The Great Lolly Scramble

For those not in New Zealand a lolly scramble comes at the end of the party when you throw heaps of sweets amongst the children and watch them go beserk. Of course once they have gorged themselves they fall in a heap as the sugar high follows by a big crash.

What we are seeing in the global markets is nothing short of a major fiasco. Banks wont lend to each other so the central banks have flooded the market with cash.

Come and get it they say. This is now starting to get silly.  They were at it again last night as well. When is it going to end?

Goldman Sachs came in with a $3bln bailout for a fund last night as well talking the deal up as a winner. Well of course there will always be distressed sellers in a credit crunch. We’ve seen it here in New Zealand with finance companies going bust with alarming regularity over the last couple of years.

The problem is that we haven’t even started to see the real pain. The real economy is quite strong globally as the spin offs from the asset price boom feeds through in consumption. But how long is that going to last. In New Zealand we are seeing housing activity level off and prices come off the top. Today we saw weak retail sales.

What I observe here is that many properties remain unsold as people will not take lower prices. This is not reflected in the data. Many properties are withdrawn unsold or just sit around in the hope some mug will pay up for them.

So at the moment we are in the distressed phase of the market sell down. People who have to sell must sell and we are starting to see that. The question is whether it slowly spirals out in the main market. We are clearly at a turning point in the economic cycle. Years of asset price increases, consumption driven higher on the back of that wealth effect, central banks with no control over the money supply, late to raise rates, now hammering rates rises home as prices peak, people locked in at high prices and high rates, wages and labour very tight………it’s a recipe for recession.

This is why the central bankers are still talking tough on inflation. They don’t want to start talking in worrying terms in case they “cause” a slowdown.

So expect the lolly scramble to continue.

But there will be a price to pay afterwards.

The True Cost of Energy

The energy debate continues to go in circles. Usually its starts with the renewable sector heavyweights: wind and solar. The free and usually reliable inputs of wind and sun are very attractive. The technology is improving and, in the case of solar energy, the transmission mechanism is close at hand.

One company in the US has actually started a rental program for solar heating. I like this idea because capital cost is a problem for many people. Energy as a service is a good business model.

Solar is a great option because you can localise it. Hopefully the technology will continue t to improve.

Wind has its drawbacks due to the requirements of location and serious land mass. But again it suits some places better than others. But how about small wind turbines on every roof?

Little and often i say. Every little bit counts.

Biomass is the latest technology on the block, a small step up from chucking wood in the burner which is very popular and cheap in New Zealand. We can grow a lot of wood down here. The biomass and biofuel solution reveal a problem in our approach.

It doesn’t have to be one or the other. It can be both/and. It’s clear now there is no one solution that is way better than another. Let the market continue to work it out. And this brings me to the main point which is that we must have a properly priced energy market.

This is going to require a major change. I have long banged on about pricing in environmental costs at source and whilst Trucost is doing great work in that area there is a long way to go.

So how could this work? Well here are a few examples:

Carbon

Let’s say we have established a price for “carbon”,this being a proxy for externalities caused in the combustion of fossil fuels. The most efficient way to alert the market to this cost is to price it in at source ie where the fossil fuel is sold wholesale. This would be the global oil, gas or coal exchanges.

In my paper, Climate Control, i argued for the establishment of a World Energy Agency, where all fossil fuels were sold through. Simply add on the price of carbon and leave it at that. As a one point global process it would be very simple and then that price information would flow out across the world. End of story.

But there are two issues here:

One is that we are trying to stop carbon quantities breaching certain levels. The price elasticity of fossil fuel consumption may hinder this somewhat as consumers of oil products are slow to change demand in response to price.

The second issue is interesting. What happens to that money? Who does it belong to? As a charge being levied by the WEA it has no soveriegn recipient. So i propose this “charge” goes into a Global Environmental Contingency Fund (GECF). I want to make clear this is not a tax, it is a cost. It is therefore directly related to an expense which is in this case the use or environmental services.

Let’s stop using the word tax. It’s incorrect and draws attention from the fact that we are simply paying for a service we are using.

So how could the GECF work? I have to give that some more thought but the rough idea is that it would hold those funds in bonds (sovereign) or could lend them out at low interest to fund projects that have a positive environmental benefit. This is the tricky bit. But let’s sit with the first piece. The money comes in and sits in bonds. That’s it. So it’s not being spent on projects of a dubious outcome. As the title implies its a Contingency Fund. We don’t know for sure what will happen in the future. The money can be repaid if required by discounting the price of fossil fuels if it turns out that the cost has turned out to be lower.

