This puzzle-game is brilliant. Spare an hour for it.
Heading for parity?
Canadians celebrated when the Canadian dollar (“the loonie”) hit parity with the U.S. dollar in September last year. At the time, there was some speculation about whether the Australian dollar might follow suit. You’re going to see some more speculation over the next few days. Fundamentals aside, there are two main things that are serving to push the Australian dollar up: the resource boom in Australia and the spread in the interest rates between the two countries, and the latter of those is about to jump.
The US Federal Reserve cut interest rates by 75 basis points a week ago in a surprise, out-of-cycle move. Today they are expected to announce a further cut. Apparently the markets are predicting that there’s an 80% likelihood that it will be a further 50 basis point drop. Next week on the 5th of February, on the back of some truly disastrous inflation figures, the Reserve Bank of Australia will probably raise their rate by 25 basis points. That would be an enormous, 150-point increase in the spread in the space of just two weeks. On that basis, it’s not at all surprising that the markets are already pushing up the AUD.
Upgrading again
Clinton seeks what from a Florida win?
This article from the FT is pretty typical at the moment: “Clinton seeks profit from a Florida win”
[F]ollowing her heavy defeat to Barack Obama in South Carolina last weekend, Mrs Clinton hopes to derive favourable publicity from her expected victory in Florida’s straw poll on Tuesday.
Almost 400,000 Floridians have already cast postal votes in the Democratic race, even though all of the candidates stuck to their pledge not to campaign there or run local advertising [after Florida had all of its Democratic delegates stripped for bringing the date of its primary forward].
Mr Obama’s camp has accused Mrs Clinton of cynicism for signalling she will ask the party to restore Florida’s delegates to the convention. Florida would have more delegates than Iowa, New Hampshire, Nevada and South Carolina combined.
Why does everyone play this as Hillary the cynical and faintly desperate candidate backing down on her pledge? I understand why Obama’s staff are playing it that way, but why are the commentators agreeing with that view?
If she wins the nomination – and the best bet right now is that she will – then it will prove enormously valuable that she went to Florida, no matter whether their delegates get to vote for that nomination or not. If she hadn’t gone but still won the nomination, then come November the Republican candidate would be speaking endlessly about her absence in such a key state while waxing lyrical about the democratic right of people to have their say.
Whoever the Democratic front-runner was at this stage was always going to be forced to go to Florida because of the attention that the Republicans are giving to it. Hillary is simply making the most of it. Barack Obama, who is behind in both the primary polls and the betting markets in most of the super-Tuesday states, cannot afford to think of November yet; if he’s looking at anything past the 5th of February, I’d be stunned.
Abusing the welfare state
I graduated from my engineering degree in November of 1998. I already had a job lined up, which I was due to start on the 18th of January, 1999. I had a couple of months to kill and I decided to go on the dole. What I wanted to do was work in a book store, and I applied to some, but not before first applying for unemployment benefits.
The Work for the Dole scheme was up and running by that point, but since it only applied to people who had been receiving payments for over six months, it was never going to be a concern for me. If I remember correctly, I had to fill out a form every two weeks detailing which businesses I had contacted in my quest for work. I definitely remember realising that all I needed to do was open the Yellow Pages at a random page, call whomever my finger fell on and have a conversation like this:
Them: Good afternoon [I was an unemployed recently-ex-student, after all. You can’t expect me to get out of bed in the morning, can you?]. This is company XYZ. How may I help?
Me: Hi. Do you have any jobs going?
Them: Uhh, no.
Me: Okay. Thanks.
I could then list that company on my fortnightly form, safe in the knowledge that even if Centrelink did bother to check – and I seriously doubt that they ever did; I could have written that I applied to “Savage Henry’s discount rabbit stranglers” and they would have just filed it away – then I was covered.
