Friday 8 October 2010

Trendy economics

Bernard Hickey, one of New Zealand's top business journalists, has flipped to the trendy side - how orthodox economics is all wrong, we need capital controls, and so on. Matt Nolan provides a rather thorough critique here.

I'd add one overarching point to Matt's, which isn't original to me but does apply. The case for markets never lay in their perfection but rather in the relative imperfection of alternatives. I'm teaching intermediate micro this semester. We go through the welfare theorems, and they're beautiful. We know that they don't apply generally. However, it's really hard to improve on the imperfection of markets. Both markets and policies are imperfect instruments. Markets fail relative to blackboards, but regulatory solutions often fail relative to the real world market alternative.

Hickey's patchwork of proposals gives a small chance of improving short term outcomes but with longer term risks for the overall economy. Nolan, linked above, highlights most of the risks. Here's one I find worrying:
The NZ Super Fund [the government's "lock-box", invested in broad markets] is already making great strides to lift its proportion of New Zealand investments from its current 20 per cent to the 40 per cent recently mandated by the Finance Minister Bill English.

What's wrong with making it more than 60 per cent? Do we really believe all the modern portfolio theories about global capital markets and investment returns over the long run? I've certainly lost the faith and would much rather the money was invested here than in some US dollar denominated asset that's about to be devalued sharply.

KiwiSaver [a tax preferred individual retirements savings vehicle] funds should also be subject to a government mandate to invest locally. Just over 40 per cent of the NZ$5.5 billion invested in KiwiSaver has been invested overseas.

It should also be closer to 60 per cent. It may not be easy or cheap for fund managers to find investments here. But that's what they're being paid for isn't it? The real danger with KiwiSaver is we force more savings to fix a local capital shortage and the majority is simply shipped offshore because it seems easier and cheaper to do it.

If there is ever going to be a move to compulsion then there has to be a quid pro quo for that effective public subsidy to the funds management industry: keep it local.
Because he personally has lost faith in modern portfolio theory, he wants to force all of us to invest locally. Yeah, things have been rough for the last few years. But the proposal here seems pretty worrying.

Again: The NZ SuperFund basically exists to help government top up its superannuation payments when the pay-as-you-go part from taxes comes up short relative to obligations. We have nowhere near a fully funded government pension system. When are tax revenues likely to be in significant shortfall relative to pension obligations? During domestic recession. When are domestic portfolio returns likely to be at their worst? During domestic recessions. So we'd have to liquidate assets at the bottom of the market. Now, maybe we'd be able to get by with divesting only the foreign part of the portfolio during a domestic recession and save the domestic part for a more solid ongoing stream of payments. But given how heavily exposed the NZ government is to domestic risk, I'd have thought having next to no domestic assets in the NZ SuperFund would be optimal.

If KiwiSaver were compelled to invest locally, I'd exit KiwiSaver: my domestic exposure through housing is far too great a part of my overall portfolio. The tax advantage of KiwiSaver isn't worth taking on additional domestic risk for lower overall returns. But Hickey wouldn't allow that. He sees a domestic investment mandate as being compensation for compulsion. I suppose it depends whether you weigh at all the interests of the folks whose money's being taken.


  1. I was wondering how long it would be before you commented on Hickey's change of heart. I don't fully understand the inner machinations of the economic world, so this is my simple laymans take on his comments. I'm sure you'll correct me when I make silly assumptions :)

    It seems to me Hickey is advocating some sort of regulation in order to reign in the unfettered free-market antics of investment fund managers and the like. I'm assuming the catalyst for his comments is the number of investment companies that have gone belly-up in recent years, and the current state of global financial uncertainty.

    I see your point about KiwiSaver, that makes sense. But I do feel for many of the people who invested in failed finance companies. Its all well and good to say that higher returns attract higher risk, and many of the investors were no doubt aware of the increased risks. But those who lacked knowledge of the process, or who were deliberately misled by fund managers, probably deserve some sympathy.

    I'm not sure what type/level of regulation would have prevented or minimised the damage in these situations, that isn't my area of expertise. But it does seem a shame when inept and/or unethical execs are able to get away relatively unscathed at the expense of simple mom'n'pop investors.

