Our financial cycles

Two economists at the University of Auckland, Caitlin Davies and Prasanna Gai, have come up with a really useful bit of practical macroeconomics. They've devised a Financial Cycle measure for New Zealand - an indicator of the overall tightness or looseness of financial conditions. Their paper, 'The New Zealand financial cycle 1968–2017', is available here in the online version of New Zealand Economic Papers.

Financial conditions indices (FCIs) are an established thing overseas. They were always relevant - changes in financial conditions have played a lead part in many business cycles, and even when not the lead have been important channels for propagating non-financial shocks - but have naturally become of greater interest since the GFC. As Davies and Gai say (p1), "Recent [academic] work ... suggests that strong credit growth and house price booms are good predictors of crisis and significantly shape macroeconomic outturns".

In the States, for example, there are a herd of them. The chart below shows five FCIs - three produced by various regional Federal Reserve Banks (Chicago, Kansas City, St Louis), two by the private sector (Bloomberg, Goldman Sachs) - plus a market-derived measure, the VIX, which is the volatility investors expect from holding the S&P500 index and which can be backed out of the prices for S&P500 options. They've all been normalised to be comparable, as described here by the St Louis Fed. Higher values for these indices mean tighter conditions.

You can see, for example, how financial conditions (ex the VIX) had been tightening ahead of the GFC, and then hit all-time highs for financial distress and unavailability of credit through the GFC itself. And if you subscribe to Austrian or Minsky style theories of business cycles, you'd argue that the pronounced period of unusually easy monetary conditions you can see in 2004-2006 sowed the seeds for the over-exuberant risk-taking that fuelled the eventual GFC bust.

Highly useful and informative things, these FCIs. And now we've got one of our own. To get it, Davies and Gai went the principal components route - take a bunch of finance and credit indicators, and see if there's a common influencing component in the background - and found that yes, there was. It combines six variables into an overall index: real credit, credit to GDP, credit to the M3 measure of money supply, real house prices, real share prices, and housebuilding to GDP.

Here's what the results look like, in raw form: for this New Zealand index, you read it the other way round to the US ones, in that higher values show easier financial conditions. The authors say that "Our measure of the New Zealand financial cycle appears to be broadly consistent with the main economic developments during the period", and I agree. You can see, for example, the surge in credit availability in the mid 1980s following banking deregulation, and the subsequent bust after the 1987 sharemarket crash. You can also see our experience of the GFC.

The authors usefully superimposed their financial index results on the business cycles identified by Viv Hall and John McDermott. The FCI for this comparison has been expressed in smoothed cyclical terms showing whether it is rising or falling (there's econometrics behind this we don't need to explore here), but same diff. Here's how they compare.

"Of the six contractionary episodes during the past fifty years, five occur less than three years after a peak in the financial cycle", the authors say (p8), and while I wouldn't immediately leap to cause and effect (and they don't either), it's a suggestive pattern.

The authors modestly say (p14) that their work "should be regarded as a tentative first-step in constructing a set of stylised facts on the financial cycle in New Zealand", but it's more than that. We had a rather large gap in documenting our recent macro history, and they've filled it. They've also created something that could easily be kept up to date, and serve as a real-time indicator of trouble brewing. As they mention, it's of obvious relevance to macroprudential policy: you might want to keep a weather eye out for where the FCI is before, for example, tightening or loosening LVRs. Indeed, you'd wonder why the RBNZ hadn't developed an FCI of their own by now.

And you can see extensions to it. This FCI is based on whatever quarterly series were available all the way back to 1968, and for a paper looking at the grand sweep of history, that's fine and unavoidable. But you can easily imagine an FCI using data that became available only more recently:I think it's highly likely, for example, that moves in corporate credit spreads, unavailable back to 1968 but available for more recent years, would feature strongly. And I think it's plausible that you could get to a monthly FCI: the Americans certainly have, and the Fed of Chicago has even gone as far as producing a weekly one (conditions are currently on the easy side of normal).

In any event this is a great start: I hope there's someone out there - the RB? a bank? the University itself? - who'll take up the baton and turn this into an ongoing up-to-date macro indicator.

Get your views in on abuse of market power

Right - you've got till 5.00pm next Thursday, June 21, to get your views in to MBIE on their targeted review of the Commerce Act.

It's important, and while I know we've all got other things to do, you'd be doing the economy a favour if you took some time out this week-end (when you're not watching the Warriors take on Manly in Perth, 7.30pm Saturday) to make a submission, particularly on our current approach to abuse of market power - the infamous section 36 of our Commerce Act.