That felt a bit too much like taking the piss though, so I made sure that my targets were legitimate. As I mentioned above, I mostly applied to book and map retailers. I never lied to Centrelink or to any of the places I applied to. I always admitted to everyone that I had a job lined up and only needed to fill in the two-month gap, but if the truth be told, I didn’t put much effort in either, except for a couple of early applications to places where I genuinely would have enjoyed working. It’s not that I was disheartened; just that I didn’t particularly care. I wasn’t desperate for the cash (although it was certainly handy) or a job (since I’d have to quit in a few weeks anyway). I was really only doing the dole thing to see what it was like and the answer was: boring, but easy.
I’ve never felt any guilt or shame at doing it and I don’t think that any of my friends at the time were judging me negatively for it. It was a little unorthodox, but just accepted. I’ve certainly paid a lot more in taxes since than I received on the dole or for my university education. Fast-forward to 2008 and I am thinking about the social acceptability of receiving welfare payments, both in Australia and abroad.
It may just be the stereotype, but I get the feeling that in continental Europe, both in 1998 and today, what I did would barely raise an eyebrow; that it would be completely accepted. In the U.S.A., on the other hand, I think that it would be regarded by many as a shameful thing to do and an abuse of federal money. In Australia and the UK, I’m not so sure. I suspect that the more “aspirant middle class” you are and the older you are, the more shameful it will seem. I have no idea if the age thing is because it’s a process that everybody goes through as they get older or if there’s been a genuine generational shift in attitudes.
Any thoughts?
Thinking on the margin: prostitution (UPDATED)
One of the most important ideas in economics is that people think and act on the margin. By that I mean that we make our decisions as if we were looking at the costs and benefits of just one more. Just one more slice of pizza. Just one more minute on the bike in the gym. Just one more share of some stock bought. If we reckon the benefits of that one more to be greater than the cost of it, irrespective of what has come before and what may come after, we’ll typically do it. The point is that we optimise, or at least act as though we optimise. We may only optimise locally instead of globally (that last slice of pizza may have seemed like a good idea at the time, but it’s not much good for my health in general), but it’s still what we do.
The idea is by no means unique to economics. There is, at the least, an entire branch of mathematics devoted to it. But economists just love to point out that optimisation – and, therefore, thinking on the margin – applies to human behaviour just as well as it does to equations on a blackboard, and that realisation can sometimes lead to surprising, even counter-intuitive observations with serious consequences for public policy.
As I’ve mentioned before (here and here), Steven Levitt and Sudhir Venkatesh are currently finishing a paper on street prostitution in Chicago. They were able to study the provision of prostitution services during a predictable demand shock and discovered that the supply of prostitution services is rather elastic: a 63% increase in quantity was associated with only a 30% increase in price. More importantly, that increase came on three margins: an increase in supply from existing prostitutes (who, on average, only work 13 hours a week), a temporary in-migration of prostitutes from other areas and the temporary entry into the market of women who are not ordinarily willing to perform sex acts for money. Levitt and Venkatesh estimate that 43 of the 63% increase in the number of tricks came from existing prostitutes in the area and the remaining 20 from the in-migrating prostitutes and the temporary market entrants.
That third margin bears highlighting. Typical thinking about the topic holds that the choice to become a prostitute, if it is a choice at all, is a discrete [update: I originally had “discreet”. It’s certainly that 🙂] one; that women and a very few men first choose – or are compelled – to be a prostitute and only then consider what money they might make. The idea that some women might choose to start or stop being a prostitute in the face of a ten, five or even one dollar an hour change in the money available doesn’t make sense in this thinking. I believe that the reason for this is founded in a moral abhorrence at the very idea of prostitution – the belief that in addition to any social or economic conditions faced by prostitutes, the act of prostitution itself is immoral. Since it has become au fait, among Western intelligentsia at least, to never accuse people of direct moral failure, it has also become the norm to conclude that all prostitutes were misled or forced into their position and thus need to be rescued. The terrible issue of people trafficking naturally lends support to this idea.
I do not want to belittle the tragedy and travesty that is people trafficking. It is a truly awful phenomenon and the fact that it exists at all, let alone in countries that are supposed to be based on freedom of the individual as a founding tenet, is abhorrent. It needs to be stamped out.
