Tuesday, 27 October 2009

A bottled water frenzy

The Grauniad appears to have saved the day again by quickly alerting us hoi polloi to the imminent danger/disaster/apocalypse into which we were plummetting. This final warning on the complete depletion of Adelaide's water supply seems to have done the trick:


You will recall that last month Adelaide had but one week's supply of water left before emergency bottled supplies would need to be shipped in. It seems that the local population has been extra busy, by pouring the emergency bottled supplies directly into the drinking water reservoirs, which have increased from 90% of capacity to 93% capacity.

Apocalypse averted. Keep up the good work guys.

Wednesday, 21 October 2009

NAMA. "It's about getting liquidity flowing"

I was in Cork yesterday attending the Chamber of Commerce conference there. One phrase that was oft repeated was that we needed to "get the liquidity flowing from banks again". That doesn't really make a lot of sense from an economics point of view. Liquidity in the strict sense of the banking system related to the workings of the money market; being that market for short-term lending (under 30 days by general convention). This is dominated by banks that use it balance their immediate needs for funds - say to fund withdrawals of deposits.

But I think what everyone meant was that they didn't think that banks were lending large enough sum to enough companies - my general impression was that this included any company that wanted/needed it.

A couple of observations on that line of thinking that seems to be too prevalent and, in my opinion, likely to meet a sudden stop against the cold hard facade of reality.

Firstly and briefly, should banks be lending? No. Banks should be managing risk. If a loan, line of credit or overdraft does not make commercial sense from a risk and expected return basis, it should not lend.

Secondly, what is likely to happen when the Irish banks wend their way to the ECB and exchange their NAMA bonds for some freshly minted Euros? As some commentators have already indicated, the likely outcome is that they will pay down some of their liabilities. They will shrink their balance sheets.

Why would they do this? Simple. Because their balance sheets are too large. Don't tell me you have forgotten already how we came to be in this mess? Let me remind you. We (the collective people of Ireland) borrowed until we had put into hock virtually all our future income earning potential. And then we borrowed some more. That, dear readers was the expansion of the balance sheets of Irish banks.

And flowing directly from that, we have our present economic obstacle. Too much debt - synonymously bank balance sheet are too large.

And flowing from that is the unavoidable economic correction that needs to take place. A contraction in the balance sheets of Irish banks.

The following things will cause this to happen:
  • Writing off bad debt/defaulting on some liabilities starting from the top and moving down the capital structure (e.g. shareholders' equity, unsecured bond holders etc.).
  • Use any excess liquid assets (thank you NAMA/ECB) to retire short-term laibilities

The following things would not allow this to happen:

  • Increased growth in lending

And are you curious about how big the balance sheets of Irish financial institutions became of recent years? Here is a handy comparison. The UK is considered one of the more leveraged countries in the world. Total assets held against residents (i.e. outstanding lending to UK residents) reached 1.9 times annual GNP at the end of 2008. The equivalent for Ireland was around 2.5 times annual GNP. For the US the ratio is about 0.6.

People really need to be told. There is too much debt, which means banks will be taking every opportunity to shrink their balance sheets. That means no free money.

Need credit? State owned enterprises to the rescue

An interesting announcement yesterday. Bord Gais, the state owned gas monopoly, have announced that they are moving into the market to provide a wide range of consumer energy related services. Not only will they supply you with gas, but they will sell you all manner of insulation, heating and associated services.

All very good, thinking at the margin and employing their core comparative advantage (direct access to households) to their strategic corporate gain. Let's leave aside concern about market power that one might have (they might easily throw other suppliers out of the market due to their size, brought by their state enshrined monopoly in gas supply, or their very favourable access to capital markets as a state owned monopoly utility). No, what I am thinking about is the way they are going to allow customers to pay for such big-ticket capital expenditures.

It is the intention of the Bord Gais that customers will be able to "pay via their gas bill". That is just another way of saying that Bord Gais will extend credit to allow customers to undertake expenditure. No need to borrow from a bank (that has quite rightly tightened up its lending criteria). Bord Gais will, in the words of their CEO John Mullins at the Cork Chamber of Commerce yesterday, let customers have it "on the never-never".

There seems to be a general clamour for banks to open up the taps to all comers. The Irish government is happy to play along. I find this a curious development in such a context. With credit comes euphoria, if only for a short time until the never-never arrives for payment.

Tuesday, 20 October 2009

How are the recapitilisation plans going boys?

One thing that gets pushed off the front pages during the NAMA debate is the fundamental question of how and by how much Irish banks will recapitalise themselves.