All the background and how to submit can be found here. While technically MBIE is calling for 'cross submissions' on earlier input, anyone can put in something from scratch, though for good form you should probably phrase it as being a response to something already on the record.

There are three issues being canvassed, one big, one medium, one small.

The big one is potential reform of s36, the abuse of market power provision of the Act. In my opinion, and others', the thing is banjaxed. The law is poorly designed, has been interpreted strangely by the courts (both the old UK Privy Council and our newer Supreme Court), and in practice allows behaviour to go unchallenged that would not be countenanced in jurisdictions with better arrangements.

If all this is news to you, read the paper I gave at this year's NZ Association of Economists' conference, 'Abuse of market power: the end of "make-believe" analysis?'. If you'd like to see opinions saying no, everything's hunky-dory as it is, you'll find them in the original set of submissions to MBIE (try the law firms' ones). Whichever way you go on the issues, get your opinion on the record: these issues are too important to be left to 'the usual suspects'.

My cross-submission (I put in a submission first time round, too) is going to be along the general lines of my recent post on s36, 'The law is an ass', and will say:

• Our competition authority, the Commerce Commission, has given up on making the current regime work despite having identified instances where it thinks there have been potential abuses of market power that it is unable to address

• Its Aussie equivalent, the ACCC, agrees with it that our system is munted

• The law is poorly phrased in the first place

• Hence and otherwise the jurisprudence on s36 has seen the legislation effectively gutted in all but the most egregiously awful cases. In particular, courts are supposed to ask, would a firm without market power have done the same thing, and if so, the firm with market power is home free. This completely subverts the whole point, that some actions when undertaken by firms with market power have anti-competitive effects

• The Aussies have, rightly and after a very extensive consultation process, decided to change their law (it's currently similar to ours) for something better

• When the Aussies change, it will be silly and inefficient to have companies facing different legislative tests on either side of the Tasman, and we should harmonise on the better Aussie approach. Harmonisation is a government priority in any event

• The arguments against change - broadly in  the categories of 'business certainty' and 'potential chilling effects' - while valid, are not strong.

There are two other issues you might want to look at.

The medium sized one is whether someone - probably the Commerce Commission - should have the ability to go out and proactively look at the state of competition in a particular sector. The short answer to that, is yes, of course it should. If you want a very quick potted summary of the case for, try my post 'The case for market studies - again', and if you'd like something more comprehensive there's my paper at last year's NZAE conference, 'Is the competition toolkit missing its torch? The case for market studies'. 

The smaller one is around the Commerce Commission's enforcement powers, and especially the 'cease and desist' process. I'm very sympathetic to some kind of quick-response tool for competition authorities, but there are arguments that the current 'cease and desist' process isn't working the way it ought. This is probably one for the lawyers amongst you.

On your marks, get set...

The law is an ass

My paper, 'Abuse of market power: the end of "make-believe" analysis?', drew a good crowd at the NZ Association of Economists' annual conference. That's partly because people like to session-hop at conferences and listen to areas outside their usual specialty - a fair few in the audience were folks who don't usually 'do' competition - and partly, I'd guess, because people reckon it's an important policy issue: markets won't work as we'd want them to, if competition is subverted by players with market power.

From the discussion, it was clear that people were left shaking their heads at the folly of our statutory wording (in s36 of the Commerce Act) and its subsequent jurisprudence in the courts. Very briefly, the folly consists of:

• statutory wording that looks for a 'purpose' to knacker competition and the 'taking advantage' of market power, but
• 'purpose' is subjective (barring careless e-mail trails) and often business behaviour has multiple purposes, many benign, which can veil the bad stuff, while 
• 'taking advantage' has been interpreted by our courts as meaning you're home free if you've done something that a firm without market power would have done
• which completely misses the point that something done by a firm with market power can have very different effects than the same thing done by a firm without market power, and
• leads to an examination of what would have happened in a fantasy counterfactual world, and
• nowhere looks at the important issue of what are the actual or likely effects of the behaviour in the market, and
• Australia's just come to the view that their regime (very like ours) is not fit for purpose, and 
• in sum the whole shebang comes close to giving firms with market power a free pass on pretty much anything that isn't the most obvious of rorts.

But you knew that (and if you didn't, there's chapter and verse in the paper).

The reason I'm raising it again is that there's an opportunity for people who may be concerned about the current toothless (and internationally idiosyncratic) state of affairs to do something about it.

