Property spruikers are currently having a field day proclaiming the productivity of housing investment. These claims are fallacious. Housing investment does NOT improve productivity.
To clearly explain why this is the case we first need to define productivity. Productivity is a measure of output from a production process, per unit of input. A productive capital investment therefore enables more future goods and services to be produced per unit of input (such as labour, materials etc).
An example of a productive investment may be a machine that enables a new design of metal fasteners to be produced from less metal, and with less labour time, but is equally as strong. In this case we have a productivity gain in terms of materials and human labour time for the same output. This investment allows use to produce more fasteners in future periods even with no more inputs.
Housing does nothing of the sort. It simply houses more people and does nothing to improve the per capita productivity.
Let's use a little thought experiment to prove the point.
Imagine an island nation of 1000 people occupying 400 homes. The only production activity on the island is the making of nails from raw metals – an activity in which everyone participates. The metal is imported and the nails exported, and the income generated from the sale of nails is used to import all other goods required by the people. With present techniques each person can produce 500 nails per kilo of raw metal per week.
The people of the island breed and accept some immigration until the population reaches 1250. They begin to get cramped and decide they best build some more houses. 400 people spend a year of their time constructing the 100 new houses, and expanding the factory, before all 1250 return to the nail trade.
After all this population growth and a massive investment in housing, equivalent to 20% of the existing stock (along with a massive investment in new factory space) each person can still only produce the same number of nails per unit of labour time and per unit of raw metal. There are no productivity gains from any investment.
In fact this growth has been costly. It took 400 people out of production for a year to build the new homes and extend the factory – a loss of 10 million nails (10,000 per original occupant or 5 months of work) that cannot be recovered.
If our island nation had instead invested in better production techniques such as automation, specialising the use of labour for particular parts of the process, or even invested the time to redesign the nails to be easier to manufacture with less material, they would have had productivity gains.
Interestingly, Australia has seen no measurable productivity gains since 2004. This, not surprisingly, coincided with a significant increase in annual housing investment.
The most popular claim by property spruiker is that housing is productive because it produces this thing called ‘somewhere to live’. Clearly there is a misunderstanding of productivity here. Tomatoes produce something to eat, as do bananas, which are equally as important as shelter. But it doesn't mean that growing a tomato improves our productivity.
The second most overlooked issue is that even if you redefine the argument to say that productive investment is any investment in capital that enables future production, which is the case for housing because homes enable future production of occupied space, you can easily overlook the fact that there are varying degrees of productivity of an investment. Housing productivity is clearly extremely low, with net rental returns (the measure of the future production you are enabling), around 2-3% in most areas.
Of course, property spruikers will still tell you that capital growth proves their point about relative productivity, but in the current financial climate, I would say there is still time to learn about the fragility of asset prices and the disconnect between the current price and the true productive contribution of the asset.
Thursday, February 25, 2010
Tuesday, February 23, 2010
Irrational saving or rational spending?
One question economics prefer to avoid is why irrational solutions to common problems faced each day by individuals seem to work. For example, our lounge room clock is 20mins fast (yes, I know that’s a lot). But when chatting with my wife the other day about whether we should put it back to the real time we decided to keep it fast. For some reason if the clock says 8 o’clock, even though we know it’s 7.40, it seems later than it really is. I don’t know why, but it does.
Another classic example is saving. Economists assume that the savings rate is fixed by our preference for current consumption over future consumption (not only this, they assume that individual preferences are fixed over time – that’s right, from birth to death). To any person living in reality, this fixed assumption is obviously not true.
For example, there are literally millions of websites preaching new an innovative ways to implement a saving strategy. Freezing your credit card in a block of ice to overcome spending urges is one solution. Having your salary paid directly into a fixed term investment account that can’t be touched is another.
The intriguing question is why we can be rational enough to use these ideas, but not so rational as to not need them. I want to examine this point today.
Dan Ariely (one of the most interesting behavioural economists around) has a nice presentation about how people can change their behaviour to overcome our predictably irrational tendencies and act more rationally. For me there are two important findings of his work:
1. People can’t think properly about the opportunity cost of current spending. We have difficulty comparing $10 a week on coffee to a holiday in Thailand in two years time (which it could easily add up to be).
2. The simultaneity of paying and enjoying goods makes consumption less enjoyable. Paying far in advance or far later than the time of consumption makes paying far less painful. Seeing the ‘pain of paying’ when we make the consumption decision helps us save.
But Dan never really gets to the bottom of the problem. Even if we can objectively think about our consumption needs in advance, and follow Dan’s trick of using envelopes with our budget for each type of good for the month so when we pay for something we see our remaining balance decline (the pain of paying), what is to stop us simply using another envelope when the time comes to pay for something? After all, wasn’t that our problem in the first place?
Dan’s experiments are extremely insightful and may help some people to save. But I have a feeling that the majority of people who begin using these irrational saving tips fail to prevail in the long run. If this is the case, we can either assume that in the long run people a rational enough not to outsmart themselves or that saving itself is irrational.
I believe the second option is most likely – saving itself is irrational.
At the individual level there is no incentive to save. This is a classic example of the moral hazard of welfare. For example if you lose you job, or have some other unforeseeable downturn in the family finances, and you had been saving, you will have a large pool of capital which will disqualify you from welfare. If instead you spent everything you had and saved nothing, you would be supported by everyone else’s tax dollars. Like so many policies, our welfare system they reward those who contribute least (not that this alone is a reason not to have such systems in place).