My concern is to highlight that not all prostitutes are forced into their profession. There really are women who, faced with an outside option of $7/hour, are not willing to be a prostitute for $25/hour, but are willing to do so for $35/hour. I have no doubt at all that – and this is important – the same statement would be true if you multiplied all of those figures by 10.
The upshot of this is that, slaves aside (and that’s what people trafficking is – slave trading), you cannot simply save or rescue a prostitute. It is not a problem, if you consider it one, to be tackled. It is not something that you solve, once and for all. Prostitutes are people like everyone else and like everyone else, they think on the margin and respond to incentives. If your concern is that prostitutes live in poverty, that they are compelled into their work by economic hardship, then you must work to improve their outside options. But at the same time, you should recognise that you will not be stopping prostitution from happening; you will simply be raising the minimum asking price. That will lower the quantity demanded, but it will never remove it altogether.
Update (5 April 2008):
See my new entry here. It would appear that maybe even the figures for human trafficking are overblown.
From marriage to trade with China
In another great example of bouncing topics around in the often-academic blogs, we have this:
Betsey Stevenson and Justin Wolfers wrote an article for Cato Unbound: “Marriage and the Market“. Here is a brief summary of their idea (the exact snippet chosen is stolen directly from Arnold Kling):
So what drives modern marriage? We believe that the answer lies in a shift from the family as a forum for shared production, to shared consumption…the key today is consumption complementarities – activities that are not only enjoyable, but are more enjoyable when shared with a spouse. We call this new model of sharing our lives “hedonic marriage”.
…Hedonic marriage is different from productive marriage. In a world of specialization, the old adage was that “opposites attract,” and it made sense for husband and wife to have different interests in different spheres of life. Today, it is more important that we share similar values, enjoy similar activities, and find each other intellectually stimulating. Hedonic marriage leads people to be more likely to marry someone of their similar age, educational background, and even occupation. As likes are increasingly marrying likes, it isn’t surprising that we see increasing political pressure to expand marriage to same-sex couples.
…the high divorce rates among those marrying in the 1970s reflected a transition, as many married the right partner for the old specialization model of marriage, only to find that pairing hopelessly inadequate in the modern hedonic marriage.
It produced a flurry of responses and reactions, but the chain I want to follow is this one:
- From The Economist’s in-house blogger(s): “The age of hedonic marriage“
- In turn, Bryan Caplan wondered: “How Can Guys Be So Lazy Around the House?“
- Megan McArdle took umbrage with Bryan’s views in: “Marriage minded“
- Finally, Tyler Cowen, who had already encouraged his readers to look at Betsey and Justin’s piece, reacted to Bryan and Megan with: “Bargaining theory“
Which finally brings me to why I wrote this entry. I love this sentence from Tyler:
Symbolic goods usually have marginal values higher than their marginal costs of production; Americans for instance love the idea of their flags but the cloth is pretty cheap, especially if it comes from China.
Brilliant. 🙂
Bankers’ pay
I’ve been meaning to read this piece by Martin Wolf (chief economics commentator for the Financial Times) for the last week. As it happens, it’s a “me too” response and a minor expansion to this brilliant piece by Raghuram Rajan (professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the IMF). I recommend reading both of them in full. Here are some cut-down snippets from Rajan’s efforts:
The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha.
…
[T]here are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. [e.g. Warren Buffet]
…
A second source of alpha is from … using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. [e.g. a venture capitalist]
…
A third source of alpha is financial entrepreneurship or engineering – creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.
…
How do untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.
…
True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.
Martin Wolf’s addition comes in like this:
By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.
We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).
Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.
Dani Rodrik has been noting for a while that Martin Wolf seems to be coming ’round to his point of view in economic development. I’ve seen the same thing and it’s great to see.
Biting off more than I can chew
Today I sat down with my supervisor, Professor Andrea Prat, to talk some more about my research ideas. I would have liked to speak with him more frequently over this year, but it turns out that teaching is taking more time than I anticipated, just as everyone warned me it would.
