Competition Series Part IV: The future

While competition can clearly bring significant consumer benefits (think Virgin Blue and the airline shake up, or Aldi and current supermarket competition) the evidence is clear that this is not always the case, and that harnessing the innovation stimulated by competition can come with a large coordination cost.

One major consideration as to whether competition can work effectively – will government still control a production bottleneck?

For example, once airport runways are operating at capacity, the government will have the final say on approving new runways. In the mean time, the cohort of airlines can act as a monopoly as there is a huge, in fact insurmountable, barrier to entry.

A second consideration is whether the private firms will be allowed to take all their risk.  In banking we have seen a bizarre situation where banks have been thrown a government lifeline with no obligations, and have since returned to record profits (read this article for a good discussion on reciprocal obligation of banks).

Further, competition reforms have also been more broadly focussed than the privatisation of various layers of vertically integrated monopolies.  Where this cannot be achieved, one outcome is that a regulatory authority ensures that a monopoly ‘acts in a competitive manner’ without actual competition, and the risks that competition exposes. This type of reform is the least effective – government sets prices that ensure returns commensurate with a hypothetical competitive firm, with associated levels of risk, yet there is in fact no risk taken.  If the monopolist undertakes ineffective investment, the regulator will set a price that ensures a profit is made anyway.  Indeed, the incentive under this arrangement is to increase costs, knowing that government set a price that recovers a return on any expenditure.  None of the supposed benefits of competition exist under this arrangement.  

Competition reform without actual competition fails.  The only possible saving grace could be if profits from government owned corporations were used to reduce tax burdens elsewhere in the economy (although it is a stretch to expect this type of efficient spending from government).

In the end, avoiding government incompetence and rent seeking from monopoly control comes at a cost, and it appears that the mixed economy is here to stay.  In the mixed economy, government monopolies can provide a base upon which private firms can compete.  Government already provides the democratic and legal base upon which private enterprise thrives.  Why not think of the provision of some monopoly services as an extension of basic government requirements?  I’ll leave the final word on this series to Professor John Quiggin.   

The case for public ownership is strongest where market failure problems are likely to be severe. In the case of infrastructure industries, several market failures are important. First, because of the equity premium and the associated problem of short-termism, private providers of infrastructure may not invest enough, or in a way that maximizes long-run benefits. Second, infrastructure facilities often generate positive externalities that are not reflected in the returns to the owners of those facilities. For example, good quality transport facilities will raise the value of land in the areas it serves. Finally, there are problems associated with the natural monopoly characteristics of many infrastructure services.

Conversely, the case for private provision is strongest where the efficient scale of operations is small enough to allow a number of firms to compete and where markets function well, rewarding firms that innovate to anticipate and meet consumer demand, and eliminating those that produce inefficiently or provide poor service. In particular, in sectors of the economy dominated by small and medium enterprises, where large corporations cannot compete successfully, it is unlikely that government business enterprises will do much better. My home state of Queensland provides historical support for this claim, having experimented, unsuccessfully, with state-owned butcher shops, hotels and cattle stations early in the 20th century.

There will always be a range of intermediate cases where no solution is obviously superior. Depending on historical contingencies or particular circumstances, different societies may choose between public provision (typically by a commercialized government business enterprise), private provision subject to regulation, or perhaps some intermediate between the two, such as a public-private partnership.

Friday quick links

On personal freedoms, litigation, and common sense (a good read)

Did he really say that? Chris Joye, optimist, reckons that stability and continuity are valuable things for an economy that is hesitantly emerging from the global financial crisis and about to embark on a period of above-trend growth

Does light rail improve public health? This study has results showing obesity declining in areas serviced by light rail in a before and after comparison.

In the spirit of the competition series running this month I thought it opportune to comment on Sam Wylie’s recent article on reciprocal obligations of banks following government support.  Thinking about the whole story makes the situation seems ridiculous.  The government privatises the banking system, allowing privately owned businesses to determine the money supply, and then bails them out after a crash which resulted from their undue risk taking, then left them to go on their merry way to make abnormally high profits once again.  Clearly, there is no moral hazard here and this wonderful situation is highly beneficial for the people.

Can you draw a conclusion about the impact of population growth on economic welfare from this graph? 

What does it mean for an economy to ‘turn Japanese’ and what determines whether it will?

What few seem to appreciate, either inside or outside of Japan, is just how strong the resulting Japanese recovery from 2002-2008 was. It was the longest unbroken recovery of Japan’s postwar history, and, while not as strong as pre-bubble Japanese performance, was in fact stronger than the growth in comparable economies even when fuelled by their own bubbles.

How on Earth did Japan manage that with their ageing population and zero population growth? Indeed, Japan outperformed Australia in productivity growth since 2000 and very nearly kept pace with real GDP per capita growth.