So far we know:
  • The banks were insolvent, regardless of fiction that appeared in company accounts
  • The Banks are unloading 77bn of assets on their balance sheet in exchange for 54bn in sovereign paper (and then on to cash via the ECB Refi window).
So how big is the capital hole, how is it going to be filled and by whom? Plans really should be afoot now, but I have not seen so much as a rumour appearing in the press.

Monday, 19 October 2009

Associated loans - what the hell are they?

Yes, NAMA again.

This question has been keeping me awake at night. The Draft Business Plan for NAMA identifies 36% of loans to be bought as being "associated loans", without any clear explanation of what that might mean. The Department of Finance is only marginally more enlightening with this:
Associated loans will be those loans which are not in the land and development category but which are held by individuals/companies that also have land and development exposures or the borrower may be a systemic risk to the financial system. Associated loans will take account of cross collateralisation and other associated loan exposures of borrowers.
which is pretty much what one would have guessed, but gets us little closer to the purpose for which these funds were advanced and to whom.

I have been searching for more detail, but have found nothing. And in the absence of facts the imagination runs riot. Are they unsecured? Do they represent advances to insolvent creditors (like rolled up interest for example)? I don't know, but would sure like to know.

I think we, as taxpayers, have over 27 billion good reasons why we should be told a bit more about this.

Friday, 16 October 2009

NAMA - how much write-down?

One for the greatest unknowns about the NAMA escapade is the proportion of loans that will be recovered by this newly conceived Naughty Bank (increasingly naughty by the day). Under the Plan, the loans to be acquired will have a nominal value of €77bn and will be purchased by John Q Taxpayer for €54bn. The Draft Business Plan for NAMA assumes that €62bn of the €77bn will be reapid - an 80% recovery rate. 62 is greater than 54, brilliant, we're laughin'. Let's just ignore for the moment the matter of interest on this €77bn pile of debt, which is a tidy sum itself, which may or may not be paid.

Now, you may have read in the press that NAMA is going to make us taxpayers a tidy €5.5bn in profits. That of course depends on the ability to recover from the various borrowers 80% of what they borrowed. If we get only 70% paid back, that is €7.7bn lost and there goes the profits and up go the taxes. Not much wriggle room in those assumptions, I think you will agree. I wonder what type of robust analysis has been done to arrive at the 80% recovery assumption. How certain can we be that it will be achieved. Well, here it is:

"Over a five year period in the early 1990s, one UK bank experienced a default rate of less than 10% on its whole book. Given the concentrated nature of the prospective NAMA portfolio and the risk of a prolonged recession, a 20% default rate assumption has been made."

Looks impressive, doesn't it? We have found out via Karl Whelan at irisheconomy.ie that this "one UK Bank" was in fact Barclays. So let's have a little gander at Barclay's accounts.

In the five years between 1990 and 1994 inclusive Barclays recorded realised losses on write-offs of £7.0 bn. At the start of 1990 Barclays had a total loan book of £77.7bn. Now what I am about to do is a massive fudge, as it assumes that all the write downs occurred on loans on the balance sheet at the start of 1990. But I am writing this on the hoof and in the spirit of NAMA I don't think it appropriate to get to pernickety about precision.

Barclays realised default rate was 7/77.7 = 10% near enough for any Naughty Bank.

Excellent. This seem quite robust then. But, just for fun, let's dig a fraction deeper. Let's look at the type of loans NAMA is taking on. This is taken from the Draft Business Plan again and is a broad breakdown by borrower:

Doesn't look great to me. Lent to people to develop property assets, to buy land to develop property assets and to buy things associated with buying land and developing property assets.

I think we can safely say that there is a comprehensive diversification of exposure right across the property development/construction sector of the Irish economy. It is the contention of the government that this Naughty Bank will recover all but 20% of lending from this portfolio of loans.

Now let's look what Barclays did in 1990:

Yes. Do you see that pale blue slice around 6 o'clock. That is the amount that Barclay's accounts for 1990 identify as being to customers in "property and construction". The rest is spread all over the place (what were these guys thinking?????).

Do you want to see where the UK economy generated its income around 1990? Here is a breakdown of Gross Value Added by sector. Not directly comparable, but the best I could do on my budget (45 minute lunch break):

Note that I have taken out the public sector as best I could. Also note, that I have built in a novel "Individual" sector; this doesn't exist of course, but I need some device to compare with Barclays lending. I could have allocated that lending across the Barclays book - and maybe should have, but the affect on what this data is telling us should be the same.

Now look at those two compared. The proportion of Barclays loan book exposed to any sector minus the size of that sector in the economy by income).

It looks like this:

You can see the affect of my fudge. It assumes that Barclays exposure to individuals was neutral on a sectoral basis (i.e. it wasn't all to people in finance for example). You can also see the overweight and underweight position of Barclays' loan book. A maximum exposure of around 10% to broad sector. Underweight manufacturing and finance and overweight services and property and construction.