    Awaiting the barrage of corrections with bated breath :)

  2. Hickey's prescriptions go well beyond reigning in fund managers. Wanna regulate fund managers, regulate fund managers. Don't impose capital controls on the whole country.

  3. I agree his focus is broader than my simple analysis. Regarding his comments on currency markets, at what stage should the reserve bank step in and control our currency if the $US continues to devalue as seems likely? Or ought we just jump on and ride the rollercoaster? What are the risks of each strategy?

  4. $0.75 is locally high but not crazy. It was in there most of 07/08 or higher.

    There are automatic stabilizers in the currency. If the exchange rate is high, that dampens inflation pressures a lot, putting downward pressure on interest rates and moderating the exchange rate pressures. We're already seeing this. I'd not be surprised if RBNZ put rate hikes on hold for the rest of the year.

  5. With regards to the finance companies I think one of the real issues was that the interest rate offered did not actually reflect the risk involved - from memory some of the shakiest finance companies were only offering rates 0.75% higher than Rabobank. Geez does 0.75% cover the massive increase in risk, I think not.

    I kind of assumed that everone understood the relationship between risk and return, but apparently not, as evidenced from the fallout of the failed finance companies.

    Whilst I have sympathy for those people misled by funds managers (ala ANZ/National Bank advisors) or dodgy prospectuses, to a certain extent it is beholden on people to do their own research into what the finance company is investing their funds into. Of course a number of firms obfuscated what exactly they were doing with the funds, but that in itself should be a warning sign.

    And to go back on topic, (kind of) setting a percentage of the superfunds to be held in NZ is nuts. It's either going to distort the stockmarket over the long term or more likely it is simply the government wanting access to cheap funds via issuing debt - I'm guessing it's a variation on what they did to EQC.

  6. Are you sure that they misunderstood it, Duncan? I think it was you and me instead. Those guys generally got bailed out. I'd take a tiny premium if all the downside risks were on government too.

  7. "I'm teaching intermediate micro this semester."

    Are you using baby Varian?

  8. Of course. Am doing the calc version of the course.

  9. Lats: I think Hickey is arguing that we should punish ourselves because of what Goldman Sachs did rather than Geneva Finance. But on that topic, it's interesting to consider that the Core Funding Ratio policy that Hickey loves so much actually relies on one of the big flaws of the finance company model: retail depositors are a 'stable' source of funding precisely because they don't price risk correctly and don't read the warning signs.

  10. You have to remember that bernard is about as much economist as he is brain surgeon.

    He is a journalist and has no training in economics - hence his
    'interesting' proposals (read silly)...

    Some economists should send him a strongly worded message to get schooled in the subject before he starts mouthing off and talking self serving bollocks.

    Its all about driving traffic to his website... nothing more.

  11. You may know that I think the NZSF should be dismantled but, if that's not possible, the whole should be invested entirely in equities (no cash, bonds or property). The NZSF is effectively 100% leveraged so it makes no sense to invest in fixed interest options.

    As to the NZ/overseas split, direct equity stakes in growth New Zealand opportunities can be justified; everything else should be in unhedged, passive international shares. This part of the portfolio is, in reality, an insurance fund against the relative future underperformance of the New Zealand economy. Passive will usually outperform active on an after-fees basis.

    On KiwiSaver, if there are to be rules about how much should be invested in New Zealand (a very bad idea) that doesn't necessarily mean forgoing the tax subsidies so it may not be sensible to pull out of KS. A 100% subsidy (to $1,043 a year plus tax-free employer subsidies of up to 2%) can withstand a fair thrashing on comparative investment performance before it makes sense to pull out.

    But then, I am not an economist.

  12. @Michael: Agreed on equities. I have no problem with NZSF deciding to invest in some domestic equities as part of an overall portfolio where they remain judged by their returns.

    I really don't like mandates on portfolio composition. If NZSF were directed to put that big a chunk of its assets into domestic holdings, by how much would they push down the rate of return on NZ investments? I'd have to start running the numbers were the govt to start pushing big domestic investment constraints on Kiwisaver. But you could be right that I've underestimated how much the tax subsidy affects returns.