The RBA’s Ric Battelino seems confused. In a recent speech on the Australian economy he notes that “the slowdown in productivity growth has meant that GDP growth in the latest decade was not as fast as in the previous decade”, while also saying that for the past two decades “part of the growth came, of course, from the fact that the population grew strongly over the period, particularly in recent years.” What? The data he presents shows a negative correlation between economic growth and population growth, yet he continues to promote a positive relationship.

Australia’s average annual real growth in GDP per capita (currently the best measure of economic performance) since 2000 is 1.28%. While I can’t find a direct measure from the Japanese Statistical agency, using the World Bank data collection I can make a comparison of real GDP growth per capita of Australia and Japan using a common methodology. Using these statistics I find that Australia had a mean annual growth in real GDP per person since 2000 of 1.8% while Japan’s was 1.4%.

Notice in the graph however that Australia’s growth in real GDP per capita fell considerable from 2004, when population growth rates began to push up from 1.2% to a peak of 2.16% in 2008. Since 2002, when Japan’s real growth per person increased, the population growth rate declined from 0.2% the preceding 2 years to near zero (average 2003-2008 is -0.002%) till the financial crisis hit at the end of 2007.
 
Like Australian situation I described in a previous post, per capita growth appears to be compromised by higher rates of population growth in this sample of data.

Australia’s economic performance is terms of productivity growth looks pitiful in comparison to Japan. Average annual Total Factor Productivity growth since 2000 was a shy 0.47% (including a productivity recession in 2004-05) while Japan recorded a strong 1.77% over the same period (data from OECD here).

Of course there is always unemployment to consider.  The graph below shows that on this measure, Australia is also behind Japan (having been in front for just the period 2007-2008).  Some longitudinal data is here.

Recent research also suggests that Japan’s economic track record was unfairly blemished by asset price deflation followed by short recessions in the 1990s (1993, 1997 and 1998). The graph below (from here - including 20yr data set), shows Japan’s solid performance over the past decade, with their longest boom since WWII occurring from 2002-2008.

It appears that turning Japanese is not the tragedy it is made out to be by popular economic commentators. Here’s just one example:

As it turned out, Japanese investors lost nominal wealth equal to three entire years' GDP. And the economy today hasn't grown in 17 years or created a single new job.

Nor has the debt been reduced. Instead of permitting the private sector to destroy and pay off its debt, the public sector fought against it...borrowing heavily to try to bring about a recovery. Result: no recovery...and almost exactly the same amount of debt. But while the private sector paid off its debt, the public sector picked up the borrowing. Now it's the government that owes money all over town.

Detractors cite the massive and growing public debt in Japan as a problem, but if denominated in Yen, and with interest rates set at near zero, there is no burden from the debt. In fact, the Modern Monetary theorists would claim public debt in its own currency is never a burden because the government can print money to pay it down. (Maybe the Japanese government prescribes to this theory and keeps the debt as a record of past spending.)

The above graph confirms that Japanese government debt has replaced a substantial portion of private debt since the early 1990s. In my view this is a justified effort to keep the value of the yen stable by maintaining money in circulation - an approach that could be adopted in Australia in the coming decade, with government debt replacing household debt for the same reason.

One must keep in mind that it is probably not the intention of the Japanese government to ever pay off this debt. I am sure they are happy to continue to progress with a high savings rate, high productivity, high GDP, net exports and almost every other fundamental ingredient for economic success.  Turning Japanese appears to be about more fundamental economic prosperity cradled in an unfamiliar monetary framework.

Living in a bubble

Morgan Stanley’s Gerard Minack aptly uses the phrase ‘living in a bubble’ as the title of his research note about Australia’s housing market. Minack’s conclusion is that Australian housing is overvalued, but he sees prolonged stagnation rather than a dramatic pop of the price bubble - I expect that the real returns on residential investment will be negative over the next decade.

I want to highlight a few key charts from the research note. The first is a comparison of prices to rents, showing a massive increase above the long run average since 2000 (I believe this figure is price divided by annual gross rent divided by 100). One could call on interest rates as an explanation, but mortgage interest rates have actually been increasing over much of that period.

The second chart is a comparison of the value of the housing stock to household income, which further supports this claim that home prices are 30-40% above average levels.

The next chart is one that compares the share of household debt by income level. One of the RBA’s claims has been that Australia’s housing market is stable because most debt is held by high income earners - ...our assessment is that the increase in debt has broadly been concentrated in the hands of those generally more able to service it.  This is identical the the US situation in 2007.

 

The next interesting chart shows the degree of speculation embodied in market prices for housing. There was a strong change around 2000 where losses being made by property began to increase.  This is not attributed to rising costs, but to rising prises. Gross rents and costs follow a very stable trend, while interest costs, due to higher prices, lead to the current extremes of negative gearing losses. Minack highlights the boom in number of negatively geared property owners, further supporting Leith van Onselen's findings on negative gearing - negative gearing cost the Government around $2.6 billion in foregone tax revenue in 2007/08, meaning that average Australians are massively subsidising property investors.

