How Labor’s new budget is going to reduce our surplus

Today I will once again digress from our macroeconomic analysis for some opportunistic politician bashing. As July 1^st fast approaches, it’s becoming less and less likely that even our acrobatic Julia Gillard won’t be able to pull off the super backflip required to repeal the carbon tax. I was hoping I wouldn’t have to do this, but through some crafty economic graphing we can show you EXACTLY how the government is wasting your money. It’s not often that you can promise that. Once businesses have to pay a tax on their carbon emissions, they will inevitably raise their price to cover some of the cost. That’s not what this article is about. The government plans to use the money raised by the tax to reimburse households for the increase in prices that will occur, so it is often touted that overall, no one will suffer. This is of course rubbish and here’s why.

If you don’t like graphs and numbers don’t worry about the colourful pictures underneath. All that you really need to understand is that: the demand curve slopes downward (because as the price goes up, we as consumers tend to buy less of a good) and the supply curve slopes upward (because as the price goes up, those greedy producers tend to want to sell more). You can see from graph A that at $8.00, people will want to buy two cars ie two cars will be demanded, and further down the demand curve, if the price were only $6.00, four cars will be demanded. The supply curve in graph B works the same way but in reverse. At $5.60 suppliers will only want to sell 3.6 cars, but at $6.00 they will supply 4 cars. (note however that the three demand curves in the graphs A, B and C are all the same ie based on the same equation, and all three supply curves are based on the same equation). Of course only one price and quantity can arise in a market, and buyers and sellers get together and decide on the price that results on the same amount being supplied that is demanded. That price on our graph as you can see is $6.00, where four cars will be sold in our market.

What’s important to notice for the purpose of implementing a tax, is that some people would have bought a car even if the price of the car was $8.00, and those people have only had to pay $6.00. In fact, based on the demand equation used, if the price of a car were nine dollars, one car would still be bought, implying that one person values a car at nine dollars. If the price were eight dollars, two cars would have been bought. Yet all these people only had to pay $6.00. This excess of “value received’ over “amount paid” is called, oh yes; consumer surplus, and you can bet by the end of this article, I plan to convince you that labor’s carbon tax is gonna reduce it. One way to calculate consumer surplus is to work out at each price how many cars would be sold, and calculate how much extra value was received above the six dollar price that was paid. For example if the price were nine dollars, one car is sold (implying it was valued at nine dollars) and six dollars was paid for it, meaning an extra three dollars in consumer surplus was enjoyed. At eight dollars, one more car would be sold, meaning this car (valued at eight dollars) provided a consumer surplus of two dollars. Doing this for every price will allow you to calculate total surplus, however a better way is to calculate the area underneath the demand curve, but above the price. This is the green shaded area in Graph A, and is equal to $8.00 (the fact that this equals the $8.00 highlighted on the vertical axis is purely coincidental).

In graph B you’ll notice that even if cars were sold for only $5.60, producers of cars would still wish to sell 3.6 of them, yet at the market price they are able to receive $6.00 for each car. As you can see, these producers are receiving a producer surplus of forty cents. Producer surplus is worked out by calculating the area above the supply curve but underneath the price: the yellow area in Graph B, equal to $8.00.

One of the cool things about having studied economics is that you know the true “value” being traded in a market is not just the price of a good multiplied by how many are sold. It’s not gonna get you laid or anything, but it does gives you a useful tool for analysing the costs and benefits of a lot of government intervention. The effect of a tax is to put a wedge between the price that buyers pay and the price that sellers receive. The government pockets the difference.

Assume the government decides to put an eighty cent tax on every car sold. With a bit of algebra you can work out that, based on the demand and supply curves we used, the price that buyers pay will be $6.40, and the price that sellers receive after the tax is $5.60. 3.6 cars will be sold, and what you end up with is a pretty little picture that looks like a triangle house with elevator doors (in Graph C). At the higher price, less cars are demanded by consumers, and the lower price received by sellers (after paying the tax) means they wish to supply less cars. The resulting equilibrium in Graph C shows how consumer and producer surplus have both shrunk to $6.48. The grey area is represented by the tax collected by the government (eighty cents multiplied by 3.6 cars). The reduction in surplus results because at the higher price for consumers, some people won’t buy a car (and hence won’t have one), and at the lower price received by suppliers some won’t sell a car (and hence receive money for it). This area is highlighted in Graph C, in that most relevant of all colours, red. The total loss in surplus is equal to sixteen cents, or one percent.

Now we usually put up with some loss of surplus due to taxes because the money raised can be used to provide useful goods and services that the market generally won’t produce (roads, schools etc). However when all the government is planning to do is give the money back, the reduction in surplus is for nothing! This just goes to show that while in economics you can never get something for nothing, in politics you can have something taken away, and receive nothing in return. Such is the magic of government intervention.

