Matt Nolan

OCR review preview

/4 Comments/in /by

The October official cash rate review will be on the 25th October.

The main points that will be driving RBNZ policy are:

  1. Strong economic growth (including revisions) in the June year.
  2. The surprising strength in the export industry, even before the TOT shock has fully eventuated
  3. A weak CPI reading, however many of the shocks driving down the number where one-off and so will be over-looked
  4. Credit market uncertainty and the volatility of the dollar
  5. Weakness in the housing market – Potential weakness in domestic demand

It seems more than likely that the RBNZ will keep rates steady. Any cuts would be irresponsible in the current climate, while a rate rise would seem heavy-handed given weakness in some domestic indicators. The probability of a hike is greater than the probability of a cut, given underlying inflationary pressure.

Matt Nolan

Banning fossil fuel plants

/in , , /by

The government has decided to ban the construction of new fossil fuel plants for the next 10 years, as they believe that they are unnecessary.   However, I feel that this policy is unnecessary.

I do believe that if we left power generation to the free market, too much CO2 would be produced, and our liability under the Kyoto protocol would be ‘too high’.  But wasn’t that why the government introduced a carbon trading scheme?

In economics terms, the externality from fossil fuel plants is greater than the externality from Hydro, or wind power generation.  The government can try to fix this externality by putting an externality charge on unit production (which is what a tax or a carbon trading scheme does) or by directly regulating the industry.  As the carbon trading scheme is coming into place, the firm producing the power will have to pay the full social cost of producing the power.  In this case, if the firm still decides to build a coal power plant instead of a wind farm, it must be because the full social cost of the coal plant is lower than the full social cost of the wind farm.  As a result, banning the construction of fossil fuel plants seems unnecessary, as in this example, society is better off with this coal plant than with the wind farm.

jamesz

Too much of a good thing?

/5 Comments/in /by

My attention has been drawn (thanks Paul) to an article which describes how one might find the optimal number of members of parliament in a representative democracy.

In a nutshell, a parliament with too few representatives is not “democratic” enough, possibly leading to an unstable political system, in which various undesirable forms of political expression, including of course violent ones, will develop. In contrast, too many representatives entail substantial direct and indirect social costs, they tend to vote too many acts, interfere too much with the operation of markets, increase red tape and create many opportunities for influence, rent-seeking activities and corruption.

In their paper the authors derive a formula in which the optimal number of representatives is approximately proportional to the square root of the population of the country.

They test their formula against the data and find that Israel, New Zealand, the Netherlands and the USA have far too few representatives. I’m not sure how this correlates with their predictions about the instability of under-represented democracies: all four countries are very stable, non-violent democracies as far as I’m aware. I don’t have access to the CEPR paper but I’d be curious as to whether they address this issue. Their model makes some predictions which are easily falsifiable and I’d like to know how it stacks up against the evidence.

jamesz

Economists tackle ‘the surge’

/1 Comment/in , /by

Economists like to claim that their discipline is about providing tools for analysis, not answers to ready-made problems. OK, so they’re hardly alone in that but Dani Rodrik links an interesting paper by Michael Greenstone that walks the walk. Greenstone

…shows how data from world financial markets can be used to shed light on the central question of whether the Surge has increased or diminished the prospect of today’s Iraq surviving into the future. In particular, I examine the price of Iraqi state bonds, which the Iraqi government is currently servicing, on world financial markets. After the Surge, there was a sharp decline in the price of those bonds, relative to alternative bonds. This decline signals a 40% increase in the market’s expectation that Iraq will default. This finding suggests that, to date, the Surge is failing to pave the way toward a stable Iraq and may in fact be undermining it.