The housing undersupply and shortage myth (that somehow high prices are the result of poor government planning and delayed infrastructure provision) is exposed by the following graph. If such supply side constraints really could explain prices, we would expect to see city prices climbing much more than in regional areas. Alas, this is not the case, with almost identical price gains in the past 15 years.

Finally, a graph that makes the point that when it comes to house prices, what goes up normally comes down.

Helmet law research hits the headlines

Helmet laws hit the headlines with a new Australian study proclaiming their ineffectiveness at providing safety to cyclists, while in Canada the debate is heading the other way (due to this study - sorry I can't get the full text to review the methods).

The Australian study neatly controls for the number of cyclists and distance cycled by comparing the ratio of head to arm and hand injuries resulting from cycling activities from hospital records. A change in this ratio (lower head injuries per arm and hand injury) would be a clear indicator of the success of helmet wearing in preventing head injury.

The figure above shows the ratio (ICD9) from 1988 to 2000. Helmet laws were introduced in 1991, and self-reported compliance for two age groups (<16years and >16years) are plotted from 1991 to 1995.

The essential argument is that the large decline in the ratio of head to arm injuries occurred before the helmet law, and much before compliance with the law. In the two year period where helmet wearing took off following the legislation (1991 to 1993), the ratio dropped from 0.8 to 0.75 – hardly a success. The drop in the two years preceding the helmet law was from 1.15 to 0.8.

The author suggests that other road safety measures contributed to the decline, while the law itself would have contributed to a decline in the number of cyclists (some evidence for the decline is here) which itself made cycling more dangerous and lead to a flattening of the trend -

The reduction in numbers of people cycling may have actually increased the risk to the remaining cyclists because of Smeed’s Law and the safety in numbers hypothesis.

The Shadow Public Service

Tyler Cowen asks: Why does anyone pay for macro-economic forecasts when they are typically wrong and in the public domain? The answer is simple. Forward planning requires some assumption about the future. One comment notes that you wouldn’t plan a military exercise without checking the weather forecast, no matter how inaccurate.

But more fundamentally, the reason for paying for such advice is due to the need to appear objective. Whether objectivity involves accuracy is a secondary concern.

Governments face this problem regularly. To avoid accusations of political influence they engage an army of external consultants to provide trivial advice that can easily be determined by internal staff. This army is the Shadow Public Service.

Oddly, critics fail to note that external advice that does not support a government position will be filtered anyway. Like a barrister in a criminal trial, they won’t ask questions they don’t already know the answer to.

I regularly deal with private economics consulting firms and can’t help but wonder how big an industry is supported by the farcical drive for an illusion of objectivity by government. I have personally engaged millions of dollars of work from private economics consulting firms for the sole purpose of having a basis for a predetermined decision that appears independent.

The final irony of it all is that the best qualified people tend to leave government departments to take on the same role as a consultant, but at five times the cost. And, of course, governments have a habit of filling vacant positions whether they are required or not.  Either recruit the staff you need to provide proper advice, or get rid of them and draw upon the resources sitting in private firms.  Don't waste money on a shadow public service unless they provide a real contribution beyond the objectivity illusion.

Competition Series Part III: History

Often forgotten in the competition debate are the reasons for a monopoly’s existence in the first place? A few are:

1. Mergers and economies of scale of private enterprise
2. Government development for its own needs (including defence)
3. Government intervention due to natural monopoly features (either too high risk for private enterprise or too much scope for price gouging)
4. Government intervention due to positive externalities (for example, cleanliness and health benefits of sewerage)
5. Government intervention due to fairness and equitable access – once a technology becomes a necessity it is politically expedient to promote fair access (including regional development)

While many may disagree that government involvement in some infrastructure networks was necessary from the start, citing the textbook benefits of the profit maximising natural monopolist, the onus should be on those promoting change to demonstrate that the world has changed sufficiently for competition and/or private firms to now deliver these services.

Historically, with the advent of new technology, government will typically step in if it sees benefits to centralisation - creating an entity tasked with equitable provision of the new service. Prior to centralised water and sewerage in cities, each property owner would have had a rainwater tank, bore or well to supply water, and a thunderbox for waste. Health benefits of newly designed reticulated sewerage systems were overwhelming (although it took some time before waste was treated in any fashion before being dumped into waterways). Private investment in sewerage reticulation could only recover cost from those who accessed the system, yet the social benefits were much broader. A government established (and subsidised) monopoly was the only way to go. A similar story can be told for water reticulation.

These water and sewerage examples confirm points 2-4 above. While a private enterprise could have undertaken sewerage works, there were positive externalities, and issues of equitable access. Furthermore, a private company would expose themselves to competition with existing methods of treating waste and capturing water supply.

On a more technical note, electricity generation was originally the domain of manufacturers who generated and used their own power onsite. With the wide acceptance of Tesla’s AC power, which could be sent vast distances with greatly reduced losses, the centralisation of electricity began. In this industry economies of scale were so great that governments typically took control of all generation and distribution to reduce costs. Ironically, we now believe that competition will in fact reduce costs and subsequently consumer electricity prices – a situation yet to transpire is State’s where this has happened.