We also have distorted incentives for saving, as compulsory superannuation has taken away much of the incentive for young people to voluntarily save for retirement.
The graph below is the household savings rate in Australia. Notice, the inverse relationship between the saving rate and periods of strong economic growth. It seems that when the going is good we don’t save, and when it is not so good, we save a lot more.
When the going is good there is less incentive to save, as financial pain from unforeseeable events is estimated to be temporary, while in the bad times, we become frightened of long term welfare dependence.
So where does that leave us on our tour of irrational saving. For the individual, it appears that our inability to save may in fact be our rational self striving to break through the social pressure to save. It also appears that when we really need to, we seem to have the ability to bite the bullet and through whatever ‘irrational’ techniques, save in a quite rational manner.
Another classic example is saving. Economists assume that the savings rate is fixed by our preference for current consumption over future consumption (not only this, they assume that individual preferences are fixed over time – that’s right, from birth to death). To any person living in reality, this fixed assumption is obviously not true.
For example, there are literally millions of websites preaching new an innovative ways to implement a saving strategy. Freezing your credit card in a block of ice to overcome spending urges is one solution. Having your salary paid directly into a fixed term investment account that can’t be touched is another.
The intriguing question is why we can be rational enough to use these ideas, but not so rational as to not need them. I want to examine this point today.
Dan Ariely (one of the most interesting behavioural economists around) has a nice presentation about how people can change their behaviour to overcome our predictably irrational tendencies and act more rationally. For me there are two important findings of his work:
1. People can’t think properly about the opportunity cost of current spending. We have difficulty comparing $10 a week on coffee to a holiday in Thailand in two years time (which it could easily add up to be).
2. The simultaneity of paying and enjoying goods makes consumption less enjoyable. Paying far in advance or far later than the time of consumption makes paying far less painful. Seeing the ‘pain of paying’ when we make the consumption decision helps us save.
But Dan never really gets to the bottom of the problem. Even if we can objectively think about our consumption needs in advance, and follow Dan’s trick of using envelopes with our budget for each type of good for the month so when we pay for something we see our remaining balance decline (the pain of paying), what is to stop us simply using another envelope when the time comes to pay for something? After all, wasn’t that our problem in the first place?
Dan’s experiments are extremely insightful and may help some people to save. But I have a feeling that the majority of people who begin using these irrational saving tips fail to prevail in the long run. If this is the case, we can either assume that in the long run people a rational enough not to outsmart themselves or that saving itself is irrational.
I believe the second option is most likely – saving itself is irrational.
At the individual level there is no incentive to save. This is a classic example of the moral hazard of welfare. For example if you lose you job, or have some other unforeseeable downturn in the family finances, and you had been saving, you will have a large pool of capital which will disqualify you from welfare. If instead you spent everything you had and saved nothing, you would be supported by everyone else’s tax dollars. Like so many policies, our welfare system they reward those who contribute least (not that this alone is a reason not to have such systems in place).
We also have distorted incentives for saving, as compulsory superannuation has taken away much of the incentive for young people to voluntarily save for retirement.
The graph below is the household savings rate in Australia. Notice, the inverse relationship between the saving rate and periods of strong economic growth. It seems that when the going is good we don’t save, and when it is not so good, we save a lot more.
So where does that leave us on our tour of irrational saving. For the individual, it appears that our inability to save may in fact be our rational self striving to break through the social pressure to save. It also appears that when we really need to, we seem to have the ability to bite the bullet and through whatever ‘irrational’ techniques, save in a quite rational manner.
Thursday, February 18, 2010
Firday quick links
No need to correct my spelling. It's my new revenue generating strategy (thanks Ben). At least it will be if current research on misspelled domain names is anything to go by.
It appears that someone has spent time investigating the potential ad revenue from websites that are misspelled variations of popular websites. Surprisingly, a viable business model is to register misspelled website domains, and simply post ads relevant to the real website (or to the real website), to ultimately generate a decent profit.
But is there anything wrong with that? The authors of the study think so, and they have launched a lawsuit seeking damages from Google for facilitating this practice with their Adsense for Domains tool.
To me, this is a classic example of market fulfilling a niche function. There is nothing stopping businesses buying the domains which are misspellings of their own if they are willing to pay more than the value of revenue generated by advertising to the current domain name owner. Further, I would suggest that typing a web address to navigate to a site is fast becoming obsolete as you can generally navigate to the site with less typing by using a search engine.
In other news, the Brisbane Young Economists Network is hosting an event in Brisbane on the 4th March. Pecha Kucha presentations will be given by some local economics PhDs, drinks are supplied, and there will be plenty of time for socialising.
It appears that someone has spent time investigating the potential ad revenue from websites that are misspelled variations of popular websites. Surprisingly, a viable business model is to register misspelled website domains, and simply post ads relevant to the real website (or to the real website), to ultimately generate a decent profit.
But is there anything wrong with that? The authors of the study think so, and they have launched a lawsuit seeking damages from Google for facilitating this practice with their Adsense for Domains tool.
To me, this is a classic example of market fulfilling a niche function. There is nothing stopping businesses buying the domains which are misspellings of their own if they are willing to pay more than the value of revenue generated by advertising to the current domain name owner. Further, I would suggest that typing a web address to navigate to a site is fast becoming obsolete as you can generally navigate to the site with less typing by using a search engine.