That isn't too bad I would suggest, when you compare with NAMA, which is 100% overweight property and construction.

Now, this data isn't particularly robust. But it is certainly more detailed than that revealed in the NAMA draft Business Plan, which is a type of finger in the air exercise. But I think it tends to suggest that if Barclays managed to confine their losses to 10% of their loan book with a good amount of diversification, then NAMA will have one hell of a time trying to confine its losses to 20%. Even 30% seems a bit racy to me.

You can make up you own mind. Then cross your fingers. That is what the architects of this seem to be doing.

Tuesday, 13 October 2009

Water charges - some political slight of hand

I blogged about water charges a little while back. I don't think they make sense in the form of water metering in Ireland.

Now those Red-Green (does that make purple?) political advocates for around 2% of the electorate are proposing a flat rate household water charge. All my points about water as a scarce resource in Ireland still apply. Little reason to set the marginal price of water above zero.

What I want to highlight here is this bit:
"Charging for water in every house was agreed by the government parties, at the Greens' behest, as a way to reduce waste and fund local government."
Do these people really think the electorate are that stupid that they think they are presently getting water for "free"?

This is ludicrous beyond belief. The overwhelming majority of houses in Ireland have mains water. This makes a flat rate household charge a type of "poll tax" - although levied per household rather than per head.

It is also coming on top of the tax paid that presently funds water catchment, storage, distribution, treatment and maintenance. This is more tax on top of the tax that currently goes towards paying for our mains water.

Is a little bit of honesty too much to ask. Even if you are purple?

Negative equity - what to do?

Negative equity is back in the headlines in Ireland again over the last couple of days. Here is a paper from the ESRI on this issue released this week.

Negative equity is when people pay too much to capitalise their future housing costs. This can be because:
  • They over estimate the likely rate of increase in real rents, or
  • Under-estimate the discount rate over the long term.
In Ireland, it is likely to be a function of both. People were expecting low interest rates over a long time that would, by the miracle of compound interest, make future rental payments very high in today's money. This is the fallacy of the "affordability" approach to property. Low short-term interest rates certainly make it easy to finance a variable mortgage, but to work out the price of a house you need to consider what interest rates will be in 5, 10, 15, 20, 25 and sometimes 30 to 40 years time.

When you get a decision like this wrong, by that I mean the decision to buy a very long series of cash flows (when you buy a house you a buying a lifetime of market rents), the ramifications are significant. Small changes in the actual increase in real rentals, or changes in expected interest rates will cause a large change in the capital value - i.e. the price of the house. A bond trader knows this. House buyers should also.

So Ireland now finds itself in a position where too large a proportion of the population got caught "on the wrong side of the trade". And they have a capital loss. What are the potential implications for the economy?
  • The loss in wealth. Those people with no debt against their homes have suffered little. They were perfectly hedged - they had enough capital to finance their future rental costs and they still do. Those with mortgages have suffered because they were geared. They never had sufficient capital to pay for their future rental costs, they borrowed to do that and paid to much.
  • The loss in mobility. This occurs geographically and demographically. Growing families need more room. Unemployed people need to go to where the work is. And people get together and separate.
  • Lack of well functioning property market. People in negative equity can not sell their house for less than the mortgage. It is a legal impossibility unless the lender agrees to it. And no lender is willing to agree to it on this scale (size of potential shortfalls and number of borrowers affected). That means there is a significant proportion of the housing stock that has a an artificial price floor. The market wants to adjust to lower prices (there is excess supply), but sellers are not free to drop prices as far as they need to clear the market.
Those are the big ones. So what can be done? About the first, nothing in aggregate. You could transfer wealth from those not affected (the sensible/prudent) to those who have suffered loss. The loss hasn't vanished, it has just been redistributed. Would that be sensible? I would be most concerned about the clear message that sends to people making decisions in the future - don't worry about the risk. That is the "moral hazard" problem. So I think it a bad idea. People made a decision, a bad financial one and lost. It happens all the time. They can work hard and rebuild. It will be better for everyone in the long run if they do that.

What about the second. This is tricky. The benefits of mobility are not explicit. It is no doubt important that people are able to change their circumstances, but how important is not really quantifiable. Qualitatively, I would say it is pretty important.

The final point is perhaps the most transparently important one. Ireland is in for a long period of real house price deflation if nominal prices have a floor under them due to the extent and size of the negative equity problem. Like he removal of a band aid, getting you pain in one short burst is usually the best. So it is with prices. Just ask the Japanese.

Thinking about those points on balance, my default position is typically that public policy has a limited role. People need to save their way back to solvency.

However, I am ready to be convinced that there is a social and economic benefit to finding a way to facilitate a much faster resolution to the negative equity problem, due to the mobility and price adjustment issues, but would object to a policy based on wealth transfer.