The history of water supply in Britain follows a similar pattern, with government intervening in the 1860s to take ownership of the private supply market due to massive inefficiencies from infrastructure duplication required for competition (water in 1851 was about 60% privately supplied). The costs from these inefficiencies were hindering uptake of reticulated water which proved to have external benefits of improved sanitation and health in the cities. Much of the water industry was then reprivatised in 1989.

The unfortunate part of these stories is that once an industry is in the hand of a government entity, there is no risk, and therefore no incentive to innovate. Rather than government showing the willpower to provide incentives to reduce price and improve service provision of its own monopoly, it instead decides that competitive pressure is the best way to go. To maximise social benefits, government is now required to properly regulate a market of smart, influential, profit seeking firms, instead of properly regulating or managing its own corporation properly. While I am generally pro-competition, one wonders if those in charge of competition reform appreciate this irony.

In somewhat of a return to the past, the federal government is now keen on subsidising the rollout of a fibre broadband network. The justification for government provision is the same –characteristics of natural monopoly, positive externalities of information access, and fairness of access. This is perfectly in keeping with the theory and evidence discussed above, apart from the intention to vertically separate at the wholesale level (a rather grey distinction if you ask me). It seems we have come full circle.

The turning of the tide against privatization predated the financial crisis. Internationally, a number of major privatizations have been reversed. The UK government was forced to renationalize its rail network after the failure of the privately owned operator. In Australia, dissatisfaction with the privatized telecommunications monopoly has led the government to announce that it will get back into the telecommunications business by constructing a publicly-owned national broadband network. New Zealand, where market liberalism was implemented in a radical form in the 1980s and 1990s, renationalized its national airline in 2001 and its railways a couple of years later. And even relabeled as “choice”, Social Security privatization proved so politically unsaleable that it was abandoned early in Bush’s second term.

While the economic evidence suggests it is socially optimal for government to proceed with its rollout of the NBN, I have reservations. New fibre internet connections will have to compete with existing broadband on the copper network, and with developing wireless technologies. I expect there to be a significant cost to go from existing 20Mbps connections to 100Mbps, yet most users will not notice the difference, and may not be willing to pay. If the government goes ahead, it needs be aware that cost recovery may be very low for some time and the justification for its involvement are the positive externalities.

In the long run I still believe the NBN will be a socially beneficial investment. As technology develops on fibre networks, who knows what speeds will become standard and the opportunities this technology will provide.

An understanding of the history of competition and privatisation is necessary to better critique arguments from both sides.

Last piece of the population puzzle

I was pleasantly surprised by Dick Smith’s Population Puzzle documentary last night. He covered most of the key economic arguments against growth, including a rebuttal of the skills shortage and age dependency arguments. I was not taken by the food security argument, but was impressed by the way he highlighted the clash over land use on the urban fringes (where some of the most fertile soils are found).
Most importantly Dick raised the issue of vested interests promoting population growth early in his piece. He rightly singled out the property development lobby as a key exponent of higher population growth, and their obvious vested interests which do not align with the interests of most Australians.

Page 58 of today’s Financial Review has run a pro-population growth response to the Dick Smith documentary, advocating population growth on the grounds of economies of scale – an argument that is easily debunked.

A second argument appeals to economies of scale and suggests that with greater domestic consumption industries can expand to a point where they have economies of scale that make them internationally competitive. Why domestic population is currently a barrier to industry development is beyond me. If there are no artificial constraints on trade, shouldn’t the world be the marketplace of any industry even in its infancy? This argument only works if you couple high population with protectionism.

Economies of scale from increasing the size of the market only apply to monopolies in any case, and even then it is hard to know whether futher efficiency gains are possible (and whether they would be passed on to consumers).

But the confusion of the pro-population growth position is revealed later in the article when it states:

Of course it is possible to have economic growth without population growth – by setting up the conditions for higher productivity growth.

But the ‘meeting the challenges of growth’ argument persists in the end. We are apparently better off investing in massive duplication of infrastructure (roads, housing, energy and water) to accommodate higher population growth, which decreases productivity and economic growth, rather than focus on improving the productivity of the existing population - an absurd conclusion.

I have explained in detail in a previous post how housing investment and other infrastructure duplication does not improve productivity – it is a short term cost that simply allows more people to be equally as productive as the current population at some time in the future. Slower population growth is the recipe for improved per capita well being.

The relationship between growth and productivity is interlinked, but not in the way pro-population growth advocates maintain. Higher population growth is strongly negatively correlated with improved productivity. The graph below uses the ABS multifactor productivity measure and percentage change in population growth to demonstrate. Productivity improved most dramatically when population growth was around 1%.

The investment duplication argument is the final piece to the population puzzle.