In other news, the Brisbane Young Economists Network is hosting an event in Brisbane on the 4th March. Pecha Kucha presentations will be given by some local economics PhDs, drinks are supplied, and there will be plenty of time for socialising.
Tuesday, February 16, 2010
23 things I have discovered about Singapore
A guest post today from my very good friends Yo and Matt who are currently living in Singapore.
Yo's list -
1. People buy whitening products for their skin – it is considered more beautiful – funny that a tan is beautiful in the west! No one sunbakes.
2. The people walk very slowly, they are never in a hurry.
3. No one EVER sticks to the left.
4. People always sit on the aisle seat in the bus so that no one sits next to them
5. “la” is said at the end of most sentences (I still don’t t know why this is)
6. People hold a business card with two hands when passing it to someone whom they have just met.
7. The umbrella is actually useful on a sunny day *shame* and is a must for the handbag
8. Pashmina’s are also a necessary handbag item – the air-conditioning is set to arctic wherever you go.
9. Chewing gum is not illegal
10. You get the cane for any sort of graffiti (10 lashes I believe)
11. Kids don’t play in parks, or generally for that matter...they are very academic from a young age
12. There are alot of really, really expensive cars: Ferraris, Lamborghinis, Bentleys, Aston Martins...etc etc
13. Public transport is exceptionally cheap to encourage high patronage – it really puts Australia to shame. It is also very efficient (except to Matt’s work of course).
14. Affordable housing is done well, there are very little, if any homeless people.
15. Maids (mostly from the Philippines) invade Orchard road on Sundays – it’s their day off
16. Being Caucasian, and blonde (and female), you get stared at alot...you learn to win stare-offs very well. (Phebs, prepare yourself)
17. You pay for incoming calls on your mobile
18. You don’t see many policemen.
19. Shopping is a sport. More importantly, bargain shopping.
20. It’s all about the food here. Everyone is always asking about your next meal. (Chappo will fit in just fine)
21. Taxi’s are cheap, which is odd considering a Toyota Yaris is about $50k (just imagine what the Ferrari’s cost).
22. Starting Salary for a graduate engineer is about A$20,000.
23. You can have a maid for A$400/month. They will work 6days/week.
To round out Yo’s top 23 things to a top 30, Matt adds-
24: Almost all residents who live in Singapore are not from Singapore. Most are from Malaysia, Indonesia and other surrounding countries.
25: “Can” means yes, as in yes I can do that
26: Cash for payment is received in two hands (similar to Yo’s no. 6)
27: When someone invites you out to Friday afternoon drinks, that means you leave work late, not early
28: You can pay $2 for two coffees. You can also pay $20.
29: In addition to Yo’s no. 20, people never bring lunch with them to work. We don’t even have a microwave in the kitchen. Lunch with Singaporeans is always a sit down hot meal in a restaurant or cafe.
30: A 100m walk to a Singaporean is equivalent to a 1k walk to an Australian. No one walks very far here.
Yo's list -
1. People buy whitening products for their skin – it is considered more beautiful – funny that a tan is beautiful in the west! No one sunbakes.
2. The people walk very slowly, they are never in a hurry.
3. No one EVER sticks to the left.
4. People always sit on the aisle seat in the bus so that no one sits next to them
5. “la” is said at the end of most sentences (I still don’t t know why this is)
6. People hold a business card with two hands when passing it to someone whom they have just met.
7. The umbrella is actually useful on a sunny day *shame* and is a must for the handbag
8. Pashmina’s are also a necessary handbag item – the air-conditioning is set to arctic wherever you go.
9. Chewing gum is not illegal
10. You get the cane for any sort of graffiti (10 lashes I believe)
11. Kids don’t play in parks, or generally for that matter...they are very academic from a young age
12. There are alot of really, really expensive cars: Ferraris, Lamborghinis, Bentleys, Aston Martins...etc etc
13. Public transport is exceptionally cheap to encourage high patronage – it really puts Australia to shame. It is also very efficient (except to Matt’s work of course).
14. Affordable housing is done well, there are very little, if any homeless people.
15. Maids (mostly from the Philippines) invade Orchard road on Sundays – it’s their day off
16. Being Caucasian, and blonde (and female), you get stared at alot...you learn to win stare-offs very well. (Phebs, prepare yourself)
17. You pay for incoming calls on your mobile
18. You don’t see many policemen.
19. Shopping is a sport. More importantly, bargain shopping.
20. It’s all about the food here. Everyone is always asking about your next meal. (Chappo will fit in just fine)
21. Taxi’s are cheap, which is odd considering a Toyota Yaris is about $50k (just imagine what the Ferrari’s cost).
22. Starting Salary for a graduate engineer is about A$20,000.
23. You can have a maid for A$400/month. They will work 6days/week.
To round out Yo’s top 23 things to a top 30, Matt adds-
24: Almost all residents who live in Singapore are not from Singapore. Most are from Malaysia, Indonesia and other surrounding countries.
25: “Can” means yes, as in yes I can do that
26: Cash for payment is received in two hands (similar to Yo’s no. 6)
27: When someone invites you out to Friday afternoon drinks, that means you leave work late, not early
28: You can pay $2 for two coffees. You can also pay $20.
29: In addition to Yo’s no. 20, people never bring lunch with them to work. We don’t even have a microwave in the kitchen. Lunch with Singaporeans is always a sit down hot meal in a restaurant or cafe.