It’s a hard one to get right on  a global level but worth a look.

Agriculture

In New Zealand we have trouble with dairy farming, a highly profitable business which has seen huge swathes of land converted from other activities to supporting cows. The externalities of this business are numerous but center around water pollution through fertilizer run off into streams and down into the water table as well as cows crapping all over the place..oh yes and the methane burps.

Here it would be simpler. A charge would be applied per head of cattle and immediately be applied to cleaning up that pollution at source. Why should the taxpayer pick up this tab. Its a cost for the consumer to bear and if the consumer doesn’t like the slightly higher price then the producer will quickly alter his habits.

The moral of this  story is simple: We need to know the true cost of our global economic activity. Then as consumers we can respond appropriately.

Trying to say which energy source is better than another is simply guesswork.

Monetary Policy 101: time for a rewrite?

Local government rates go up followed by interest rates.

Energy prices go up followed by interest rates.

So people are made worse off by increases in prices for goods and services that they cannot easily deflect or cut back on. That’s hard.

But wait there’s more, like a boxer climbing off the floor after a big punch they are hit again even harder by interest rate rises.

And to cap it off it’s all their fault.

I must be missing something here.

The only result of this type of policy is a regular cycle of boom and bust with more and more people forced into bankruptcy for no good reason.

It could be argued that interest rates should be cut in this scenario so that people are not forced to seek higher wages to compensate.

The main concern in the inflation issue is asset and commodity prices. But really its asset prices that are the culprit. They have been driving the global economy for many years now, most notably since financial deregulation in the 80s.

Talk has surfaced recently of the Treasurer invoking a clause in the Reserve Bank Act to move the inflation target aside in order to focus on the exchange rate. Whilst this is a bit far fetched it is another symptom of the policy malaise NZ is facing.

The Reserve Bank Governor has made the same mistake many others have before him: not understand the role and process of bank credit.

It’s as simple as that.

Using an inflation target to manage an economy is like riding a bike with one eye closed. Eventually you have a write off.

Economists have feelings too!

I have just spent the last 3 days at the NZ Association of Economists annual jamboree in Christchurch. It was well worth the time as it was a good opportunity to meet economists working in a wide range of areas and sub disciplines.

There were plenty of interesting papers on monetary policy, forecasting, environmental economics, migration, work and of course the housing market. There was a good mix of age and gender which added to the energy.

The keynote speakers were interesting with talks as diverse as climate change and the economics of sexual harassment.

The paper on Climate Change from Warwick McKibben is worth a look and the paper from Motu on Nutrient Trading provides a micro view of how trading in externalities might work at the local level. The work on allocating and trading pollution permits dovetails nicely with the work from Peter Barnes on reclaiming the commons and allocating rights to pollute which can be traded.

The general feeling on the housing market is that the boom is coming to an end but that it has been justified by low interest rates and the ability to ringfence losses from geared rental properties. I should add to this that migration and willingness to pay higher prices than locals has also contributed to the excessive rise in house prices. The banks have played their part in happily lending the required amounts and no doubt will be the first ones to notice any pullback from investors. This seems to have already started.

I would like to have seen some papers on behavioural economics as i think that is starting to build as an interesting field alongside new wave areas like neuroeconomics.

Economist is a dirty word in NZ due to the long hangover from the economic revolution of the 80s but i can report they are a good bunch….really

Currency Intervention: Kiwis don’t fly

On June 11th the RBNZ intervened in the NZ$ by selling NZ$ around the US$0.7660 level in thin markets. This was followed up by another bout or two resulting in short term sell offs to US$0.76.

This action has create a fair bit of comment most of it apoplectic in nature focusing on the poor NZ central bank against the might of global speculators. The commentary uniformly blasted the RB and trotted out the story of how George Soros buried the Bank of England back in 1992.

Well this is one time i can say “i was there” as i was actually trading Stg at the time, with the regular trader lying on a beach in the Carribean. It was a crazy time to be in the markets but when you were the focal point of action that feeling was magnified. The Bank of England phone line was running hot as we called up to sell more and more Stg. The voice on the other end of the phone was resigned to the ship going down.

It duly did. The next day i had my biggest one day loss in 12 years of trading as the market all but disappeared and every customer was looking to trade. I remember my broker took me out to dinner at the casino in Park Lane to recover. Nice.