So don’t let some polarised one minded labor lacky (and I know liberal has them too) tell you that just because the government is giving the money raised by the carbon tax back that no-one’s paying. We’re all paying. And that’s before you take into account the hundreds of thousands of dollars of administration costs wasted on operating a pointless tax. The next time they tell you how important it is to return to surplus, ask them: what about my surplus? And this is before you even begin to debate on whether or not this tax is necessary, but that’s an article for another day.

2012-13 Budget

Labor government

Consumer surplus

Producer surplus

Budget surplus

Can the Federal Reserve "Really" affect interest rates?

At the end of When is an Investment not an Investment I talked about the inevitable rise of real interest rates once the RBA has finished lowering them by printing money. It’s now time for a discussion on real and nominal variables. While this isn’t totally necessary to understand the next article, it does highlight an interesting anomaly: a lower interest rate at the bank shouldn’t necessarily induce anyone to borrow more.

In So what’s the best way to hedge against inflation? I talked about how nominal interest rates (the full interest rate quoted by banks) are made up of two components (check out paragraph three for a recap). The “expected inflation” component is simple enough to undertand, but businesses generally don’t care about this. Once you borrow money, inflation in a funny way is your friend (making Ben Bernanke your hero). Just as the dollars that Rob Mariano won in 2010 weren’t worth as much as the dollars his wife won six years earlier on Survivor, the dollars that businesses use to pay back their loans years later are not worth as much. To understand this abstract use of the term value think which dollars you rather have, the ones that Rob was given, or the ones that Amber was given six years earlier, that could buy more goods. Businesses that borrowed in 2004 got Amber’s dollars, and the banks that lent the money were getting Rob’s dollars back in 2011. So if the nominal interest rate rises (and hence your nominal borrowing costs rise) but expected inflation rises as well, they tend to cancel each other out, and the real cost of borrowing hasn’t changed. What’s left is the real interest rate that businesses need to be concerned about. This relationship holds virtually one to one. If the expected inflation rate falls by one percent, the nominal interest rate tends to falls by one percent, but businesses have no incentive to invest further, even though the nominal interest rate has fallen. In the long run lenders face the same trade off. If their inflation expectations rise they will be happy as long as nominal interest rates rise to compensate them (one percent higher inflation, one percent higher nominal interest rates). you can see that even though the nominal interest rate has changed, no one has borrowed more or saved more. The nominal interest rate is (approiximately) equal to the real interest rate plus inflation expectations.

Its only when that residual, the real interest rate, changes that there is an incentive to move money. This residual is simply determined by borrowers and sellers getting together and deciding on an interest rate in the market: it is determined by the demand for and supply of savings. It should be becoming clear now that it is not controlled by the central bank, at least in the long run. So what’s the best way to hedge against inflation explains how investors vote with their feet and determine interest rates. In the short run the RBA can print money and lower nominal rates as in The Wonderful Central Bank of Oz (which, holding all else equal lowers real rates) but rates will eventually rise back to their original level to maintain the real interest rate, and then a little bit more to compensate savers for the extra inflation from the additional money printing. The primary point to take away is that the real interest rate hasn’t changed.

This illustrates, and this is common, accepted, mainstream economics, that the reserve bank can only affect the real interest rate and borrowing in the short term. Any investment made at the lower interest rate thanks to the Central Bank will be unprofitable when things normalise.

Something's gotta give

China has chosen to widen the band on its Yuan exchange rate, starting today, allowing its currency to fluctuate a further one half of a percent either side of the peg. However most people can only see the Yuan appreciating. This makes our recent articles on the ballooning money supply of China, caused by its undervalued exchange rate, quite timely (that’s my version of a brag). Following China’s gradual easing of its capital controls, it was either going to have high inflation or a higher exchange rate. It also shows that china is not going to be bullied by anybody about its exchange rate. When the US was screaming the loudest about the Yuan being undervalued (which as we said causes large exports) China’s trade surplus was massive (when exports are larger than imports it’s called a trade surplus) boosting the economy along!  But the data of late on Chinese trade has shown a drop in exports! If China was going to bow to US pressure to raise its exchange rate, you’d think they would bow in the face of bullish economic data, not soft. What’s more, the soft trade surplus data has resulted in diminished outcries from the US. I think this is evidence that Yuan appreciation will never have anything to do with US tantrums (which will never be as scary to Hu Jintao as having the wrath of all China bearing down on him, but that’s an article for another day).

But we can think of some other reasons that China might want to raise its currency!

More on the business cycle soon. I haven’t forgetten.

When is an investment not an investment?

