New Economist

US housing bubbles: Half froth?

A key risk facing the US economy this year is the deflation of the US housing boom. Whether or not it is a bubble has of course been subject to much debate. The Economist has long criticised Mr Greenspan for "inflating a housing bubble by holding interest rates low for so long". The OECD argue that some regions - especially California and Florida - suffer from "price overheating", but there is no housing bubble at the national level. (Dearieme commented "that must be a considerable consolation to everyone who's managed to buy a national house"). See also my previous posts.

But how best to detect and measure those local hotspots? HSBC economists Ian Morris and Ryan Wang recently published 110 page report, A Froth-Finding Mission: detecting US housing bubbles(Warning: 1.9Mb PDF), gets to the bottom of the issue. The report itself concludes that the "glass is half froth":

We suggest that about half of the US housing market is frothy and that this ‘bubble zone’ may be overvalued by as much as 35-40%, after taking into account low interest rates and tax advantages. Current valuations imply a large permanent reduction in the risk premium and/or a sizable step up in future capital gains, not all of which, we think, is justified. The ‘bubble zone’ accounts for 50% of US GDP, or over USD6trn, nearly the size of the German, French, and UK economies put together. In other words, it’s big. Therefore, when these housing bubbles begin to deflate, it is likely to have substantial macroeconomic consequences.

What’s troubling is that even a perfect ‘soft landing’ in the form of flat national house prices would be consistent with a 35-40% collapse in existing home sales. The gush of liquidity from mortgage equity withdrawal would dry up, resulting in a growth drag worth over 3% of GDP. If this adjustment can be managed over many years (and hopefully it will), the economy can avoid recession and get away with soft growth. If the process is squeezed into a shorter time frame instead, then recession is probable, forcing the Fed to once again consider unconventional policy options – a probability that would only rise if the money supply were to decline at the same time the ‘bubble zone’ deflates.

To my mind the HSBC report's analysis and conclusions are about right. There's no nation-wide bubble, but there is enough overheating in major parts of the United States for there to be serious downside growth risks should they burst.

I do not consider this to be the greatest threat facing the US or global economy. As I have argued before, the experience of both the Reserve Bank of Australian and Bank of England is that housing bubbles can successfully be deflated over a 2-3 year period by steady rate hikes and clear, consistent messages to investors. If the Federal Reserve is able to follow their example - and there's no obvious reason why they can't - that would detract around 1.0 to 1.5 percentage points a year from GDP growth. Enough to drag annual US growth below trend, but nowhere near recession territory.

What are the risks to such scenario? One is that the Fed could raise rates too aggressively. But I doubt that; they seem to be near the end of their tightening cycle. A greater risk is if a major crisis (banks or hedge funds collapse, avian flu pandemic, war with Iran) caused the Fed to pump massive liquidity into the finnacial system, giving the housing boom a second wind - and then followed that some months later with aggressive rate hikes. That might trigger a more rapid downward price spiral, rather than gentle price deflation. It's not my central scenario, but I would not rule it out.

By the way, the HSBC report is based on HomePulse, their new online US housing valuation model/spreadsheet:

It is an effective tool for evaluating the housing ‘bubble’ debate and we are making it available to clients. Access it at HSBC Home Pulse. Users can apply a wide array of valuation techniques to over 200 areas and aggregates, including all 50 states and 150 cities, and one can create customizable ‘bubble’ and ‘non-bubble’ zone aggregates. Assumptions for many variables, such as mortgage rates, can be changed, which is useful for scenario analysis. This will allow users to be better informed about the US housing bubble debate.

So all you 'bubble' types can develop your own house price scenarios and valuations!

P.S. For an earlier blog post on the HSBC report see Calculated Risk (and the 24 comments below).

Globalisation = bigger government

Paolo Epifani and Gino Gancia argue that the relationship between trade openness and the size of government is "remarkably reobust' in their new paper, On Globalization and the Growth of Governments (PDF):

This paper investigates the relationship between trade openness and the size of government, both theoretically and empirically. We show that openness can increase the size of governments through two channels: (1) a terms of trade externality, whereby trade lowers the domestic cost of taxation and (2) the demand for insurance, whereby trade raises risk and public transfers. We provide a unified framework for studying and testing these two mechanisms.