Last year, MBIE started a 'targeted review of the Commerce Act', which included looking at the operation of s36. An initial issues paper drew 39 submissions. But now there's an opportunity for cross-submissions: you don't have to be one of the original submitters to get into the fray. You have till July 21 to get any views you've got into the policy pot. Full details of the process thus far can be found here, including links to the previous submissions and the logistics of submitting your own.

I'd emphasise that this isn't an anti-big-business agenda. The primary point here is the proper functioning of markets, for everyone's benefit, businesses and consumers alike. The big loser from anti-competitive behaviour is often other businesses.

In any event, get your views on the record. If you're not in, you can't win.

What's happening at the petrol pump?

Petrol prices, and petrol profit margins, have been in the news. Labour, for example, wants an inquiry; ACT doesn't; and apparently the AA hasn't been happy about 'miserly' falls in local petrol prices as the world oil price has dropped sharply.

Much of the attention has been based on MBIE's weekly monitoring of 'importer margins', the 'importer margin' being "the margin available to the retailers to cover domestic transportation, distribution and retailing costs, and profit margins". Here's the latest picture, for regular petrol.

As you can see, the importer margin looks to have been climbing over the past two years, from an average of around 24 cents a litre to about 32.5 cents/litre, and on the face of it the rise looks rather dubious: it's doubtful that domestic transportation, distribution and retailing costs have increased much in our low inflation economy, which means the only moving part left is wider profit margins.

I don't know that I'm personally quite there yet with the wider profit margin story, though. For one thing the prices at the pump as measured by MBIE don't reflect the discount you get at the supermarket, and I strongly suspect that those discounts have been rising. For ages our standard supermarket discount used to be 4 cents; then 6, 10 and even 20 cent discounts started popping up (tied to spend); and every other day my phone beeps at me with offers from the petrol companies themselves (the latest was a Caltex Black Caps 10 cents promo on Saturday, which I used). If everyone uses discounts - and they must have become pretty extensive by now - and the typical discount has gone from 4 to 10 cents as (perhaps for valid strategic or tactical marketing reasons) petrol companies have elected to pass on lower costs via coupons and discounts rather than as outright cuts to the pump price you see at the side of the road, then you could arguably explain away a good chunk of the apparent 8.5 cent rise in margins. It's possible too that currency hedging might have produced a higher landed cost for oil than the unhedged estimated price MBIE uses.

If, however, subsequent inquiry shows that the higher importer margin is real, and does not have an arguably competitive explanation, what if anything should be done?

One thing you might be tempted to reach for is some sort of control on the size of retail markups. As a recent paper*, 'The Impact of Maximum Markup Regulation on Prices' (here as a pdf) has said, they have a clear logic: a maximum markup will catch the most egregious profiteers, who will be forced to lower prices, but won't affect those who were able to get by on a lower one.

Or that's the theory, in any event. But when the researchers looked at what had actually happened in Greece when the Greeks did away with the maximum markups wholesalers and retailers could charge on fruit and vegetables, they found that retail fruit and veg prices went down - the opposite of what you'd have expected when the constraints were removed. And by sizeable amounts: the authors found that retail prices dropped by 6-9%. Using the 6% number, the decline "corresponds to a 1 percent decrease in the price of food of a typical Greek household, and a 0.16 percent decrease in the consumer price index. This in turn corresponds to a decrease of €23 in expenditure per capita per year, amounting to €256 million [NZ$380 million] per year in aggregate (about 0.12 percent of GDP)".

Retail prices went down because wholesale prices had gone down, and wholesale prices had gone down because the regulated markups took away "focal points for coordination". You can imagine the discussion in the taverna around the corner from the Athens Central Wholesale Market: "So. Any of us could add on 12%, eh?" "Yup". Thoughtful silence. "Another retsina, anyone?" "Don't mind if I do. Cheers, lads".

There are wider lessons here beyond the price of artichokes in Athens. The big one is that the first best solution to excessive profits is likely to be more competition: in Greece, the wholesale market was "a closed market in which only licensed sellers can operate" and one that had "several features... that make it more prone to collusion (centralized physical arrangement, barriers to entry, limited number of large competitors, daily interaction)". Deal to that, and you're well on your way. And secondly, and relatedly, don't be too quick to reach for a big knobbly stick if you do go the regulation route: the authors say that their work fits with a lot of other work showing that "heavy regulation is generally associated with greater inefficiency and poor economic outcomes". If you're going to regulate, be as smart and light-handed about it as you can.

*It's in an excellent series of discussion papers published by the Centre for Economic Performance at the LSE. The Centre takes an interdisciplinary approach to "the determinants of economic performance at the level of the company, the nation and the global economy", and their output is always interesting. I know, another source of discussion papers will be overload for some - you can already spend too much time at SSRN or at the IZA - but if you've got the time, have a look. Well worthwhile.