Very interesting links

Following my previous post on the Debt Reduction Taskforce, I thought I would provide some links that explain my views on monetary theory more explicitly. Essentially, the money multiplier is a myth, and money is created first by debt, and reserves are accumulated after the fact if necessary - try Bill Mitchell’s blog for an explanation of Modern Monetary Theory (which is close to my personal views), and this site for more detailed discussion on the multiplier myth.

Ross Gittins reiterates my population growth arguments

Environmental concern and unemployment – a negative correlation. We are all too happy to worry ourselves about the environment when the going is good, but in a recession we suddenly shuffle the environment down our list of concerns.

Update on skills shortage and emigration of Australian trained professionals. This recent research suggests that “positive selectivity is stronger where the reward to skill in the destination is relatively large”. Translation: those who pay get the skills they desire.

Economists applying statistical techniques to strange social phenomena - worship and sacrifice:
The theory we test is that, when faced with uncertainty, individuals attempt to engage in a reciprocal contract with the source of uncertainty by sacrificing towards it. In our experiments, we create the situation whereby individuals face an uncertain economic payback due to “Theoi” and we allow participants to sacrifice towards this entity. Aggregate sacrifices amongst participants are over 30% of all takings, increase with the level of humanistic labelling of Theoi and decrease when participants share information or when the level of uncertainty is lower. The findings imply that under circumstances of high uncertainty people are willing to sacrifice large portions of their income even when this has no discernable effect on outcomes.

The Superstar Effect – when you receive massive gains from being marginally better than second best. The paper is here. I read once that the Beatles were probably underpaid for the wellbeing they imparted on the masses through their music. My view was that they earned a pretty penny. They were probably only a little better than the next band that would have formed and become an international sensation had the Beatles never existed. In the purest economic sense they were superstars.

Population problem? It’s called longevity

Population growth advocates often rely on the ‘age dependency ratio’ as their core economic argument.  This ratio is the population aged over 65 divided by the population aged 15-64.  To give this measure meaning there is an assumption that people will not work beyond age 65 and will therefore be need to be financially supported by those at a working age.  Workers will get less of the return on their productive output because it needs to be shared with more non-workers.  Essentially, the percentage of people in the formal economy will decline. 

I have a different opinion on the age dependency ratio. I see it as a shining beacon of success.  People are working for shorter periods of their life.  We as a group are finally taking some of our productivity gains of the past half-century in the form of leisure time. 

Whether or not you agree this a problem, the suggested solution of population growth is, in reality, counterproductive, and will only aggravate the situation.  An increase in the dependency ratio is principally caused by improving longevity. If each generation lives longer than the last we will face this problem even with a growing population. Simply adding more at the bottom of the population pyramid to keep it bigger than the top has the apt label ‘population Ponzi scheme’. Indeed, to counteract this trend would require a significant increase in the natural birth rate, or age biased migration policies, or even the extreme scenario of sending migrants back home when they hit 65.  None of these are desirable.

Australia’s age dependency ratio is 16^th out of this comparison of 20 developed nations; none of whom appear to be in a hurry to stimulate population growth to ‘solve’ this problem. Sweden, Norway, UK, USA, Denmark, Germany and Canada all appear to cope quite well with their demographic fortunes.  Our culture, financial structures and welfare system, are still adapting to a population pyramid becoming more cylindrical.

Notably, on one side of the debate are the vested business interests. Businesses which face demand limits per person (a single person can only consume one of the same newspaper per day) and are limited to domestic consumption (which foreigners are interested in Australian newspapers) have the most to gain from population growth.  The other side includes a fair swag of the rest of us, including Dick Smith, who will be a guest in many living rooms Thursday night when he airs his anti-population growth documentary.

Overcoming the apparent economic strain of age dependency issue is extremely straightforward.  People need to save during their productive years to be self supporting during their retirement years.  Isn’t that the point of superannuation?  This dissaving during retirement also shifts wealth to the next generation.

There are a number of other factors at play which are consistently overlooked in the age dependency argument.

1. People will work longer.  Seventy will be the new sixty.  A gentleman I used to work for is 65 this year and is looking to acquire new skills for the next phase of his career.
2. People will spread their work time over the life much better, possibly taking intermittent retirements between careers.  They will probably work part time and casually long after 65.
3. The participation rate may improve
4. Productivity of the workforce will improve
5. The population aged under 15, who are also dependent, will shrink

My policy prescriptions to ease Australia to social and economic security with a cylindrical population pyramid include:

1. Have the population minister put forward a stable population by 2030 as a goal for Australia
2. Encourage older people still dependent on welfare into casual/part time work.  This can be achieved by allowing up to, say, $15,000 to be earned before they lose any pension payment
3. Remove the baby bonus
4. Possibly phase in a reactive immigration quota based on last year’s population change to meet the target set in point 1
5. Allow proceeds from the sale of a principle place of residence for those above 65 to be exempt from affecting social security allowances for a fixed time period – maybe 5 years.  This encourages financial independence in the long run.
6. Incrementally increase the pension age starting at a future point.  In Germany it is now 69. We could make it say 66 on 2014, 67 in 2017, 68 in 2020, 69 in 2023, 70 in 2024.