First, we show how their relative strength depends on a key parameter, the elasticity of substitution between domestic and foreign goods. Second, while the terms of trade externality leads to inefficiently large governments, the increase in public spending due to the demand for insurance is optimal. We show that large volumes of trade may result in welfare losses if the terms of trade externality is strong enough while small volumes of trade are always beneficial. Third, we provide new evidence on the positive association between openness and the size of government and test whether it is consistent with the terms of trade externality or the demand for insurance.

Our findings suggest that the positive relationship is remarkably robust and that the terms of trade externality may be the driving force behind it, thus raising warnings that globalization may have led to inefficiently large governments.

Asian blogs 11: China Digital Times

A website I have been checking regularly, and have added to my blogroll, is the China Digital Times. It is run by journalist students at the Berkeley China Internet Project, and features links to several news items a day.

Latest China wrap: Kung Hei Fat Choi

My second wrap-up of China articles and blog posts of interest. Kung Hei Fat Choi to my readers.

* Battling for China's IPOs: Kevin Hamlin writes for the latest Institutional Investor about how China's state-owned enterprises are shunning overseas listings

* Brian Bremner, writing in Business Week, says Don't Be Afraid of China

* China: Can the Slowdown be Denied? ask Morgan Stanley's Denise Yam and Andy Xie

* Selling in China? Which one is it? David Lague of the International Herald Tribune writes about the distinct regional differences in today's China. (Hat tip: China Challenges)

* Thailand is taking learning Chinese seriously, according to Michael Vatikiotis's article The soft power of 'Happy Chinese', also in the International Herald Tribune.

* Mark Thoma posts on the growing economic ties between Africa and China

* The ADB Institute have a recent Policy Brief on Renminbi Revaluation: Lessons and Experiences

* China to ease foreign exchange accumulation, according to Chris Giles in yesterday's Financial Times

* Ford is not the only US auto company that should be worried about China. Gal Luft writes about The dragon at Detroit's gate in the Asia Times

* Simon's World warns us that the People's Bank of China has launched an anti-corruption drive drawing on Marxist theory and methods (more on Beijing's aim to modernise Marxism here)

* Adult nappy sales are soaring in China as millions prepare to endure marathon train journeys to be with their families for New Year

Rodrik on the 'augmented' Washington consensus

Sorry readers, yet another recent paper by Dani Rodrik that is worthy of your attention. Unlike Andrew Leonard, I don't love the guy. But he's certainly prolific and thought provoking.

This post is about his recent review of the World Bank’s Economic Growth in the 1990s: Learning from a Decade of Reform. Writing for the Journal of Economic Literature, Rodrik's piece Goodbye Washington Consensus, Hello Washington Confusion? (PDF) starts on a positive note:

There are no confident assertions here of what works and what doesn’t—and no blueprints for policy makers to adopt. The emphasis is on the need for humility, for policy diversity, for selective and modest reforms, and for experimentation. ...Occasionally, the reader has to remind himself that the book he is holding in his hands is not some radical manifesto, but a report prepared by the seat of orthodoxy in the universe of development policy.

Rodrik contrasts the World Bank's interpretation of the 1990s with the IMF's, which has increasingly emphasised the importance of institutions and the need for good governance and institutional reform:

What has become clearer to practitioners of the Washington Consensus over time is that the standard policy reforms did not produce lasting effects if the background institutional conditions were poor. Sound policies needed to be embedded in solid institutions.

Moreover, there were significant complementarities across different areas of reform. Trade liberalization would not work if fiscal institutions were not in place to make up for lost trade revenue, capital markets did not allocate finance to expanding sectors, customs officials were not competent and honest enough, labor-market institutions did not work properly to reduce transitional unemployment, and so on. The upshot is that the original Washington Consensus has been augmented by a long list of so-called “second-generation” reforms that are heavily institutional in nature.

The paper also discusses "yet another vision of reform strategy": the United Nations’ Millennium Project, led by Jeffrey Sachs.

The U.N. Millennium Project is based on the view that we basically know enough to mount a bold, ambitious, and costly effort to eradicate world poverty. We have successfully identified all the margins that matter, and we better move on all of them simultaneously. Learning from Reform, by contrast, is an ode to humility. What we have learned, it says implicitly, is the folly of assuming that we know too much. We need to downplay grandiose claims, move cautiously, and concentrate our efforts where the payoffs seem the greatest.