On that basis I would strictly oppose some of the following, which are all a variation on a theme of wealth transfer:
  • Debt forgiveness
  • Government subsidies
  • Any public funded sale and lease-back type agreements

So what would I propose? I would suggest a government financed unsecured loan, to the value of the negative equity. This would have the following characteristics:

  • It would be a charge against the owner logged against their tax number by the Revenue.
  • Recovery would come in the form of a levy on all income (say 5%, but could be more) through the tax system, until the debt is repaid.
  • Interest would be charged at long term fixed rate at a modest premium to the current 30 year government bond yield.
  • Repayment in full could be made at any time without penalty.
  • An optional charge on the estate at death could also be include to strengthen the recovery.

That type of arrangement would keep the proper incentives in place:

  • You would still want to get the best price possible for your house.
  • You would not be getting a bail out, helping to mitigate against moral hazard problems.
  • It would allow more efficient adjustment in the property market, by allowing losses to be crystallised by sellers at price buyers are willing to pay.
  • Tax payers would not be bailing anyone out, although more public debt is required in the short to medium-term.
  • With the correct interest rate, this could self financing - noting that some people will never repay all of their debt in their lifetime.

Monday, 12 October 2009

Green tax proposals

The Green party are using their NAMA brought political leverage to play in Ireland by extracting some concessions out of the senior coalition partners. Natural, being Green, these are of a particularly Red hue.

One change was lifting the ceiling on PRSI, which was in fact raised not long ago. Since I ran some analysis of Irish marginal and average effective tax rate recently, I thought I would update the charts. I have had to assume that lifting the PRSI ceiling will not come with a revision of the "health levy" that applies to high incomes. Otherwise it wouldn't make much sense to do it in the first place. By removing the ceiling on PRSI, you would increase the marginal rate of tax by 4% on all income over €75,000 approximately. The implications are illustrated in the chart below.

Ireland already has very high marginal rates of tax applying very low down the income scale. This will reinforce that general approach. A 54% marginal rate of tax would apply before you hit twice the median earnings. and 56% would be incurred further up the income scale. This is an implicit statement from the Greens (and to be fair most of the Irish political industry) about who they believe have the primary rights over the market value of your time and expertise.

It isn't you. It's them.

The average rates that would take effect are illustrated below. Ireland's tax structure is already punitively progressive in my opinion. This is another notch on the ratchet of a couple of percent. Given that the massive open pit mine that is Ireland's public finances, I anticipate that we will be seeing more of this type of shift; a couple of percent here, a couple of percent there.

Thursday, 8 October 2009

What I hate about climate "debate"

In a word. Strawmen. Making up a statement or claim by an opponent so you can knock it down. One which is a popular target for "debunking" is a strawman that a climate scientist (specialising in oceanography) and contributor to the IPCC, Mojib Latif, was now forecasting a decade or two of falling average global temperatures. The usual suspects and others are no all abuzz pointing out how Mojib Latif has not made any such predictions.

Let's get one thing straight first. There appears to be different reporting of Latif's comments in the media and across the interwebby. Some indeed suggesting that he made a "prediction" of cooling. I am happy enough that he did not make a prediction, but made a hypothetical along the lines; "if there was a cooling, and I don't think that is impossible".

A journalist called George Will is a particular target of this manufactured argument. He is thoroughly disliked by a large proportion of the Dangerous Climate Change lobby because he takes an opposing view. How distasteful. But regardless of whether Mojib was making prediction of or not, this was never the issue. Look at what George will wrote. Verbatim:

The Times says "a short-term trend gives ammunition to skeptics of climate change." Actually, what makes skeptics skeptical is the accumulating evidence that theories predicting catastrophe from man-made climate change are impervious to evidence. The theories are unfalsifiable, at least in the "short run." And the "short run" is defined as however many decades must pass until the evidence begins to fit the hypotheses.

George Will

Cooling Down the Cassandras

This isn't written in ancient sanskrit. It is pretty plain English. The point is not what anyone is or is not forecasing - including Mojib Latif - but the apparent impossibility that any data might falisfy the DCC hypothesis. It clearly says what skeptics have difficulty with is the way nothing (even a hypothetical two decades of cooling) would still not falsify a theory of global warming.

That is what skeptics are getting increasingly frustrated with. The proponents of the DCC hypothesis would advance their standing in the eyes of skeptics immeasurably if they began drawing some clear lines in the sand, which if they are truly scientists they should do. Does Latif imply that no amount of cooling would falisify the DCC hypothesis? His quote doesn't say that wouldn't be they case, he just leaves it at "cooling would not falsify".

