturity equal to the period of regulation (often five years). It would be simpler just to write down what it actually paid, not mess about guessing what a firm just like it might have paid.

It's less restrictive, because it would not risk imposing unnecessary and possibly inefficient constraints on the maturity of the debt raised. Right now, there'll be many a corporate treasurer who reckons that we are at a cyclical low point in borrowing costs, and will be keen to lock in currently attractive prices for as long as possible. If they're right, paying a bit more than you'd pay today for five year debt in order to issue ten or fifteen year debt could well work out cheaper - maybe a lot cheaper - in the long run, benefiting consumers. Allowing the regulated entity only the five year cost could be counterproductive.

The current formulation also potentially inhibits other efficient approaches to borrowing. There are good rationales, for example, to match the maturity of debt to the working maturity of the assets they finance. In regulated industries, the assets tend to be very long lived indeed. What is the logic of not compensating the regulated entity for the actual cost of doing the sensible thing?

And many treasurers will want to avoid a concentration of debt maturities falling due around the same time: you don't want to be going around the money markets with a large begging bowl if it happens to be in the middle of the next GFC.  Rather, a prudent treasurer will have a mix of maturities: on average they might approximate to the five year maturity the regulator will allow, but equally they mightn't. Why impose a penalty (or subsidy) on what a prudent maturity mix actually costs?

A purely ROE-focused approach, one which drops determining an "appropriate" cost of debt, is a better way to go as a general rule, but I mentioned one possible exception. That's where the debt providers are associated parties. Let's suppose the regulated entity is owned by a private equity company. It could fund its "debt" from a financing vehicle in the group, and stream above-market "interest" payments effectively to itself. But in normal circumstances most companies borrow at arm's length from banks and the capital markets. A quick check that its funders are not interlinked, and in most cases you'd be done.

There is one aspect of debt that regulators should properly monitor, and that is excessive leverage. With an effectively guaranteed income, there could well be a moral hazard risk of the regulatee putting in $10 of equity and a squillion dollars of debt, juicing the ROE if all goes well and lumbering the bondholders and any operator-of-last resort if it doesn't. A maximum leverage ratio, or as a more market-oriented option, a minimum investment grade debt rating, might be a useful regulatory adjunct. But beyond that, leave it to the corporate treasurer to figure out the cheapest financing bundle.

A final benefit of an exclusively ROE-based approach is stopping some game-playing. Quoting the WACC that the regulator has allowed can be deceptive. The regulator can say, "See how effective we've been? We only allowed them 6%!". The regulatee can play the same game: "See how unfair they've been? They only allowed us 6%!". In both cases - particularly at today's interest rates - the WACC is low because the debt component is low. The regulator may not in fact be especially effective; the regulatee may not in fact be hard done by. It's only the ROE that can answer those questions.