My ideas are a lot more fleshed-out than the vague arm-waving on my research page and Prof. Prat seemed excited at where they are going. That’s big in itself – when one of my friends here at LSE heard that he was going to be my supervisor he replied with: “Wow. He must have an IQ of, like, a million.” Not having great, gaping holes shot in my thoughts is a minor victory in itself. 🙂
I wasn’t planning on developing it fully for my research paper this year, but even on the area that I was thinking of doing, his unnerving comment was that it is probably still a bit too big an idea for this year.
Bugger.
Australia, you’re not as rich as you think you are
We’re covering this in my EC102 classes this week and I thought it interesting enough to share with a wider audience:
Looking at what goes into GDP is usually a pretty tedious affair, but the simplest way to think of it is like this: GDP is meant to represent the total value added. It is new work done; new stuff produced.
One upshot of this is that new houses are counted in GDP, while sales of existing houses are not. This is because sales of existing houses are just value transferred – an exchange of assets – and so don’t represent new effort. That’s not quite true. The real-estate agent fees and legal fees associated with the sale count, since they are new work done: they add new value by facilitating the trade.
Here’s a trick in looking at value added: we only need to look at the prices of final goods. This is because the price of the final good will represent the total value added along the entire production chain. The typical example of this used in introductory textbooks is bread:
| Who | Sells | Price | Value added |
| Farmer | Wheat | $0.10 | $0.10 |
| Miller | Flour | $0.20 | $0.10 |
| Baker | Bread | $0.45 | $0.15 |
| Supermarket | Packaged and convenient bread | $1.00 | $0.55 |
The price of the final good – packaged, convenient bread – is $1.00, which exactly equal to the sum of all the value added. So when the statisticians want to calculate a country’s GDP, they can ignore all the intermediate levels and just add up all the final goods that were produced.So what counts as a final good? Anything that gets sold to someone for consumption or investment. That might be to an individual, or to a private firm, or the government, or someone overseas. (Of course, since I buy both bread and flour from my supermarket, flour is sometimes an intermediate good and sometimes a final good; but it’s easy to tell which is which – flour sold by the supermarket is final, while flour sold by the miller is intermediate.)
Now consider a country that has a large natural resource sector. Australia is a great example. So are all the oil exporting countries. We’ll pick the mining of iron ore in Australia as an example. Just like with the wheat above, there is a whole range of production possibilities based on the iron ore. However, when it’s exported, the final good that gets counted from the point of view of the Australian economy is the iron ore in the ship as it sails off to another country.The mining companies are definitely adding value. They’ve got to find the stuff in the first place, dig it up, clean it a bit to get rid of the dirt, transport it to the coast and then ship it overseas. They’ve also got to maintain all their equipment and allow for the fact that they wear out over time. All of that is new effort. But the price that India or China pays for the ore is more than cost of doing all of that. A large fraction of the price they pay represents the market value of the underlying asset – the ore – itself. But since the mining company didn’t actually produce the ore, that part of the price shouldn’t really count in GDP, for the same reason that when existing houses are sold, only the agent and legal fees are counted. None of this is really news.
When natural-resource-based industries are only a small part of a country’s economy, there’s not too much distortion, so we tend not to worry about it. But when those industries represent a large share of the national income, then the overestimates can be significant. In Australia, mining represents about 6.7% of the national economy. A fair chunk of that will be “true” value added, but a large share of it is really just the transfer of assets. How much? Well, BHP currently has a Return on Equity of 49%, while the long-run, risk-free return on capital is more like 8-10%. So as a very rough guess, assuming that BHP is representative of the mining industry as a whole and that the mining industry is competitive, we might suggest that Australia’s “true” GDP is at least 39% * 6.7% = 2.6% smaller than we think it is.
Some people might at this point wonder about the farmer back in the bread example. What if the farmer who, like BHP, is taking something from the land, is actually only adding 60% of the value that we think she is? The answer lies in the fact that there is a large production chain that builds up from the farmer’s wheat. Even if we remove a large fraction of the farmer’s value-added, that is only a small share of the total value added that we see in the final good’s price. So we would expect this overestimate to be very small overall. The point about mining is that we are only adding a small amount of value relative to that of the asset we are trading away, so as a percentage of the final good, the asset itself is quite large.