On Tuesday we talked about the loose monetary policy of theFederal Reserve and how it was propping up stock prices. This process falls under the term mal-investment in its simplest form. Mal- investment is a term developed in the Austrian school of economic thought. It simply refers to poor economic decisions being made by firms, and resources being allocated inefficiently to areas of the economy where prices would otherwise not send them. The Austrian business cycle predicts that the artificially low interests rates (the price of money) and government intervention give misleading price signals and result in money pouring into the wrong places, ultimately causing asset bubbles. It is a competing economic theory with the more mainstream neoclassic economics, which tends to believe that you can smoothly adjust monetary (central bank) and fiscal (government spending) policy to adjust the level of investment in the economy. With the booms and busts in the business cycle, you can’t help but wonder if they’re wrong.

The Austrian Business Cycle Theory predicts that when interest rates are lowered by a monetary authority for an extended period, businesses will borrow and overspend on capital goods in order to ramp up production (the credit expansion phase). The eventual end is that businesses have large loans which were used to purchase equipment which is not needed. The resulting default on these loans causes the contraction in credit and the ensuing chaos. The big problem with the Austrian Business Cycle Theory is that it doesn’t provide a very convincing reason why people would make these bad economic decisions. The sophistication of forecasting techniques and relative transparency of central banks lead me to believe that a recurring and erroneous overspend on capital goods by the whole business sector is unlikely. I believe booms and busts are more to do with the short term outlook of business, moral hazard, and an inability to comprehend a system as complex as a national, let alone global economy (although we do our best to make some sense of it here). However, whatever the reason for it, you can’t deny that “mal” or “bad” investment occurs. Did the economy really need 2 million houses in 2005? Did it really need a company called webvan.com so bad that it was worth 1.2 billion dollars? History suggests it didn’t. And yet these investments continue to go ahead, cycle after cycle.

The green shoots of the next cycle of mal-investment in its simplest form are occurring as investors are pushed out of bonds and into riskier investments like stocks as described in Economy doing too well. Stocks Slump. This is how bubbles begin. Initially, long term capital investments are too illiquid for businesses to be convinced to invest; a fund manager will invest in shares knowing that he can sell them at the push of a button, whereas a factory cannot be quickly sold before it drops in value when Bernanke announces a withdrawal of stimulus. However hold interest rates down long enough, and mal-investment eventually sprouts into more complex forms of investment as the boom cycle gains momentum, but with one thing in common: being inefficiently allocated, they are unlikely to make a sufficient return. The reserve bank can lower interest rates to make borrowing less expensive, but it can’t engineer profitable investment opportunities.

Mal-investment doesn’t just come from the private sector. Governments around the world have been “allocating” (blowing) cheap money to “inefficient projects” (cash for clunkers) like it’s going out of fashion. It is private sector mal-investment that is the primary concern though, as it has the ability to grow to epic proportions. Eventually enough printed money runs out of profitable avenues  for investment, and so it starts chasing bad ones. These bad investments are profitable when it costs 3% per year to borrow, but when rates inevitably rise the investments tank. Next article I plan to show exactly why reserve bank stimulus won’t help the economy.

Economy doing too well. Stocks slump.

On Monday night while everyone was peacefully sleeping (possibly on a mattress stuffed with money because they don’t trust the Bernanke fuelled financial system) the US markets did a peculiar thing. Good (or should I say improving) economic data from the United States has started to trickle out over the last eight months in the form of a slightly lower unemployment rate. The market marched steadily higher but then hit a roadblock. Then, on said Monday night, the inflation fairy Ben Bernanke commented on the frailty of this recovery in jobs, and the unchanged weak outlook for the US economy. Markets rallied. This is a prime example of the short term mindset of Wall Street traders driving prices.

The obvious question is why should stocks rally when the economic outlook is dire? The obvious answer is that there is no good, long term sustainable reason. However there is a short term, get rich quick, Ponzi scheme reason. And here it is. In The Wonderful Central Bank of Oz I outlined how Central banks like the RBA and the Federal Reserve manipulate interest rates by buying and selling bonds. In practise central banks only deal in government bonds when manipulating interest rates. However as interest rates on these bonds fall, holders find themselves less willing to hold them. They sell their government bonds and use the money to buy slightly riskier bonds. This higher demand for riskier bonds increases their price and lowers their interest rate. The price changes tend to ripple through all assets, until money flows into stocks, pushing up their price.