We need to be clear about the future we want for this country.  The population choice is one we can make as a society to provide the country we desire for our children and grandchildren.

Debt reduction taskforce - bad timing

Tony Abbott recently announced his plan to establish a debt reduction taskforce to reduce government debt that he believes Labor foolishly incurred. I have no problem with governments paying down debt and aiming to have a zero debt balance over the business cycle, but does he really think that governments should pay down debt while the citizenry is trying to do the same? To me this sounds like a recipe for disaster.

Debt deflation is what happens when indebted households and businesses start to pay off debt after a period of debt accumulation. Money used to pay debts is not used for consumption and no longer circulates in the economy. This decreases demand, but also reduces the money supply. The net effect is to slow economic activity and reduce prices (deflation). To read quality analysis of debt deflation read Steve Keen’s superb articles here.

The government response to this should be to print money. Because a portion of the new money is used to pay debts, a far smaller portion circulates in the economy to cause inflation. If it is done well, it should slow deflation, keeping demand and prices stable, and allow debts to slowly be repaid without the value of debt rising in proportion to incomes.  Whether this will promote further malinvestment (investing in non-productivity improving assets) remains to be seen.

Establishing a taskforce is a clear sign that it is not Abbott’s intention to pay down government debts by printing money. His plan appears to be the reduce government spending to pay debts – the exact same thing households are currently doing.

This will only exacerbate the decline in demand and accelerate our march towards deflation.

Competition Series Part II: Theories, assumptions

Let us look at the theory to see why the productivity gains from Australia’s pursuit of competition reform have been so hard to come by. Oliver Williamson’s 1968 model of the competition-coordination tradeoff is a good starting point.

The assumptions in Williamson’s model are that the monopoly industry has a lower marginal cost than competitive firms, that the monopolist sets their profit maximising price according to traditional economic theory, and that in a competitive market firms set their prices at marginal cost.

The graph below shows the resulting welfare implications of this model.

In this situation, while the competitive firms face higher costs (MC2), they set a price lower than the profit maximising monopolist (at P2 instead of P1). The welfare implication is that the area A is transferred from producer to consumer surplus, area B is the loss of producer surplus due to coordination costs, and area C is the gain to consumer surplus. There is a net loss of social surpluses (including all producer surplus) from competition in this model, however there are significant gains to the consumer surplus (areas A and C).

For a net gain to consumers in this model, two conditions need to be met:

1. The profit maximising price of the monopolist is higher that the marginal cost to the competitive producer (MC2 < P1), and
2. The competitive producers set prices at marginal cost (P2=MC2)

Unfortunately, neither of these conditions can be known in advance. In fact, if we drop just the second assumption, which has been proven many times to be far from realistic, the chances of a competitive market generating greater surpluses than a profit seeking monopolist greatly diminishes. In the above diagram this would mean that P2 is somewhere above MC2 (and of course we still don’t know if MC2 is below P1).

Costs associated with vertical separation and competition can be significant, including:

1. Coordination costs and risks of contract development and enforcement
2. One-off reorganisation costs
3. Costs of regulation and oversight and potentially unpredictable regulatory interpretations and legal determinations
4. Marketing and advertising costs for competitive firms
5. Insurance costs (government entities would typically self insure at a lower cost)
6. Profits (not necessary for a government entity)

Additionally, incentives change under a competitive structure. The legal profession and regulators now have a vested interest in promoting complex regulation while competitive firms may feel ‘too big to fail’ and take undue risk and malinvestment.

Another incentive change as a result of vertical separation is the classic hold-up problem (a type of path dependence I have discussed previously). Although the classic GM Fisher Body problem has apparently been resolved and was not in fact an example of this problem, there are clearly cases of technology change and investment where vertical integration sheds risk and reduces costs. For example, if railways were vertically separated so that multiple companies trains operated on a monopolist's track, new track technology (materials, gradient or other change) could not be adopted without corresponding investment in trains to run on new lines. The first mover to the new technology can be held to ransom by the second mover, thus the profit maximising outcome is for neither side to make a move.

Let us now return to the coordination costs resulting from separation. Increased transaction costs result partly from contract negotiation, but also from risk. The graph below shows that the more specialised a fixed asset, the higher the transaction costs (and risk) for the vertical separated supplier. Markets provide efficient transaction cost outcomes when very large capital investments are not highly specialised. This is not the case for most infrastructure networks.

There is of course one key benefit from competition that is not represented in these models – it is the benefit of simply having consumer choice from competition. Consumers (or intermediate producers) can use their power to choose, which provides incentive for competitive firms to innovate not just on cost saving, but on service provision. For example premium and budget services could emerge (think airlines).
 