Rodrik outlines "a way of thinking about growth strategies that avoids some of the obvious pitfalls," based on growth diagnostics, targeted policy design, and institionalising reform. There is much good sense here. He concludes:

Learning from Reform is a genuinely interesting document: it represents a mea culpa as well as a way forward. It pushes us to think harder and deeper about the economics of reform than anything else out there. It warns us to be skeptical of top-down, comprehensive, universal solutions—no matter how well-intentioned they may be. And it reminds us that the requisite economic analysis—hard as it is, in the absence of specific blueprints—has to be done case by case. These should be music to any economist’s ears.

I suggest people read the whole book - it is available to download on the World Bank website.

Should the UK keep ratcheting up its minimum wage?

Guardian columnist Polly Toynbee certainly thinks so. Today's 'open letter' to Paul Myners, the new chair of the UK's Low Pay Commission, is entitled You are now the pay tsar: speak out and embarrass cowardly politicians. Polly rather predictably argues he should "keep pushing the rate up, announcing that intention so business is forewarned".

Is there a limit to how high it can rise before jobs really are lost? All economists agree there is, but none can say when: just suck it and see. Keep pushing upwards until it begins to do more harm than good. But that level would be quite different in each sector and each region - and it hasn't happened yet.

Tim Worstall reminds us of his previous post, Wage Against the Machine, which discusses the recent UK experience:

Why did we not see this effect in the unemployment figures? ...In the context of the overall economy the effects on the total unemployment figures are simply too small to be seen. But the effects on the specific individuals, those who have their hours cut, lose their jobs, are of course substantial.

Chris over at Stumbling and Mumbling, who posted More evidence on minimum wage effects just over a week ago, has also taken on Polly. He lists no less than eight reasons to be against the minimum wage, including this one:

5. Even if all the impact of the minimum wage is upon jobs rather than hours, the jobs lost are just too few to show up in macroeconomic data. Put it this way. New Labour has promised to raise the minimum wage by 30p - 5.9% - in October. This implies a rise in the aggregate wage bill of barely 0.1%. Assuming a price-elasticity of demand for labour of 0.7, this implies that just 17,500 jobs will be destroyed; there are just under 25 million employees.

This is half a week's inflow into unemployment. It's undetectable in aggregate figures. To find the impact of the minimum wage, we need detailed microeconomic studies. Like this one (pdf). It found "some evidence of employment and hours reductions" - just what theory predicts.

Unlike Tim and Chris, I support the current minimum wage system in Britain. While I agree it is not a particularly effective means of reducing poverty (tax credits are much better targeted), it does at least help to prevent exploitation of vulnerable workers.

If there have been disemployment effects, then so far they have been - as Chris argues - too small to detect. But Polly's "suck it and see" approach to future increases is not just dumb, it's dangerous. At a time when we are seeing signs of a marked weakening in the UK job market, the last thing you should be doing is ratcheting up the minimum wage as fast as you can.

A more cautious, iterative approach is surely warranted, otherwise there is a clear risk of pricing not just 17,500 people out of work but many more. I very much doubt that Paul Myners would want to leave a legacy of mass disemployment amongst the low paid as his lasting legacy as LPC chair.

How the World Works

I have added How the World Works by Salon staff writer Andrew Leonard to my blogroll. Andrew writes about many of the issues of interest to me: trade, globalisation, outsourcing, China... Here's the blurb:

Andrew Leonard is on special assignment to grapple with the mysteries of globalization. That's a big beat to cover -- too big for any one story or book. But there's a global conversation taking place online that may be up to the task, and that's where "How the World Works" comes in.

"How the World Works" is a blog that aims to bite off small pieces of the big story, while at the same time engaging with the vast complexity of the Internet's multi-threaded dialogue on the global economy.

The only annoying aspect of his blog is the need to click on an advertisement before getting to the main blog page. If you can cope with that, you should find much to enjoy.

Giving the 'Polish plumber' a chance

Last September I argued that it was time for EU countries to welcome the 'Polish plumber'. At the time of EU enlargement in May 2004, only Britain, Ireland and Sweden allowed workers from Eastern and Central Europe free access to their labour markets. The other 12 of the 'old' EU-15 member states imposed 'transitional restrictions' on labour movement.