30: A 100m walk to a Singaporean is equivalent to a 1k walk to an Australian. No one walks very far here.
Monday, February 15, 2010
Global Barefoot Marathon
I have never run a marathon. I never considered myself a runner. But lately I have grown to enjoy the rhythm of running, the pureness, and the simplicity of putting one leg in front of the other.
It is with this in mind that I propose to run my first marathon on the 20th June 2010. Want to join me?
Here’s the deal. I know there are a lot of passionate runners out there all around the world, and I want to share this run with them. While we cannot share the run with a physical presence, we can share the spirit of the run by all running together – a global marathon, synchronised, with people participating in the experience from around the world.
How will it work?
Think of this event as just an informal run with friends, who may happen to be running at any place on the planet. There will be no centrally planned event program. Anyone, from any city, can take a lead and map out a route. Post a comment and a link to the map in the comments section and at the Facebook event page, and anyone looking for their city can search this page for their city name. I suggest using Google maps to estimate the route length (should be 42.195km, but close enough is good enough) and then double-checking by riding the length with a good bike computer. My map for Brisbane, Australia is here. You can save your own maps and make them available on Google Maps.
Two laps is a good idea so that people can run a half-marathon if they choose (maybe with a delayed start to have more finishers come in together, and maybe they can pace their friends for the second lap of a full marathon).
The time and date for some of the major cities around the world is in the table below. Don’t worry if your town starts in the middle of the night. When you post a map, propose a more convenient starting time. Our European friends might like to choose a 4pm start instead, and our East Asian friends might like to wait until 6am.
City | Start Time |
Auckland | 8am, Sun 20th June |
Brisbane, Sydney, Melbourne | 6am, Sun 20th June |
Perth, Beijing, Singapore | 4am, Sun 20th June |
Berlin, Paris, Amsterdam | 10pm, Sat 19th June |
London, Barcelona | 9pm, Sat 19th June |
New York | 4pm, Sat 19th June |
San Francisco | 1pm, Sat 19th June |
Why barefoot?
Bare feet are not compulsory, but if this guy can win the Olympic marathon barefoot, and this guy can run ultra-marathons barefoot, why not? But it is more than that really. It is more a symbol of simplicity and a rejection of the commercialisation of running (and sport in general). Why can’t we just run? After all, weren’t we Born to Run? In my mind I imagine running together with my young son at the park, barefoot, free, a simple pleasure. That is what I mean by barefoot.
If you run barefoot, or in minimal shoes, good on you. If you don’t, that’s fine too of course.
What now?
If you are interested in running with me, find out if a marathon is already held in your town or city, and either adopt their course or map one out for yourself. Save the map in Google Maps and post a link in the comments. Find some friends, and make sure to spend some time celebrating together at the finish line with some delicious treats and thirst quenching beverages.
There is also a Facebook event. I would love it if the world ran with me, so please pass on the message to anyone who may be interested. Once you have a proposed route in your city, maybe start a new Facebook page for your town to coordinate lifts to the starting point, lifts home, and who’s bringing the beer.
There is no Global Barefoot Marathon website. It would be nice, but I’m not that great with computers. Also, if it is just friends around the world running together for the fun of it, do we need one? There’s no formal time keeping, no traffic redirection, no sponsorship.
Afterwards, we can all share photos and stories on the Facebook page.
I hope you can join me, but in any case, I will be out there running my first marathon just for the simple challenge of it.
Sunday, February 14, 2010
Randomness and probability: quantify with caution
One of the main lessons (or reminders for those trained in statistics) found in the Drunkards Walk deals with the reliability of data. Mlodino makes the important point that people latch on to numerical values. He uses wine tasting rankings as an example of how the numerical ranking has a huge impact on price, yet under blind tests, the people ranking are next to useless at actually determining which wine they are drinking.
Let’s look at a recent example of people latching on to the quantity without thinking of the error. Lately, ABS data has shown that unemployment has fallen by 0.1% - what is the probability that in reality unemployment has actually risen?
To determine this, we should take a close look at the errors in the ABS sample. Shown below are the 95% confidence intervals for the most recently published labour statistics.
You will notice that this interval covers a spectrum from negative to positive. If we take away all the error that keeps the change in unemployment in negative territory, we get a 16% chance that unemployment actually increased. This is simply due to sampling error. The true error, which includes possible inaccuracies of the data itself, would be much greater.
In academia, this scale of error would lead to the conclusion that the change in unemployment is indistinguishable from zero.
Of course, over time we can smooth out some of this error. For example, the Oct-Nov 2009 change in unemployment figures were identical, which brings the chance that two consecutive data points are in the wrong sign down to 2.56%.
Movements in seasonally adjusted series between November 2009 and December 2009
Monthly change 95% Confidence interval
Total Employment 35 200 -17 800 to 88 200
Total Unemployment -10 600 -41 600 to 20 400
Unemployment rate -0.1 pts 0.3 pts to 0.1 pts
Participation rate 0.0 pts 0.4 pts to 0.4 pts
The point of this exercise is to bear in mind that all measurements contain error. There must be thousands of useless statistics and rankings that have a surprisingly large impact on our lives, but in reality can become meaningless in light of inherent randomness.
Let’s look at a recent example of people latching on to the quantity without thinking of the error. Lately, ABS data has shown that unemployment has fallen by 0.1% - what is the probability that in reality unemployment has actually risen?