My question for any such climate scientists would be; what outcomes or data are you looking for that would falsify parts of the DCC hypothesis?

An answer of "none", leaves me in no doubt that we aren't talking science. And that is the answer skeptics are getting at the moment.

Wednesday, 7 October 2009

The "demise of the Dollar" - what it's really about

I posted yesterday about this buzz doing the rounds. I didn't know at the time, but it was Chinese whispers (pun intended) started by Robert Fisk. Enough said.

But that doesn't mean that some of the facts reported could be correct and most probably are. Various oil exporting countries like Iran, Venezuela and developing economies such as Russia and China have almost certainly been thinking about the Dollar for some time. However, not for the reason and economic ramifications that the widespread reports all declare.

I dealt with the issue of the ramification of changing commodity pricing to a different numeraire. Here I will discuss what is the more likely reason behind the supposed deliberations about the role of the Dollar in international markets.

The background to this is exchange rate regimes. Every geographical region - not necessarily defined by sovereign national boundaries but usually so - has over time developed a currency to aid in the exchange of goods and services, the accounting of prices and values and as a way to store value. Those are the three primary function of money:
  • a unit of account
  • a medium of exchange
  • a store of value

These work fine within the regions in which they operate, but hit a road block when one currency region wants to exchange goods or services with another. Hence we need some exchange rate that will price one currency relative to another. This can be set by decree against some durable globally traded item (fixed to gold for example), or against the currency of another region or a basket of such currencies (fixed against the US Dollar for example), or left for the market to price it freely (a "floating" exchange rate). Note that there are all sorts of varieties of fixed rates with names likes "pegs", "crawling pegs", "currency boards" and others, but they are variations of a theme only.

Some floaters include the Australian Dollar, Sterling, Euro, the US Dollar. Some fixed rates include China, Iran, Venezuela, Russia, Saudi Arabia. Are you starting to see the pattern here? Well spotted. Those countries named as the ones colluding to bring the demise of the Dollar are those that fix their exchange rates to the Dollar. And this is what this story is really about.

This story is about the fact that these countries have tied their local currencies to the US Dollar, which means that they have effectively set the price of everything they produce (their income and output) to the price price of everything produced in the US, set in US Dollar prices. So if the US goes through an inflationary bubble and the price of things in US Dollars goes up, pressure will build in the country for prices to do the same thing, bringing in the first instance pressure on output (excess demand) and then inflation. That might seem confusing, but the simple point is that with a fixed exchange rate you will import inflation (or deflation) from the currency to which you are tied.

So it is with some of these countries. China in particular has been struggling with prices in Reminbi that have become out of kilter with the US. That means lots of demand for Chinese goods to be exported to the US. Current account surplus for China, deficit for the US. This brings pressure on Chinese productive potential, the economy is at full capacity and creates shortages and pressure for an increase in the price of these Chinese goods.

What is going on in the background is that this flow of demand for Chinese goods and services is creating a big demand for Chinese Reminbi in exchange for US Dollars at the fixed exchange rate. The Chinese government has agreed to give a fixed amount of Reminbi for each US Dollar and people are flocking to them in droves.

The Chinese authorities have two options.

  1. They keep selling the Reminbi to all comers at the fixed exchange rate. As they do this they accumulate more and more US Dollars, which they need to keep in the form of currency, deposits, bonds etc. This will mean there are more and more Remminbi out in the world looking for a home. That leads to Chinese prices rising - inflation. They try to sell some of the Reminbi for other currencies, but the Dollars are coming in thick and fast and it is a difficult task. Witness the recent Chinese spending spree around the world buying up all manner of foreign assets and interest. This is them trying to unload all these US Dollars. And more are coming in every day.
  2. The alternative is they "revalue" the exchange rate. Each Reminbi will now cost more Dollars in exchange. This chokes off the flow as it has increased the price of Chinese output relative to US output. It also relieves the Chinese economy of the inflationary pressures it was under. They might alternatively just let the currency float and allow the market to push the exchange rate where it will, most likely up in the first instance.

And this is what this story is all about. China in particular, but increasingly many oil producing nations since oil oil prices increased from the lows experienced over the entire 1990s, are following track #1. It is unsustainable as a policy, so they are being forced to consider #2. But there is a political problem with this. Having the exchange rate where it is, undervalued, is not healthy; the Chinese economy for instance is eroding under the inflationary pressures being put upon it the excessive growth that is occurring forcing much investment and expenditure that it might likely regret in years to come (the over-hyped expansion of a small number of urban areas for example). However, the Chinese government (and people to be honest) get a nationalistic pride out of a booming economy that is buying up foreign assets. That is not a criticism of the Chinese people, it is a common human trait. Anyone living in Ireland over the last 10 years will recognise instantly the swelling chests that come with an inflationary boom at home and the ability to stride foreign property markets like kings.