I really like how he uses modern economic and econometric techniques to tackle important public policy issues. However, we shouldn’t rely too heavily on the wisdom of the market in evaluating the effectiveness of the surge. While the aggregation of information that occurs in market pricing might be a better indicator than anecdotal evidence, ‘The Market’ doesn’t have superpowers that grant it access to information nobody else has. Many of the decision makers in that market likely have little more access to information about the surge than you or I. Aggregation tends to dampen the influence of extreme views but it doesn’t guarantee accuracy.

jamesz

Risky regulation in the dairy industry

/1 Comment/in , /by

An article on Stuff reports that the government is choosing to do nothing about a potentially dangerous protein found in most milk produced by NZ cows. Apparently it would be very damaging to the NZ dairy industry to act on the rather uncertain scientific evidence, so the Food Safety Authority is downplaying the situation. The nutrition expert who wrote a report for the NZFSA says, “it does raise the whole question about how well… the question of uncertainty is dealt with by the authority” and partially attributes the problem to “government risk aversion com[ing] into play.” Risk aversion is well known to economists and is exhibited by most people; however, the government here is not exhibiting risk aversion at all.

What the government is doing is avoiding certain costs in favour of maintaining the dairy industry’s profits with a huge cloud of uncertainty sitting over them. Doing something about the protein now would be costly but would avoid any future risk of adverse scientific results hurting our exports. Doing nothing exposes the industry to the entire risk of such results. Why would the government act in such an apparently risk-seeking fashion? The answer comes from the field of behavioural economics and, in particular, prospect theory.

This theory was proposed by Daniel Kahneman and Amos Tversky to explain two observations pertinent to the NZFSA’s actions: loss aversion and risk seeking behaviour for losses. Loss aversion describes how people feel the pain of a loss far more keenly than the happiness of a gain of equal size. Tversky and Kahneman also found that, while people are risk averse for gains, they are risk seeking for losses. They will be willing to take huge risks in an attempt to avoid making any sort of loss. Taking these factors in to account perfectly explains the NZFSA’s behaviour: they are more than willing to take on the risk of future damage to NZ’s dairy industry in order to avoid the guaranteed losses of taking action now. Whether this is in the best interests of the country or the dairy is quite another matter as the comments in the article make clear.

Matt Nolan

The rational Chimpanzee

/9 Comments/in , /by

So according to a recent study, Chimpanzees play the ultimatum game more ‘rationally’ than humans (hat tip Marginal Revolution).

For those who don’t know, the ultimatum game goes like this. There are two players, and a sum of money that can be split between them (say $1). The first player gives decides on how this dollar should be divided between the two of them. Given this division the second player decides whether to accept this division or reject it. If the second player accepts they divide the dollar, if the second player rejects the offer they both get nothing.

If both players only value the amount of money they get then the first player will set up the division so they give player two only an infinitesimally small amount. However, when humans play the game we find that they divide the dollar up quite evenly. Furthermore, we find that when people divide the dollar up very unevenly, the offer is rejected, even though that means player two misses out on some money.

When they say that Chimps play a more rational game than humans, they mean that chimps behave in the way closer to what we would expect if the agents involved only valued money. All this really tells us is that humans value concepts like fairness at a higher rate than chimps do. Hardly a surprising result.

However, this does make a good point for economists to take on board. Humans obviously do value fairness,. Part of this is instinct, and part of this is institutional. By institutional, I mean that it is a preference we have developed as a result of the society we live in. Although economists are happy to abstract from ideas like this, when we apply economic theory it is important not to forget about the social norms that people also value.

But more importantly, the social norms that are created through the application of economic ideas may eventually change the preferences of the individuals in society. Fairness is useful as it helps reinforce co-operation in situations where a prisoners dilemma occurs. If analysts introduce policy that undermines fairness, or in some way degrades the social norm of fairness, then the socially optimal co-operative result becomes more difficult to achieve. Even more fundamentally, how does the change in preferences influence the way individuals value things, could the loss of fairness as a social norm leave people feeling more upset ceteris paribus? I think this is what sociologists have been telling economists for a while.

Ultimately, I accept the idea that social norms are important in determining preferences, but academic economists have good reason for not looking at them. Academic economists want to focus on thing they feel that they can objectively measure, so that their work does not become value laden. Defining preferences is not value neutral, and so is steered away from in academic work (except maybe in Evolutionary game theory? Not that I would know 😉 ). However, economists that want to apply their ideas to reality must realise that societies affect on preferences is non-trival. This makes the questions of how a given policy will impact on preferences more difficult.