To determine this, we should take a close look at the errors in the ABS sample. Shown below are the 95% confidence intervals for the most recently published labour statistics.
You will notice that this interval covers a spectrum from negative to positive. If we take away all the error that keeps the change in unemployment in negative territory, we get a 16% chance that unemployment actually increased. This is simply due to sampling error. The true error, which includes possible inaccuracies of the data itself, would be much greater.
In academia, this scale of error would lead to the conclusion that the change in unemployment is indistinguishable from zero.
Of course, over time we can smooth out some of this error. For example, the Oct-Nov 2009 change in unemployment figures were identical, which brings the chance that two consecutive data points are in the wrong sign down to 2.56%.
Movements in seasonally adjusted series between November 2009 and December 2009
Monthly change 95% Confidence interval
Total Employment 35 200 -17 800 to 88 200
Total Unemployment -10 600 -41 600 to 20 400
Unemployment rate -0.1 pts 0.3 pts to 0.1 pts
Participation rate 0.0 pts 0.4 pts to 0.4 pts
The point of this exercise is to bear in mind that all measurements contain error. There must be thousands of useless statistics and rankings that have a surprisingly large impact on our lives, but in reality can become meaningless in light of inherent randomness.
Wednesday, February 10, 2010
CPI update
I was attempting to create a 'Make your own CPI' spreadsheet that uses the ABS price indexes for each commodity group and allows you to assign your own weighting. I was also using the weighting from the German CPI as a comparison (which weights housing as 30% of the basket, while Australia's CPI has housing at 19% of the basket).
But there was a problem.
The price indexes for each commodity group were so completely manipulated by quality adjustment (and any other unknown statistical manipulation that occurs) that you could not dramatically change the final CPI figure. Using German weightings I was within one percent (of the total change) over a 10 year period.
Have a look at the house purchase index used for the CPI against the ABS' own capital city house price index in the graph below. The extreme magnitude of the disparity is quite shocking. The index used for the CPI increased by 36% over the 7 year period, while the capital city median price index increased 92%.
What lesson should we take away from all this? I for one will never trust an official statistic without first understanding the methodology behind it.
But there was a problem.
The price indexes for each commodity group were so completely manipulated by quality adjustment (and any other unknown statistical manipulation that occurs) that you could not dramatically change the final CPI figure. Using German weightings I was within one percent (of the total change) over a 10 year period.
Have a look at the house purchase index used for the CPI against the ABS' own capital city house price index in the graph below. The extreme magnitude of the disparity is quite shocking. The index used for the CPI increased by 36% over the 7 year period, while the capital city median price index increased 92%.
Tuesday, February 9, 2010
Food packaging less wasteful than none at all!
I wrote once before that the concept of waste has been distracting environmentalist for decades. Today I came across this exceptionally interesting article on food packaging. The main point is that packaging serves an important purpose - to preserve food. The longer food is preserved, the more likely it is to be eaten rather than wasted. Thus, packaging cuts down immensely on food waste.
I do however believe that some packaging, such as the excessive size of cereal boxes to ensure good shelf space, does not always result in benefits for consumers.
I do however believe that some packaging, such as the excessive size of cereal boxes to ensure good shelf space, does not always result in benefits for consumers.
Monday, February 8, 2010
Fail: CPI, housing and the cost of living
This short article about inflation, and the ABS review of the Consumer Price Index (CPI), prompted me to write again on the subject. In fact, some friends and family who recently returned from a few years abroad have also been bugging me about why Australian prices have shot up so much, yet we hear almost nothing about rapid inflation. Housing prices in Brisbane have typically increased 200% in the past decade - around 7% per year. If housing was just 10% of the CPI basket, it alone would contribute 0.7%pa growth to the index.
Unfortunately, not many people know that the CPI does not measure the change in the cost of living (see p6 of the ABS CPI overview report here). The ABS method, including quality adjustments and the weighting of household consumption goods, means that the CPI fails to be a useful measure for determining real incomes and purchasing power.
To do that you would use what is know as an Outlays Method, rather than the Acquisitions Method currently adopted by the ABS. What the ABS tries to do is the impossible. It tries to measure the rate of change of prices of goods and services, or the change in the price level, using the acquisitions approach.
The main difference between the two methods discussed above applies to durable goods – those goods that are that consumed over a long period, such as housing. Because the acquisitions approach ignores the interest cost of debt (as this is not a cost in a given time period, but a cost bringing forward spending form future periods), the cost of servicing home loans is completely ignored. Any changes to interest rates do no impact the CPI until prices themselves adjust to new interest rate conditions.
Quality adjustments are also killing the CPI. For housing in Brisbane for example, the CPI attributes a mere 80% growth in prices from 1999 to Dec 2009, yet my observations suggest that homes have typically increased 200% (meaning it is now 3 times the price). Are our homes really more than ‘twice the quality’ they were in 1999? The ABS thinks so.
With the quality adjustments to rental price (not ‘cost’ remember) we get this absurd result:
…that for the period December 1994 to December 2005 the average rent paid by private tenants included in the ABS Survey of Income and Housing increased by 41.1%, while the increase in the CPI rental component was 22.9%
And guess what the share of household budget the CPI uses for rent. Go on. You wouldn’t believe it. 5.22%.
And while I’m at it, what about the weighting for house purchase? 11.21% - slightly less than the weight given to motor vehicle costs.