It is a familiar choice. Sensible economic policy, or populist sentiment and beliefs. The latter usually wins in the short term until the proverbial inevitably hits the fan. These countries have been dialling up the speed setting on their fans for a few years now and the projectiles are being stockpiled.

So Robert Fisk might have simply stumbled on the latest discussions about this problem, or this might be a straw in the wind indicating that the time of inevitable revaluation (or even currency float) for these countries is on the way.

That is a big story and an investment opportunity if you can find some cheap way to access it. Go long these mainly developing and OPEC currencies that are under pressure to revalue and short the US Dollar (the second part not necessary if you are US based already).

Tuesday, 6 October 2009

Trading oil in Dollars - who cares...

This story, sometimes appearing in different guises, always gets tongues wagging. The end of the Dollar, the decline of the US. This is BIG news.

No it isn't.

When we want buy something from someone else we need some way to put a price on it. We could say, for example "this car will cost you 50 goats". No reason why we couldn't. The most astute readers will spot some potential problems with such an arrangement; for those buyers who don't own a herd of goats it will be difficult to properly assess exactly how much of your wealth such a purchase will require. How much other stuff, like housing, food, holidays etc. today and in the future will you have to forgo in order to buy this new car?

Follow this up with a couple of questions. Does the simple act of stating the price of the car in goats mean that:

  1. The seller will takes goats and nothing else in payment?
  2. If you don't currently have any goats you won't be able to buy the car, or it might cost you more than if you did have 50 of the critters munching on your front lawn?
  3. The seller is strictly demanding goats in payment (#1) so that they can be added to the ever growing flock in the paddock around the back of the car dealership?

Are we going to get any arguments if I suggest the answers to those questions are:

  1. No,
  2. No and
  3. No?


So what's the fuss about oil (or any commodity for that matter) and Dollars, or Yen, or Euros? We price stuff using some historical convention because it is convenient and communicates a lot of information to the largest number of people. Trading a global commodity sold and bought by everyone around the world is far easier when we talk the same financial language and the US Dollar has been the lingua franca of the industrial age. I can immediately compare the price of oil being sold out of Venezuela with the price of oil being sold out of Kuwait, make any adjustments I need to for differences in composition or quality and transport and know where the best deal is. That is why we use a single currency as a numeraire - which is nothing more than an accepted unit of measure. Sure, goats might make a better numeraire for a Tibetan goatherd, but the world has just naturally come to use Dollars.

But of course I am missing the point aren't I. There will be no need for Dollars any more. People won't want them. Really? Did you think about the questions I posed earlier? Saudis, Venezuelans, Iranians don't sit around thinking "damn, what can I do with all these Dollars I am getting?". They either buy US Dollar assets with them (anything from US government bonds, to real estate or equities or simply cash stuffed under the Persian rug), or they sell them to someone else so they can buy Euro government bonds, Chinese real estate or whatever.

Take the buy side. People aren't sitting on piles of US Dollars simply to buy oil. They trade what ever currency they hold to buy US Dollars (assuming that settlement is in fact in Dollars and not some other currency).

But what about currency risk you ask? If that is of concern, you hedge the currency. Changing the numeraire won't alter the economic implications of exchange rate movements. A 20% appreciation of the US Dollar (with oil price in Dollars) will bring the same affects as a 20% depreciation in the Euro (with oil priced in Euros). In both cases oil will become more expensive for some, in this example Eurozone buyers, relative to others, US buyers.

So, any change to a new numeraire for oil will not bring any earth shattering implications for the global economy. Nor will it happen at the whim of a group of people who think it matters and will try and enforce such a shift - those efforts will fail if buyers and sellers don't find it convenient. It won't be some catalyst to a dumping of US Dollar assets - this would have been done already if people didn't like US Dollar assets.

What it might do is:

  • Reduce the trade in US Dollar foreign exchange markets a little. But hardly to the extent that it would have any implications for spreads or liquidity
  • Reduce the seinorage that the US enjoys. This is the interest free loan that the US gets when someone holds some of their currency. This isn't a lot in the scheme of things at the moment and for reasons discussed above, changing the numeraire for oil trading is unlikely to dramatically reduce foreign holdings of US currency.

No. This story is just another round of penis comparison geopolitics. I fully expect that one day the Reminbi is very likely to become the global financial and trade numeraire. Nobody will need to legislate it, it will just happen over time. It will make nobody worse off and nobody better off, but simply change the language in which we talk numbers.

UPDATE: Just goes to show how poorly this blog is read. I have amended the incorrect reference to "Yen".

Monday, 5 October 2009

Talking taxes

Income taxes that is.