One must also carefully define competition. The power of consumer choice exists even with apparent natural monopolies. For example, rail freight competes with cargo shipping, road haulage, and even air freight. There is a limit to the ability of a monopoly rail line to manipulate freight prices in light of the alternatives available. There are even alternatives to centralised electricity. In remote areas on-site electricity generation is still common. Households and businesses have the opportunity to invest in their own generation capacity should the network supplier exhibit monopoly pricing behaviour (solar, diesel, wind). Water can be sourced from rain water, bores, and recycled on site, while composting toilets are an emerging trend for the environmentally conscious.

The Austrian School’s “permanent economic process” of competition follows similar logic, and argues that “market dominance is always necessarily temporary in the absence of monopoly-creating government regulation.” All industries, no matter their cost characteristics and number of competitors, are exposed to risks from new technologies and potential competitors. It is only government designation that creates true monopolies and stifles the permanent process of competition. Such designations lead to an early 20th century trend, where “virtually every aspiring monopolist in the country tried to be designated a "public utility," including the radio, real estate, milk, air transport, coal, oil, and agricultural industries, to name but a few.”

The Austrians see little benefit from public provision of any good. Yet what they fail to acknowledge it that underpinning their vision is the assumption of competitively priced access to public property – such as roads and underground space for water and sewer, and rights to erect power lines – which due to the complexity and diversity of costs to the public, can never be appropriately priced. This feature means that governments will always retain monopoly control of access to public space which forms a key production stage (this idea will be revisted in a later post).

Before leaping onto the competition bandwagon, one should evaluate the limits of monopoly behaviour due to broader competitive threats including technology change. One should acknowledge that on most occasions, monopoly power will still be held by government in some form. Furthermore, one should look to history to examine reasons for the existence of the monopoly in the first place. This historical perspective is the topic of Competition Series Part III.

Scared of deflation?

I have always been puzzled at the assymmetry of 'flation fear'.  A little inflation is good, but a little deflation is a scary thing.

Paul Krugman outlines the general argument as follows:
So the argument that deflation is a bad thing is also an argument saying that some economic problems get worse as inflation falls, and that too low an inflation rate may actually be economically damaging.

For the life of me I can't see how an inflation rate of zero can be damaging in the long run.  Also, if we look at Krugman's argument in reverse, more inflation is better.  Why isn't the optimal inflation rate zero instead of some positive number? Why 3% instead of 10%? Do human have an inbuilt behavioural trait that only we are able to plan and invest knowing that currency in the future will worth less rather than more?

Steve Landsburg on the other hand makes the argument that deflation fears are not justified by economic theory or evidence - I don’t see the problem in theory and I don’t see the problem in practice.

And he concludes that even if deflation is bad, it is easily solved.
Even if deflation is a bad thing, we know how to solve it. Print enough new money and people will eventually start spending it. It’s alleged that no matter how much you print, it can all just fall into the liquidity trap, and it’s alleged that this is what happened in Japan over the past decade. But I am sure the Japanese just didn’t try hard enough. Liquidity trap or not, I guarantee you there’s a central banker in Zimbabwe who knows how to fight deflation. If we really get into trouble, all we have to do is hire him.

As I have noted before, the world survived just fine for a long period of time with inflation at zero on average. Positive inflation in the long run did not occur until post WWII. Some might even argue that this is simply the longest ever business cycle stimulated by enough debt to keep inflation positive, and that the next fifty years, subject to international politics, might see prolonged deflation.

Avoiding deflation in the short run may have made the global economy far less stable in the long, long run.

Maybe it is just that with high debt levels adjusting to deflation from a persistent inflationary environment will unsettle much investment, and mean a transition period were many jobs are lost.  Any thoughts?

Competition Series Part I: Experimentation

The annual ACCC Regulatory Conference was held last week at the Gold Coast. At a time when various governments are intervening to separate Telstra’s business, sell public railways, subsidise a fibre broadband network, and introduce competition in water markets, any evidence on the effectiveness of competition reforms in such network industries would be helpful. Yet my take home message was that nobody is sure if competition reform has provided, or even can provide, the social benefits it was designed to achieve.

Ironically, in the second session of the conference the following findings were put forward:

...in most circumstances, profit maximising vertical integration decisions are efficient, not just from the firms’ but also from the consumers’ point of view. The vast majority of studies support this claim,.. even in industries which are highly concentrated…

However, the thrust of competition reform is directed at unbundling vertically integrated monopolies to reduce potential abuse of market power.  Railways, electricity, and telecommunications are classic examples, yet a quarter century of evidence shows that vertical integration is in fact the efficient outcome for both producers and consumers. I would note however, that even where market structures appear to be competitive, price competition and innovation may still fail to eventuate.  On the other hand, monopolies may innovate simply due to a the threat of competition. Arguing that competitive outcomes will be achieved based on market structure alone is flawed.

That got me thinking. Is competition reform more about ideology than social gains through efficiency? Are we just swapping government incompetence at regulating and incentivising its monopoly with incompetence at developing sufficient regulation for a competitive market operate while still relying on government owned monopolist components of the value chain?