While I admit that the weightings actually reflect the combination of household types, and those who own their own home outright will face no house purchase costs or rents, it still seems a little on the low side to me.
Another massive shortfall of the CPI is a bias towards higher income households. For example, low-income households spend more money on what we would commonly call ‘the basics’, such as food, fuel, and rent, but less on luxuries like computers (whose quality adjusted price declined by 50% in the past 10 years according to the ABS), dining out, holidays and airline flights, and hotel accommodation. So when the basics increase in price at a greater rate than the luxuries (which they have been in the past decade), the cost of living for the poorer households increases by more than the published figure, while the cost of living for wealthier households increases by less than the official number.
Finally, all the weightings of the CPI are here (on page 113), and the index for each component over time is here. If anyone thinks they reflect their reality please let me know.
The simple way around all nonsense is for the ABS to publish a CPI using the acquisitions approach, and a ‘cost of living’ index using the outlays approach. Discrepancies between the two would have simple explanations, and the relative change between the two indices would be of great assistance to policy makers.
I suspect however, that admitting the cost of living for many Australians may be outpacing wages is not going to be politically palatable to any party in power. Maintain the illusion of a low CPI is also one reason why hedonic indexes (which adjust for quality) are becoming more politically popular.
I will be interested in the outcomes of the current CPI review to see whether they improve or degrade this key national economic measure.
UPDATE
The ABS produces an Analytical Living Cost Index (ALCI) here, using the appropriate outlays method. Unfortunately, while interest rate are factored in, the price of home purchase is removed
the ALCIs, the changes in the amount of interest paid on mortgages (measured as part of financial and insurance services) and other costs (e.g. maintenance costs and council rates) are included for owner-occupied housing. In addition, changes in rental are measured for that part of the reference population that resides in rented dwellings. The ALCIs do not include the net purchase of housing and the increase in volume of housing due to renovations or extensions.
Furthermore, most other components of this measure are simply taken from the CPI in their quality adjusted form. Which gives the ABS an ALCI which mirrors CPI almost exactly.
I will be interested in the outcomes of the current CPI review to see whether they improve or degrade this key national economic measure.
UPDATE
The ABS produces an Analytical Living Cost Index (ALCI) here, using the appropriate outlays method. Unfortunately, while interest rate are factored in, the price of home purchase is removed
the ALCIs, the changes in the amount of interest paid on mortgages (measured as part of financial and insurance services) and other costs (e.g. maintenance costs and council rates) are included for owner-occupied housing. In addition, changes in rental are measured for that part of the reference population that resides in rented dwellings. The ALCIs do not include the net purchase of housing and the increase in volume of housing due to renovations or extensions.
Furthermore, most other components of this measure are simply taken from the CPI in their quality adjusted form. Which gives the ABS an ALCI which mirrors CPI almost exactly.
Thursday, February 4, 2010
Randomness and probability: can people intuit probability?
One of my concerns with the evidence on the misinterpretation of randomness and probability in The Drunkards Walk arises during the discussion of the first law of probability: The probability that two events will both occur can never be greater than the probability that each will occur individually. While the law makes intuitive sense, the evidence that people fail to apply it to their reasoning is a little flimsy.
Mlodino asks us to consider an experiment from Khaneman, Slovic and Tversky’s famous book on judgement under uncertainty. Given the brief description about the Linda below, eighty eight subject were asked to rank the statements that follow on a scale of 1 to 8 according to their probability, with 1 representing the most probable, and 8 the least. The results are in the order ranked by the participants from most probable to least probable.
See the results under the fold and why their finding, that people have poor intuition of probability, may be incorrect.
Imagine a woman Linda, thirty-one years old, single, out-spoken, and very bright. In college she majored in philosophy. While a student she was deeply concerned with discrimination and social justice and participated in anti-nuclear demonstrations.
Statement Average probability rank
Linda is active in the feminist movement 2.1
Linda is a psychiatric worker 3.1
Linda works in a bookstore and takes yoga classes 3.3
Linda is a bank teller and is active in the feminist movement 4.1
Linda is a teacher in an elementary school 5.2
Linda is a member of the League of Women Voters 5.4
Linda is a bank teller 6.2
Linda is an insurance salesperson 6.4
What stands out from this experiment is that the participants ranked the probability that Linda was a bank teller lower than the probability that she was a bank teller AND is active in the feminist movement. Since the bank teller statement captures the combined statement plus all options of being a bank teller and not active in the feminist movement, the probability should be higher.
My reason for questioning whether people actually fail to intuit the true probability is that my personal interpretation was that the Linda is a bank teller statement implied that she wasn’t active in the feminist movement. By default my brain registered the separate itemisation of the option to mean that it did NOT capture the bank teller and feminist statement.
In fact the respondents may have been completely correct if we apply the NOT criteria to the bank teller choice. Consider the diagram below. On the left is the way the researchers had the statement defined in their mind. On the right is the alternate interpretation where NOT feminist is implied as the first constraint in the sequence of reasoning. When we change our minterpretation of the statement, the probability of a feminist banker is 40%, while the probability of a non-feminist banker is a mere 10%.
So, depending on how we define the criteria, and how we perceive the problem, the probability changes. My personal view is that people instinctively may be better at understanding probability than made out by Khaneman et al, and reiterated by Mlodino.