Deep recessions following boomy booms almost invariable entail nice big fat public deficits. What usually happens has now happened again; our elected public representatives fool themselves into thinking that the tax revenue windfall associated with a monetary bubble are genuine, when in fact they are transient. When economies correct, the fact that politic ans have been spending far beyond the country's (i.e. tax payers') means is revealed and large deficits appear.

The economic concept is that governments may have been running significant cyclically adjusted deficits. Simply, the public balance (tax less spending) adjusted for economic output above (or below) its long run potential may be quite different to headline numbers.

And when we get deficits like this, tax rates are in the firing line. The UK Chancellor has announced a nice juicy new 50% top marginal tax rate (up from 40%). Ireland is incurring a raft of new taxes levied on income. The US is threatened with similar. The affect in Ireland is quite phenomenal, talking from personal experience. What, I would argues, is an extremely unbalanced income tax regime, raising the massive majority of incomes tax from a narrow band of earners, is becoming almost unbearable.

Consequently, I thought I might look at how Ireland's income tax system sits relative to others.

What follows is a brief look at some of the marginal and effective average tax rates that apply to Ireland and compared with the US and UK. This is only one abbreviated way to look at the data, given the fact that their is an almost infinite number of ways to cut things, given that most regimes treat different people in different ways for tax purposes (married versus single for example). But what follows looks at rates that apply to single earners and ignore any manner of tax concession that might apply. I would suggest that the extent to which different classes of tax payers receive significantly different treatment represents a failing on the part of a tax system.

Here is exhibit #1. Marginal rates that apply, including national insurance contributions in Ireland and the UK. Note for the US, these are Federal rates only, so they are good for Texas for example.

The X axis is local currency units, £, $ and €. Ireland starts with low marginal rates kicking in at relatively high minimum earnings levels. The US has low rates throughout, but more grades. The UK has higher rates kicking in lower down the earning scale. Both the UK and Ireland have much higher top marginal rates that take affect much earlier than in the US.

Also note some of the quirks. Irish (and UK) tax rates jump to very high levels very quickly. 50% of marginal income going in tax is a lot. Beyond that the government is effectively saying there is some income over which you don't have the right to keep even half. Note the spike in the UK marginal rate, which is an artifact of National Insurance rates hitting a ceiling.

While these lines appear on the same chart, they are not of much use for cross country comparison. We need some way to compare different income levels across countries. The way I propose to do that is to adjust the scale to a common currency (Euros), using a Purchasing Power Parity rate of exchange. I have used consumer expenditure PPPs and I lift these from the OECD and the most recent data is for 2007. If we do that we can compare $ and £ to Euros on the basis that we have tried to adjust the numeraire to a basis of common purchasing power.

If we do that the chart looks like this:

I have added some vertical lines to denote where Irish median (and 150% and 200%) earnings fall.

What you first notice is the shift in the lines. The top rate of tax in Ireland clearly begins to bite at a much lower level of income than in the UK. In fact it kicks in at the median earnings - so by definition half the income earners in the country should pay some tax at this rate of 50%. Let's now compute what this would imply for average rates of tax paid across the earnings scale:

Now this is the money shot, so to speak. This is the average rate of tax that would be paid under the marginal rates shown above. Here are some of the striking characterstics of the Irish structure, especially compared with the US and UK:

  • There is no tax paid until someone earns at least 50% of median earnings. Not even a token 5%, that might encourage some sense of social contribution.
  • By the time someone earns the median wage (nearly €38,000 per annum), they will pay less than 15% in tax. Note that this is before any types of legal tax avoidance measures that are available.
  • Beyond the median, income tax burdens rise at a dramatic rate. at 150% of the median you will pay around 25% of you earnings in tax.
  • The pace of increase slows only marginally beyond that and at a mere 200% of median earning it has increased to 33% of earnings in tax. That means someone earning twice the median earnings (€75,000) pays nearly 5 times as much tax as someone on median earnings.

Now personally, I would favour something more in the style of the US. It is progressive, in that the higher your earnings, the higher the proportion you pay in tax. But it is not massively progressive as evident in Ireland.

Secondly, A larger proportion of earners pay something and something material relative to everyone else. Low to median earners might pay 5-10% of their income in tax, compared with 20-25% for those on 2 or 3 times median.

One thing is clear from this. Ireland is no "low tax" country.

Thursday, 1 October 2009

Tax Commission report – congestion charges

Economists just love congestion charging. Academic economists I mean. It pushes all the hot buttons for them. A widely accepted source of “market failure” (negative externalities), loads of primary data collection and analysis, scope to play with prices and estimate demand curves in a real life situation. It is one of the very few areas where economists can play at being real scientists, with experiments and stuff, like.