This post is the first in an August series on competition which will follow my emerging understanding of this controversial topic. I hope to investigate key theoretical assumptions, investigate the history of competition reform, compare theoretical outcomes with real evidence, and identify regulatory shortcomings. In doing so my personal opinions will become known, yet I hope that some debate will challenge these opinions. Any comments and criticisms are welcome.

The competition experiment

Australia’s big push towards competition reform of nationalised industries came from the 1993 Hilmer Report. In this report, Fred Hilmer kept his eye on the prize.

Competition policy is not about the pursuit of competition per se. Rather, it seeks to facilitate effective competition to promote efficiency and economic growth while accommodating situations where competition does not achieve efficiency or conflicts with other social objectives. These accommodations are reflected in the content and breadth of application of pro-competitive policies, as well as the sanctioning of anti-competitive arrangements on public benefit grounds.

The Austrian School has a different take, suggesting that competition is in fact a “permanent economic process”, and that “market dominance was always necessarily temporary in the absence of monopoly-creating government regulation.” Competition is, by default what happens in the absence of government intervention. Indeed, one could argue that competition is simply human nature – the desire to improve one’s lot. Privatisation gives a profit motive to promote competition, but there are other surely other ways to harness our competitive drive.

One could say that competition reform is focussed on the very limited definition of competition in pursuit of profit - privatisation by another name. Why competitive pressure cannot be utilised by government monopolies remains an open question.

Of course, most people would argue that you cannot fully privatise a monopoly for both reasons of equity and for fear of the abuse of market power. To use the profit motive to promote competition therefore, the monopoly supply chain most be vertically unbundled. This then adds layers of cost to the final product, which may more not, outweigh the gains from competition driven innovations.

I asked Fred Hilmer and Stephen King during this session why they had such a long list of industries they believed could be improved by competition reform, when José A. Gomez-Ibañez’ earlier presentation had highlighted the many subtleties and challenges of improving productivity through such reform, and the potential for making the situation worse. Indeed, I highlighted a plethora of other more likely explanations for the decline in Australia’s productivity this decade, including speculative housing investment, large infrastructure investment (much of which is duplication), a technology plateau following the ICT boom, Dutch disease, and more.

Their answers gave a glimpse into the ideology behind these reforms.

To paraphrase, it is better to have a go and be wrong, then let things continue as they are. We don’t know if it’s broke, and we don’t know how to fix it, but we’ll do it anyway. I can’t think of any other part of life where such logic prevails.

While I know firsthand the inefficiencies of government control, where revenues are assured and the incentive to innovate is low, this does not preclude alternative arrangements to provide incentives for government owned corporations. Nor does it mean that the waste (deadweight loss) generated by private competitive firms is less than that of a government, or even a private, monopoly. For example, recent findings even suggest that government owned bank are better for economic growth:

...if anything, government ownership of banks has been associated with higher long run growth rates, even after controlling for institutions and other variables...

Competition was a means to a productivity improving end. Now, after much experimentation, we are discovering that it is probably the minority of cases where competition delivers. Our institutions however, seem inclined not to notice the costs of competition reform.

Part II will examine relevant economic theories of competition, monopoly and vertical integration.

Quick housing update and forecasts

The residential property bears breathed a sigh of relief with the release of the monthly RPData hedonic price index for June - down 0.7% (with Brisbane prices down 1.3%). The bulls however are happy enough with the 20% capital growth performance since June 2009.

In light of this, Steve Keen has laid out his forecast of things to come in residential property:

Firstly, with an increased stock of unsold houses on the market, buyers are likely to take yet more time to make a decision—which will add further to the backlog. If prices are falling, why hurry? The urgency will leave the buy side.

Secondly, so-called investors—whom I prefer to call speculators, since 90% of them have bought existing properties rather than built new ones—will start to consider whether they should swap from the buy side to the sell side. After all, no-one in their right mind buys an investment property in Australia for the rental returns: it’s capital gains or nothing DownUnder. Do you capitalize on gains to date, or hang on hoping that the upward trend will re-assert itself once more?

I expect these two processes to lead to an accelerating rate of decline in house prices now, as they did in the USA when “Flip That House” ceased being a winning trade.

Chris Joye has made a typically broad prediction:

Rismark had been forecasting a substantial deceleration in housing conditions back to single-digit annualised growth rates since October 2009. Over the long-run, house prices track purchasing power quite closely. Disposable household incomes were only projected to rise by about 5 per cent in 2010. We’ve had 4.7 per cent growth in dwelling values in the year-to-date. We do not, therefore, expect to see the market rise much further over the remaining year subject to labour market conditions and the course of monetary policy.

Interestingly, Joye notes the decline in housing credit outstanding, but does not seem to believe this will strongly influence prices in the near term.

Finally, over at Delusional Economics we have this gem:
There is no "soft landing" for a debt driven economy that suddenly decides to shun debt