That being said, I currently have the difficult task of explaining why a mean rainfall and streamflow figure is a poor basis upon which to evaluate investment decisions for irrigated agriculture in catchments with highly variable rainfall. One situation where people almost always fail to intuit probability is with weather variation. A weather event observed 10 times in a century becomes a 1 in 10 year event, which people then expect to happen with almost certainty every ten years. In reality however, the chance that the 1 in 10 year event will occur in any 10 year period is closer to 65%, and for a twenty year period the chance of having a 1 in 10 year event is still only 87%.
Mlodino asks us to consider an experiment from Khaneman, Slovic and Tversky’s famous book on judgement under uncertainty. Given the brief description about the Linda below, eighty eight subject were asked to rank the statements that follow on a scale of 1 to 8 according to their probability, with 1 representing the most probable, and 8 the least. The results are in the order ranked by the participants from most probable to least probable.
See the results under the fold and why their finding, that people have poor intuition of probability, may be incorrect.
Imagine a woman Linda, thirty-one years old, single, out-spoken, and very bright. In college she majored in philosophy. While a student she was deeply concerned with discrimination and social justice and participated in anti-nuclear demonstrations.
Statement Average probability rank
Linda is active in the feminist movement 2.1
Linda is a psychiatric worker 3.1
Linda works in a bookstore and takes yoga classes 3.3
Linda is a bank teller and is active in the feminist movement 4.1
Linda is a teacher in an elementary school 5.2
Linda is a member of the League of Women Voters 5.4
Linda is a bank teller 6.2
Linda is an insurance salesperson 6.4
What stands out from this experiment is that the participants ranked the probability that Linda was a bank teller lower than the probability that she was a bank teller AND is active in the feminist movement. Since the bank teller statement captures the combined statement plus all options of being a bank teller and not active in the feminist movement, the probability should be higher.
My reason for questioning whether people actually fail to intuit the true probability is that my personal interpretation was that the Linda is a bank teller statement implied that she wasn’t active in the feminist movement. By default my brain registered the separate itemisation of the option to mean that it did NOT capture the bank teller and feminist statement.
In fact the respondents may have been completely correct if we apply the NOT criteria to the bank teller choice. Consider the diagram below. On the left is the way the researchers had the statement defined in their mind. On the right is the alternate interpretation where NOT feminist is implied as the first constraint in the sequence of reasoning. When we change our minterpretation of the statement, the probability of a feminist banker is 40%, while the probability of a non-feminist banker is a mere 10%.
That being said, I currently have the difficult task of explaining why a mean rainfall and streamflow figure is a poor basis upon which to evaluate investment decisions for irrigated agriculture in catchments with highly variable rainfall. One situation where people almost always fail to intuit probability is with weather variation. A weather event observed 10 times in a century becomes a 1 in 10 year event, which people then expect to happen with almost certainty every ten years. In reality however, the chance that the 1 in 10 year event will occur in any 10 year period is closer to 65%, and for a twenty year period the chance of having a 1 in 10 year event is still only 87%.
What I've found interesting lately...
There has been a lot of comment on bonuses in the banking industry since the onset of the GFC. Read Dan Ariely's take on the effectiveness of bonuses here.
For those who believe that economics generally gets things half right, behavioural economics might be your thing. A mix of psychology and economics, this field has been enlightening economists for the past two decades. Some of the latest findings in behavioural economics are found here (highly recommended).
For those who believe that economics generally gets things half right, behavioural economics might be your thing. A mix of psychology and economics, this field has been enlightening economists for the past two decades. Some of the latest findings in behavioural economics are found here (highly recommended).
Wednesday, February 3, 2010
Ugly city syndrome
This article suggests that ugly cities are the result of poor political leadership. That seems like a long bow to draw. I believe the cause of ‘ugly city syndrome’ is more subtle, and maybe we just have ourselves to blame. The simple answer might be that in the modern day of cheap international travel we are comparing ourselves to a wider selection of cities.
But where are the incentives to create a beautiful city?
Since the cityscape is jointly determined by public investment (the quality of public space including vegetation, materials, size and layout, also roads, and other hard infrastructure, and finally, public buildings) as well as investment by private land owners, let’s deal with the incentives for each separately.
First, there are the incentives for public investment in beautification. Governments of all levels are in the unique position to justify extra spending to enhance city ‘liveability’. And these investments by governments do happen. Land at Kangaroo Point, for example, has recently been reclaimed for use as public parkland. But governments do face one major constraint. People demand wise use of public money, and spending on beautification, above and beyond functionality, is often frowned upon.
But what about private investment is the attractiveness of the cityscape? Like all positive externalities private supply of urban beauty is always suboptimal.
There are plenty of examples of suboptimal supply of public beauty. Below is SL8 in West End, which just happens to resemble the exhaust stack of the new road tunnel (as does Urban Nest at Southbank for that matter). Why are private companies building apartments that look like elaborate exhaust pipes?
The answer must simply be because people will buy them. Since inner city apartments are commonly purchased as a pure investment decision, based entirely on rental income and tax benefits, and because renters are less critical of the appearance of their building (especially if they are short tem occupants), then there a few reasons for developers to spend more on external appearance.
How do governments provide incentive for private investment in the cityscape? I am not a fan of any type of design review board or some such oversight – taste is personal and I am happy to see a diversity of design (which is exactly what is missing). In fact, apart from developer contributions to public space I see no way around this beyond an improvement in taste of the property investment community. I frown on regulations such as the requirement of a contribution to public artwork for new buildings – can’t the building itself be art.