I tend not to like them so much. Not in theory, that is pretty sound in an abstract way. But in the practice. It turns out if you really dig into this, congestion charging in most standard real world conditions is wasteful, produces an inefficient allocation of resources, opens up potential inequities (in particular regressive ones that punish lower income groups) and creates a dead loss to society in terms of welfare (I mean like making everyone pay up some money only to put it in a pile and burn it).

Let’s start with the theory. We tend to get more efficient allocation of scarce resources when there are clear and transparent prices that incorporate all costs of production. That way, people only do something if the price is less than or equal to the utility (pleasure, sustenance etc.) they derive from it. It means resources don’t get wasted where they aren’t really needed or wanted.

The concept of “externalities” in economics was identified some time ago. These externalities can be positive or negative if they impose a benefit or a cost on someone else. A lighthouse has positive externalities, while a cigarette being smoked in a confined place has negative externalities (cough, cough). The issue at hand here is negative externalities. The concept is that in the act of doing something, or consuming something I impose a cost on others. The theoretical economic framework for this is that the marginal social cost exceeds the marginal price I pay. Consider this. I drive to work at 8am and base my decision on how much petrol and wear and tear etc. on my car will cost me for the journey. I do not consider in my decision the inconvenience that my presence on the road might cause others (the congestion effect). So I base my decision on a price, but the price I am paying is less than the marginal cost. That means I am doing too much of it. Well, not me specifically, but those people for whom the price is only just worth paying. If you made them pay more, they would not drive and hence reduce the congestion affect that have on others.

The problem with the use of this type of analysis in support of a congestion charge is that it ignores a fundamental characteristic of congestion costs; they are perfectly reciprocal. What do I mean by that? I mean any costs you impose on others bounce back in equal measure to you from them. Just think about it. If my decision to drive to work at 8am has the affect of increasing the journey time of every other person on the road at that time (say 10,000 of them) by 0.1 seconds. So the total cost I impose on others is 10,000 times 0.1 seconds = 17 minutes of total lost time. But everyone else is equally guilty and each of my commuting buddies impose the same cost of 0.1 seconds of increased journey time on me. So I suffer a 10,000x0.1 = 17 minutes extra commuting time.

So, although I am indeed imposing an external cost on others, they are imposing an identical cost on me. Perfect symmetry and most importantly perfect information for me to make my decision.

When deciding whether to drive to work at 8am in the morning I am not expecting a clear road. I know I am going to suffer congestion costs. And I have an excellent idea of precisely how much they will be. And I don’t think that makes me particularly clever, everyone else will have the same information. So if I drive I am doing so on the basis that it will cost me an extra 17 minutes in travel time, which is exactly the same as the external costs I will impose.

All this means that there is no place for policy intervention. I am making an efficient decision that reflects all costs, including the external ones. To place a congestion charge on my journey would create an inefficiency, not address one.
A nice analogy is a “smokers’ room”. Smoking in an office would create external costs that fall on others. But if you have a smokers’ room where people can go to smoke you will instantly internalise the externality in the same way that road congestion does. Everybody in the room is there of their own volition, knowing that they will have to put up with the inconvenience of other people’s smoke. The only real issue is who pays for the smokers’ room. As long as the smokers pay for it, maybe on an entry fee basis, everything is efficient and equitable. Road users are similar in this way. The more you drive and the more congestion you sit in, the more tax you pay on the petrol you burn – hence paying for the road system on which you sit.

Instead, with a congestion charge, we layer even more cost to monitor and account and administer the scheme, we prevent people from driving as much as they would like (even after correctly pricing the cost of congestion they impose) and underutilise the roads that we spend a lot of money to build. This creates a dead loss to society.

So congestion charging is typically inefficient and an abominably poor application of economic theory.

But what about equity issues? These are usually brushed under the table a little when it comes to congestion charges. But consider for a moment the range of people you might see sitting in that rush hour traffic jam. They will range from shop assistants and nurses, to bankers and company CEOs. Now think about how they price their time. People in lower paid jobs would typical value money over time (it is an awful expression, but their time is cheap, so to speak). For high flyers, the opposite is true. So if you introduce a congestion charge you are actually setting a price for time, because that is where congestion has its economic affect. And who suffers most? Those who would rather spend an extra 30 minutes getting to work than have to pay €10 in a congestion charge; the lower paid. This makes a congestion charge regressive as it favours those who place a higher value on their time, which is invariably those on higher incomes. Think of the case of Michael O’Leary who went to the expense of buying a taxi licence so he could drive in bus lanes and beat congestion. A hypothetical congestion charge of €50 per day would delight Michael O'Leary and increase his welfare, but would be detrimental to someone struggling by on a below average wage.

So all in all, congestion charges are a bad idea, creating economic inefficiency, regressive welfare affects and a financial and social dead loss.