But the main point of this story is that Stg was way overvalued and stuck in the ERM where it was required under the Maastricht Treaty to keep the Pound above a certain level which was DM2.7780.

So the Old Lady was just doing her job. She wasn’t taking on Soros or the market but just fulfilling legal obligations. Soros made a bet that the UK would have to pull out of the ERM and that was a political action and you can be sure he would have done his homework there.

So it is very different to what we see when the BOJ intervenes in the Yen at 100 or 145 where there is no legal cap but an extreme extension in rates.

The RBNZ action falls into this camp. The NZ$ is appreciating well beyond fundamentals based on the current account deficit, PPP comparisons and problems for the export sector to sell its goods. It is also suffering from carry trade side effects which are causing a huge inflow of short term investment to take advantage of high interest rates.

Its intervention is justified on those grounds. The NZ$ should be trading around US$0.60 which is just above its long term average. Of course currency rates can run way beyond what might be considered justifiable and for some period of time.

The Great Game continues in the global financial markets where the US sells it paper to trading nations such as Japan and now China in return for goods. One day this game may stop and the US$ will go into freefall.

The same could happen to the NZ$. I would say the RBNZ intervention is justified though how effective it is remains to be seen. Jeff Gamlin at the NBR is quite positive on the profit implications and it’s certainly a good long term trade to buy some foreign reserves. They should be selling as much Kiwi as possible!

As it happens intervention usually works if the intervening bank has some justification. Remember currency speculators like to make money. They don’t care whether it’s up or down.

The RBNZ is in a tight spot regardless of what Grant Spencer, the Deputy Governor , says. They will need a bit of luck to get this right and will need to continue intervening if required at higher levels like 78 and 80. I think though they will be safe there as people are starting to feel the pinch of higher rates.

Also yesterday the Japanese Minister of Finance weighed into the fray with some well placed comments. The Japanese are the experts in intervention and jawboning the currency. That shot across the bows should not be ignored.

RBNZ: Have They Lost the Plot?

There has been a lot of hand wringing over the recent Reserve Bank’s intervention in the currency market. So what’s the story here?

Well the RB has a clear mandate to keep inflation, as measured by the CPI, between 1-3% on an annual basis. According to them they also say that,

“The Bank is required to ensure that, throughout the economy, money works as well as possible as a mechanism for making transactions, storing value, and keeping account.”

So let’s say they are also responsible for price stability in a general sense i.e. no serious asset bubbles or major deflationary shocks.

So how are they doing?

Since 1998 the CPI has risen 20.7% to December 2006. So an average of 2.5% per annum which is within the prescribed band.

But the key worry, or so they keep repeating, has been the housing market which in the same period has risen 143%.

So what have they done about it?

From Mar 04 to Dec 06 they raised interest rates by 2%, from 5.25% to 7.25%. That doesn’t sound like a great deal by historical standards and clearly has not had any impact.

From Mar 04 to Mar 05 rates went up 1.5% as inflation took off towards 3%. However, they stopped when they should have kept going. When CPI hit 3.4% and stayed above, the bank should have got really serious and jacked rates up very quickly.

They didn’t. CPI was above 3% from Sep 2005 to Sep 2006 and they moved only 50bp. This was their big mistake. With house prices on the march as well they should have had rates up to 8% by June 06. They are a year behind the curve and that could cause some major problems.

Alan Bollard has been soft in his approach and this may well stem from the false comfort that low global rates has brought. The great inflation crush of the late 1990s has seen global rates fall into ranges not seen for many a year. Central bankers have been playing in a very small range and have been lulled into a false sense of security.

All around us we witness the asset price bubble caused by cheap global credit. The Japanese are still at it pumping out cheap yen that no one really wants. This is a major disaster waiting to happen. We’ve seen it before when USD/JPY fell to 79.65 back in 1995 on the back of US trade concerns and Asian Central banks dumping their US$. For now the flow out of the yen and into the kiwi continues with a rise of over 15% in the last 6 months.

Yesterday Winston Peters called for an amendment to the Reserve Bank Act asking that the Reserve Bank take a more rounded approach to managing monetary policy. I have to agree with him that a major review is needed and that simply using the OCR to control the economy is not working.

Submissions for the inquiry into a future monetary policy framework close on 19th July. I will post my submission up here in due course. It’s a great opportunity to throw open the arcane nature of our monetary system and make proposals that may lead to a more productive and stable economic system.