What opportunities exist for creating a better looking city?
But where are the incentives to create a beautiful city?
Since the cityscape is jointly determined by public investment (the quality of public space including vegetation, materials, size and layout, also roads, and other hard infrastructure, and finally, public buildings) as well as investment by private land owners, let’s deal with the incentives for each separately.
First, there are the incentives for public investment in beautification. Governments of all levels are in the unique position to justify extra spending to enhance city ‘liveability’. And these investments by governments do happen. Land at Kangaroo Point, for example, has recently been reclaimed for use as public parkland. But governments do face one major constraint. People demand wise use of public money, and spending on beautification, above and beyond functionality, is often frowned upon.
But what about private investment is the attractiveness of the cityscape? Like all positive externalities private supply of urban beauty is always suboptimal.
There are plenty of examples of suboptimal supply of public beauty. Below is SL8 in West End, which just happens to resemble the exhaust stack of the new road tunnel (as does Urban Nest at Southbank for that matter). Why are private companies building apartments that look like elaborate exhaust pipes?
The answer must simply be because people will buy them. Since inner city apartments are commonly purchased as a pure investment decision, based entirely on rental income and tax benefits, and because renters are less critical of the appearance of their building (especially if they are short tem occupants), then there a few reasons for developers to spend more on external appearance.
How do governments provide incentive for private investment in the cityscape? I am not a fan of any type of design review board or some such oversight – taste is personal and I am happy to see a diversity of design (which is exactly what is missing). In fact, apart from developer contributions to public space I see no way around this beyond an improvement in taste of the property investment community. I frown on regulations such as the requirement of a contribution to public artwork for new buildings – can’t the building itself be art.
What opportunities exist for creating a better looking city?
Monday, February 1, 2010
The Australian property market debt gamble
Investing and gambling are often mistaken for each another. In one, you take risks based on known probabilities, in the other, unknown probabilities. In one, you will probably win in the long run, in the other, you are bound to lose out. In both pursuits we are psychologically predisposed to scams.
UPDATE
More here on Australian household debt, although I disagree with the prediction on interest rates. I see interest rates lower by the end of the 2010.
I find it interesting that prudent advice for gamblers is to risk only your own money, while for investors it's a different story - the more leverage the better. But there must be an optimal level of leverage, otherwise we would all simply continue to borrow and destroy the value of the currency through money creation.
Given the realities of our world, one would expect that leverage below this optimal level would not persist for an extended period, as people would begin to notice the advantages of more leverage, nor would leverage or debt beyond this optimal level be able to persist. It is therefore interesting to ask how would we know if we are above this optimal level?
One could easily spend some time on Steve Keen's blog and be convinced we are far beyond that optimal level, and that downwards adjustment in debt (debt deflation) will take place, which will result in a destruction of asset values, particularly property, which is usually purchase with high levels of debt.
The path I want to take is to first look at Australian historical data to paint of picture of where our debt situation is relative to assets and incomes, then compare household debt levels internationally to see whether a correlation can be drawn between high debt levels and a property market crash.
Below is data from the RBA B21 time series on household ratios. It demonstrates a number of interesting points for the investor gambling with more than their money.
The first critical point to note is the rapid destruction of asset values from mid 2007 to mid 2009 - asset value on paper is always at risk until the asset is sold.
The second point to note is that during the value destruction, the debt to asset ratio shot up dramatically (as you would expect). The lesson - debts are fixed while asset values are not.
The third point to note is the effectiveness of monetary policy in decreasing the burden of debt. When interest rates where reduced during 2008, the interest costs dropped almost 50%. However the downside to low interest rates is that it enables people to borrow more and makes raising rates again more painful (although the RBA seems to have no problems with that, unlike their American and UK counterparts).
Can we tell from this information whether we are above the optimal level of debt? The only worrying thing I see is that the housing interest to disposable income ratio is still far above any level experienced before the recent property boom. I suspect that even though the RBA appears to be in a tightening phase, by year's end we will see lower interest rates than at present.
The second graph below (from here) shows a fairly recent international comparison of household debt levels as a ratio of disposable household incomes. What we note is that all countries with debt levels above 150% of disposable income have seen property market crashes (of differing severity) since this time. The Dutch may yet be in the midst of a property market correction. Prices in major Dutch cities are between 1,900 and 3,360euro/sqm which, quite unbelievably, are much the same as the apartment prices in Brisbane at the moment ($3,000-$5,000/sqm). Further, as I have mentioned before, interest rates on home loans in Holland are around 4.5%, and the interest own your own home is tax deductible.
A second interesting feature is the flatness of Japan's debt ratio since the late 1980s. Japan never saw debt levels as high as those currently observed in Australia and yet the central bank decreased interest rates to near zero since the time of their property market peak in 1990, decreasing the burden from this debt, but failing to significantly reduce it.
The take away message from these two sets of data must be that some form of property market correction will occur. Whether it takes the form of static prices for some years, or some sharp drops, price increases such as those seen since 2001 will not be a feature of the coming decade. At the moment, Australian households appear to be ignoring the advice given to gamblers, and are using high levels of debt to invest at a market with plenty of unknowns, and plenty of risk.
UPDATE
More here on Australian household debt, although I disagree with the prediction on interest rates. I see interest rates lower by the end of the 2010.
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