Another quiz

The Herald's Viva magazine this morning had a round-up on the past year's restaurant scene, 'The Year in Food: What we loved and loathed in 2013'. It's a good article, even if I disagree on the attraction of communal tables in restaurants. And 'raw' cooking, if it comes to that.

It also provided the opportunity for another quiz, so here it is.

Context (quote from the Viva article):

"Failed restaurants ... yes, we love a new restaurant as much as the next person but if the council keeps granting permission, without a massive influx of people to Auckland to support them, expect to see some close. Better planning please".

Q1 What happens when supply of a service is restricted?
A Prices go up
B Choice goes down
C Potentially better providers get shut out
D Businesses unproductively invest in the approval process
E Incumbents get an unfair advantage
F The planning process gives market power to functionaries, who may abuse it
G All of the above
H Consumers benefit

Q2 Is keeping every incumbent business going a good aim of public policy?
A No
B No
C Both of the above

Q3 Why should new restaurants, or any other licit business, have to get local authority planning approval?
A Buggered if I know
B Sounds daft
C Mostly A
D Mostly B

Make some time for this essay

If you're like me, the disks arrive with the latest issues of the American Economic Review, the Journal of Economic Literature, the Journal of Economic Perspectives, and you say to yourself, I really must sit down some evening and work my way through them. But things interrupt, time goes by, and life is what happens to us while we are making other plans.

But if you are minded to catch up with at least one of the recent articles, make it this one - Timothy Besley's essay, "What’s the Good of the Market? An Essay on Michael Sandel’s What Money Can’t Buy", in this June's issue of the Journal of Economic Literature (Journal of Economic Literature 2013, 51(2), 478–495, http://dx.doi.org/10.1257/jel.51.2.478). And you'll also need to pop out to the library or a bookstore for Sandel's book, if you haven't read it already.

You may well have - it created quite a stir when it came out, and it deservedly got a good reception pretty much everywhere, including from Besley in this essay ("a great book and I recommend every economist to read it even though we are not really his target audience. The book is pitched at a much wider audience of concerned citizens"). And it was of course welcomed especially warmly in the sorts of places where markets tend to be scorned in the first place. John Lanchester for example praised it in the Guardian (saying that some might even have wanted a "more sweeping, angrier book, one that is more heated about the morally debased landscape brought to us by the ubiquity of market thinking"), as did John Gray in the New Statesman ("In a culture mesmerised by the market, Sandel’s is the indispensable voice of reason").

Sandel is an internationally respected political philosopher and a professor at Harvard. His book carries the sub-title, "The Moral Limits of Markets", which is his message in a nutshell. As Besley summarises it in the JEL essay (p483), Sandel makes two main points. "First, there is an objection to market outcomes based on fairness. This is partly the standard observation that inequality in market choice is a reflection of underlying inequalities in purchasing power". And "Second, there is the corruption / degradation objection to the use of markets. This is the view that trading in markets can lead to valuable attitudes and norms being damaged or dissolved. So WMCB argues that “markets are not mere mechanisms; they embody certain values. And sometimes, market values crowd out nonmarket norms worth caring about”".

It's that second point that seems to have got most coverage, and it's an interesting one. It's the point that caught my attention, too. I have to confess that I'm a bit of a book-reading tragic, and keep a spreadsheet of books I've read and my comments on them: Sandel, I thought, made a good case that "commercialising some things changes their character for the worse, something you should think about before setting out to create markets in them or create incentives for their use". I didn't necessarily agree that there are many real-life examples that fitted the bill, but I can see the point.

Besley's essay is a terrific resource from many perspectives - it is an excellent survey of where economics has got to with its thinking about markets, as well as a thought-provoking engagement with Sandel's arguments - and I'll leave it to you to work your way through it without much further editorialising.

I will add a few observations, though.

I agree with one of Besley's conclusions, namely that Sandel does not appear to have a good answer to the question, (as Besley puts it, p489), "What are the alternatives to using the market?...If there are problems with using markets to allocate goods, then ultimately we have to say what we should do about it". And I'd just point to the quotes from Yarrow and Wheelan that I've got in the 'Welcome to my blog' sidebar.

And I was also rather baffled by the mugging that Sandel and his reviewers gave to viatical insurance, described as follows in the Guardian review: "These were insurance policies that had been taken out earlier in their lives by people who were dying of Aids. The life insurance policies of these dying patients were valuable – so a market developed in which these policies were bought by investors, who would give the Aids sufferer a lump sum and would pay for their care during the terminal illness. Then, when the patient died, the policy would pay out: kerching!"