But by 30 April 2006, member states have to declare whether they aim to ease, lift or keep the restrictions in place for another 3+ years. A EurActiv report, Member states ponder lifting labour market restrictions, expects most of the remaining twelve to lifyt or ease their restrictions on the 'Polish plumber' and other migrant workers:

Spain, Finland, Portugal and Greece now appear inclined to ease or even remove restrictions on labour movement from the EU-8 states in May 2006. France and Belgium are reportedly considering easing the restrictions only gradually, leading up to their full removal by the end of the decade. Denmark said that it will give its policy a careful review. Austria and Germany, both saddled with high unemployment, have indicated that they will keep the restrictions in place. 

Non-EU member Norway is also considering opening its doors to the new EU member states. In a referendum in September 2005, Switzerland decided to open up its labour market to workers from the EU-10 countries.

Britain has easily absorbed the quarter of a million foreign workers it has received over the past 18 months. Many British employers say they could not do without them. In London the Eastern European shop asistant is now so ubiquitous, and so accepted, that it's hard to remember what the fuss was all about. Let's hope other member states can emulate the UK's positive experience.

Are China's exports really so special?

Yesterday's post, What's so special about China's exports?, cited a new paper by Dani Rodrik which argued that "China is exporting stuff that is way too sophisticated for its level of income, and that explains part of its success". It's an interesting argument. But is Rodrik right?

A recent paper by Sanjaya Lall (RIP), John Weiss and Jinkang Zhang, entitled The ‘Sophistication’ of Exports: A New Measure of Product Characteristics, suggests that his claims may be exaggerated. This paper proposes:

...a new classification - ‘sophistication’ - as a means of analyzing product characteristics in great detail, based on the average income of exporting economies. Sophistication captures more than technical characteristics; it includes product differentiation, production fragmentation, resource availability and other factors. However, it has the advantage of providing unique continuous scores for each product at any level of detail. We calculate sophistication scores for 237 exports at the 3-digit SITC level and 766 exports at the 4-digit level for 1990 and 2000...

Table 6 in the discussion paper, which ranks country export sophistication, locates China in 2000 with a sophistication index close to those of Chile, Indonesia, Egypt and India.

Figure 2 shows the divergence between actual and predicted sophistication scores in relation to income. Though it shows that China's actual export sophistication is higher than expected from its income levels in both 1990 and 2000, the divergence was not especially big in 1990 - and had halved by 2000. Moreover, many other countries showed a much greater positive divergence in export sophistication. Ireland lead the list in 2000. Also doing better than China were Mexico, the Phillippines, Brazil, Malaysia, Korea, South Africa, Thailand, Costa Rica, Argentina, Taiwan, Germany, the UK and Finland.

If one used purchasing power parity-adjusted per capita income levels the rankings would be somewhat different, but even so, this is hardly a stellar performance.

Note: A shorter version of this paper has just been published as The “sophistication” of exports: A new trade measure in World Development, February 2006.

UK productivity: the London effect

For many years the UK government has pumped billions of pounds into depressed English regions in the hope it would help narrow their growth, employment and productivity gap with London and the South East. But new research by Martin Boddy and colleagues at the University of the West of England suggests that those large regional differences can largely be explained. Regional Productivity Differentials: Explaining the Gap (UWE discussion paper 05-15) argues that these differences "can be explained by a fairly limited set of variables", including travel-time from London.

Issues of productivity and competitiveness at a regional level have increasingly been a focus for both academic and policy concern. Significant and persistent differences in productivity are evident both in the UK and across Europe as a whole. This paper uses data relating to individual business units to examine the determinants of regional productivity differentials across British regions. It demonstrates that the substantial differences in regional productivity can be explained by a fairly limited set of variables. These include industry mix, the capital employed by the firm, business ownership and the skills of the local labour force. Also important are location-specific factors including travel-time from London and population density.

Taken together, these factors largely explain regional productivity differentials. The analysis extends those studies that have identified but not quantified the role of different ‘productivity drivers’ in a systematic fashion or that have focused on only a limited set of drivers. It has important policy implications particular in relation to the role of travel time and possible effects of density and agglomeration.

If they're right, the sensible public policy response might be to reduce regional assistance and spend the money on improving transport links with London instead.