In theory this is how monetary policy spreads through the economy and affects interest rates, including the implied rate of return on stocks. As Ben Graham originally highlighted, this return is inversely related to price like all assets, but I digress. Traders and fund managers know this so as soon as they get a wiff of words like Quantitative easing they dive into the share market. A more realistic description of the same (monetary policy) process is that with interest rates at rock bottom levels traders can borrow money cheap and plow it into the stock market. Ben Bernanke wants this because it makes everyone feel richer. People who feel richer spend more, which will supposably kick start the economy. Ben Bernanke has promised the continuation of this cheap money until 2014. But what traders have been worried about up until Monday night is that if the economy improved too much, the proverbial punchbowl would be removed in the form of higher interest rates and less cheap money being printed. Traders are aware that without these low interest rates the market will fall and the economy wont be able to stand on its own two feet. However they will buy as long as the “hot” money is coming thick and fast and cheap from the "fed". They all think they’re smart enough to jump out before the drop. They can’t all be right. Bernanke’s less than stellar report on the economy has allayed their fears of stimulus withdrawal, and the market surges. Anyone who can’t get to sleep tonight click here for the same old scripted political drawl. This is classic short termism at its greediest, and the first sign of the “mal-investment” that begins every boom cycle. In the next article we’ll talk more about this term and see how we’re already stoking the next asset bubble before we’re even finished popping the last one.

What have China’s money supply and America’s money supply got in common?

At the end of What do Chinese economists and Rhianna’s feet have in common? we saw how China mops up extra money flowing into its country as the United States buys its goods. While this will reduce the money supply, we have learnt that it will also increase interest rates. Americans are currently getting around two percent on their saving deposits, but if they were to put it in a Chinese bank account they would get closer to seven or eight percent. Better yet, why not borrow money in America at rock bottom interest rates, exchange it to renminbi at a fixed unchanging rate, and put that money in a Chinese bank account. The continuation of this process will increase the money supply in China, and negate attempts by the Chinese government to reduce it. Up until recent years the Chinese have of course been wise to this “carry trade” (after all, this concept was foreseen by mundell and flemming in the 1970s) and have had tight “capital controls” over money flowing out of and into the country. However loosening of those controls means that as the Chinese central bank raises interest rates to "make way" for the American demand, "hot" investment money will flow in and interest rates will fall again, rendering null and void the attempt to curb inflation.

China’s economy is less than half the size of the United States as measured by income or GDP. However China’s money supply was measured in October to be a third larger than that of the United States in this article. As the US continues to depress its interest rates by printing money, the carry trade will flow into China and balloon their money supply, and the Chinese will have limited ability to contain the torrent.  This is the so called “impossible trinity” proposed as part of the Mundell –Flemming model. Of a fixed exchange rate, free capital flows, and control over the money supply, you can have any two, but you can’t have all three. And that’s why. An inflationary monetary policy in the US will translate to an inflationary monetary policy in China. So what have China’s money supply and America’s money supply got in common? Unfortunately for China’s money supply: Ben Bernanke.

What do Chinese economists and Rhianna’s feet have in common?

Trick question. Nothing.

Armed now with your newfound knowledge on interest rates and the money supply from The wonderful Central Bank of Oz it’s time to take it to the next level.

China has had its currency fixed to the US dollar more or less since 2004. The low value at which the renminbi is set makes renminbi cheap to buy for Americans, and hence Chinese goods are cheap to buy. A currency is said to be relatively cheap if you dont haveto part with much of your currency in order to get one unit of another. If the renminbi price of a Chinese good stays the same, then the less of your currency that you haveto give to get one unit of renminbi, the cheaper a good becomes. This process is described in slightly more in detail in Is the Australian economy “diseased?” This creates a large demand for Chinese goods from America. If this demand becomes great enough, it outstrips the Chinese manufacturing sector’s ability to produce (or supply) the goods, and prices begin to rise. This is the same effect described in Is gold a good hedge against inflation? except that the demand pull comes not from the domestic government printing money and spending it, but from Americans taking advantage of relatively cheap goods. As described in Is the Australian economy diseased? if the currency were floating and not fixed, the value of the renminbi would tend to rise as Americans scrambled to get their hands on it to buy cheap Chinese goods. The more expensive renminbi would make Chinese goods more expensive and the American demand would subside.

With the fixed exchange rate however, Americans can keep enjoying cheap goods indefinitely. But to stop the increased demand for renminbi from raising its price (and maintain the fixed "peg") the government must raise its supply. They print renminbi to give to Americans, which as we know results in inflation. But we also know the government can mop up this extra liquidity (cash) by selling bonds as we saw in The wonderful Central Bank of Oz , which is equivalent to raising interest rates. The other side of the "interest rate money supply coin" is that the Chinese are raising interest rates, to curb demand by the Chinese, to "make way" for the extra demand from Americans (who are not directly affected by the interest rate increase). But this works fine only while China has capital controls in place to stop money flowing into the country. The reduction in capital controls announced greatly dilutes China’s ability to reduce its money supply as we’ll see in the next article.