I appreciate that this may, to some people, look a bit macabre. But for the life of me I can't see what's morally, or any other way, wrong with this market. Quite the reverse: it seems to me to be a rare example of a Pareto optimal outcome, where two groups are clearly better off (the dying people who get care they wouldn't otherwise have had, and investors, who get another option for their consideration), one group is completely unaffected (the insurance companies, who will pay out what they were always up for anyway), and nobody (that I can see) is worse off.

And I was sorry the section of the essay on "Economic Perspectives on the Achievement of Markets" (pp484 et seq) didn't give Walras at least a passing mention. I don't know what economics students get taught these days about general equilibrium, but in my undergraduate days we got a decent blast of Walras' imagined omniscient auctioneer, conducting auctions in all the markets of the economy, nudging prices up where supply was short of demand, nudging prices down where demand was short of supply, and through this 'tâtonnement' (groping) signalling and coordinating an entire economy towards an efficient equilibrium. They say there are mathematicians who weep at the beauty of the binomial theorem: I still get the same sense of awe at Walras' model.

Revealed preference

Despite TV2's programming schedule, which is strong evidence the other way, I'm generally inclined to believe that people aren't stupid, and I'm correspondingly inclined to believe that there are fewer markets than you might think where consumers are, supposedly, unable to spot or judge quality differences.

I'm not saying that there aren't any markets where people can't be sure in advance of the quality or features of the good or service that they are contemplating buying, and I'm not saying that we shouldn't use appropriate mechanisms (such as occupational licensing, or information disclosure regulation) in those cases to help deal with what could be a potential issue of market 'failure'. Of course there are, and of course we should.

But the more I observe how people actually behave when buying supposedly 'hard to tell what you're getting' stuff like medical care or an education, the more I'm leaning towards the view that people can make quite a good practical fist of judging quality, that 'market failure' on this score is less significant than you might think, and that there is a stronger case for letting markets do their job and a weaker case for non-market mechanisms.

Earlier I posted about the latest heavy duty research on US charter schools. Consider this quote from the Executive Summary (p8): "Charter school students now comprise more than four percent of the total public school population in the United States, a proportion that continues to grow every year. There are estimated to be over 6,000 charter schools serving about 2.3 million students in the current 2012-2013 school year. This represents an 80 percent increase in the number of students enrolled in charter schools since CREDO released its first report on charter school performance in 2009, Multiple Choice: Charter School Performance in 16 States".

What this says to me is that very large numbers of parents and students in the US (and the equally large numbers of families in Sweden and the UK who have been queueing to get into new private schools there, too) are capable of spotting differences in educational quality - indeed, capable of spotting quite small differences in quality (at least in the US), and acting on them. To think otherwise is to argue that 2.3 million American students and their families are systematically deluded, and on a matter that is of high priority to them.

I very much doubt that, not least because Word Gets Round. People can generally judge whether they or their neighbours have had a good outcome, and they adjust their behaviour accordingly. As one big study of offering more choice in the UK health system unsurprisingly found, when given a menu of hospitals to choose from, "A patient with a bad experience of their local hospital was much more likely to choose a non-local provider compared with someone who had a positive experience at their local hospital" (p65 of the report). People also use workably effective rules of thumb as guides: as the same report noted (p93), patients rated facilities on three big criteria, "cleanliness, quality of care and the standard of facilities", with cleanliness apparently being not only valued for its own sake but also being used by patients as a rough and ready way of steering themselves away from hospitals with high infection rates from the likes of "superbugs".

And people share their experiences, good and bad. I've swapped notes with others about our eye cataract operations, like (I'd guess) every other parent in New Zealand I've discussed the local schools and local teachers with other parents, and I'm a member of the support organisation for people who've been through through the barrel of laughs that is an acoustic neuroma. Do we have useful ideas to share about what worked or didn't? You betcha.

It is of course true that what many professional services provide is multifaceted, and not easily reducible to a single criterion of better or worse. And it is easy to take the next step and say that only the professional gatekeepers can make a good job of telling good from bad, and that consumers don't (or will never) have the information or analytical nous they need to be able to make socially effective decisions, and that markets can't therefore be the way to allocate things.

But that can be a step too far. The marketplace of consumer revealed preference may often need a bit of supplementary regulatory or supervisory assistance to work well: fair enough. But personally I'm becoming more impressed by the growing evidence that in many markets people are adequately capable of sorting the good from the bad.