Friday, January 2, 2015

Zombie Economics

I was going to cover this when it came out, but didn’t find the time. Still, better late than never (excerpt, emphasis added):

Prepare for tough times ahead

We have often heard the phrase ‘we must change our lifestyles’ and the truth is that it will be difficult to adjust – but adjust we must….

…I wish our leaders at all levels would come together and ponder what it would be like if our country were to face a deep economic crisis.

I am no alarmist but experience teaches us that once-wealthy countries can suddenly become poor due to a variety of factors: we should not forget the economic crises that have plagued Argentina and Brazil as well as, more recently, Ireland, Greece, Spain and other countries caught in the European sovereign debt problem.

A similar fate could befall us and I believe our leaders must determine if, in 2015, some “cuts” should be put in place so that we can start living within our means again….

…As such, civil servants and technocrats at the apex of the bureaucracy must be willing to make unpopular decisions, such as budget cuts, early so that we can save enough to pay for essential services….

…It’s not just the Government in Putrajaya that will have to adapt. Those in the private sector must also do the same, for currently the trend among corporations is to invest heavily abroad….

…Other corporations are investing abroad because they are just following the trend – overseas deals are seen as successful and profitable for these companies and it is also prestigious to be involved in businesses in London, Saudi Arabia, Melbourne, Beijing and so forth.

The commissions are attractive for the deal-makers and the returns on foreign investments might be better than those available in our own country – but perhaps corporations should remember that risks abroad are also quite different compared to those at home….

…In these perilous times, it makes more social sense to invest in Malaysia. Those of us with the means to do so should take active steps to help our country keep its head above water. In fact, why not stop investing overseas altogether, at least until the storm passes?

More investments should be directed to small towns, enterprises and industries where profits are still possible but – much more importantly – capital stimuli will go a much longer way in terms of developmental impact….

…Corporations with socio-economic responsibilities should look at ways to help educate people rather than be interested only in investments in London and elsewhere. Surely investing in our own future is an obvious priority?

I agree with some of the arguments he makes (check out the full article, especially the stuff I didn’t quote above), but the sections above are full of wrong ideas, what John Quiggan colourfully called “Zombie Economics” – ideas that should have been dead and buried years ago, but somehow keep clinging to a semblance of life:

Idea 1: We must live within our means, so the government should cut expenditure when revenue falls

After over eighty years of developing macroeconomic theory and practice, one would think that this idea would have died a natural death decades ago. Yet it remains surprisingly prevalent. I was going to write a really snarky post on this, but thought better of it.

Then just today, along comes a certain Nobel Prize winning economist on the same subject, and he pulls no punches (excerpt):

Joseph E. Stiglitz | The politics of economic stupidity

…The near-global stagnation witnessed in 2014 is man-made. It is the result of politics and policies in several major economies—politics and policies that choked off demand. In the absence of demand, investment and jobs will fail to materialize. It is that simple.

Nowhere is this clearer than in the euro zone, which has officially adopted a policy of austerity—cuts in government spending that augment weaknesses in private spending….

…In Japan, one of the three “arrows” of Prime Minister Shinzo Abe’s programme for economic revival was launched in the wrong direction. The fall in gross domestic product that followed the increase in the consumption tax in April provided further evidence in support of Keynesian economics—as if there was not enough already.

The US introduced the smallest dose of austerity, and it has enjoyed the best economic performance. But even in the US, there are roughly 650,000 fewer public-sector employees than there were before the crisis; normally, we would have expected some two million more….

…For the past six years, the West has believed that monetary policy can save the day. The crisis led to huge budget deficits and rising debt, and the need for deleveraging, the thinking goes, means that fiscal policy must be shunted aside.

The problem is that low interest rates will not motivate firms to invest if there is no demand for their products. Nor will low rates inspire individuals to borrow to consume if they are anxious about their future (which they should be)….

…This brings us back to politics and policies. Demand is what the world needs most. The private sector—even with the generous support of monetary authorities—will not supply it. But fiscal policy can. We have an ample choice of public investments that would yield high returns—far higher than the real cost of capital—and that would strengthen the balance sheets of the countries undertaking them.

The big problem facing the world in 2015 is not economic. We know how to escape our current malaise. The problem is our stupid politics.

Stupid indeed.

Two more points to add to the above: Datuk Zaid mentions the European PIGS, yet completely misses the fact that fiscal austerity has made those economies incomparably worse off, not better. The irony of then advocating budget cuts is physically palpable. The correct lessons don’t appear to have registered.

Second, since Malaysia has run a current account surplus (the overall balance of payments has almost always also been in surplus as well) for the last 16 years, the country as a whole is in fact “living within its means”. One must then ask, since the government runs a deficit and the household savings rate is low, who is actually benefitting. Which brings us to the capital/labour income ratio and inequality, and the realisation that budget deficits aren’t the problem, but must be part of the solution.

Idea 2: Risks versus returns and home bias

The idea that corporations, and especially domestic investment institutions, should stick to investing at home is a very, very old one. It’s also almost totally wrong, both from an economics standpoint and a financial standpoint. As long ago as 1776, Adam Smith railed against home bias in his “Wealth of Nations”. One of the greatest current puzzles in international economics and finance is not why capital goes abroad, but why not enough does so.

Investing at home only makes sense if the risk return trade-off is better. But even here, basic portfolio theory says you should diversify your investments to minimise risk, preferably by investing in assets or markets where prices are not correlated or imperfectly correlated. Investing wholly at home means you’re putting all your eggs in one basket – you’re raising the risk you’re taking on, not reducing it. This is investment theory 101.

I’d also point out that despite the despite all the publicity given to Malaysian investment in properties in London and elsewhere, these represent a minority of the investments made abroad. Bigger and more liquid investments have been made in securities markets around the world. Heard of Google, Apple, Ali Baba? Chances are, working Malaysians all have an indirect stake on all of them.

Lastly, the institutions that Datuk Zaid mentions (LUTH, LTAT and EPF) have very specific social goals, not a general one. Forcing them to invest in areas they never had a mandate for is folly, as it means that they must abrogate their primary mission on behalf of their members in favour of a general mission that may not generate a return for funds invested, since (in the example used above) the returns to education, and especially higher education, are largely private not public. The experience of PTPTN should give pause to any such policy.

Again, Datuk Zaid brings up international examples, yet fails to draw the right conclusions – some of the issues causing trouble in Brazil and Argentina for instance, are from appropriation of pension funds for government directed domestic investment. You have been warned.


  1. Happy New Year, Hisham!

    I was kind of nodding my head agreeing with the comments you made in this thread, when I happened to open my copy of the Singapore Sunday Times paper.

    And what do I see on page 22?

    An AFP, New York Times report carrying the heading "Prince Alwaleed lashes out at Saudi fiscal policy".

    Interesting, right?

    Delving into the report:

    - "Billionaire Prince Alwaleed bin Talal has lashed out at Saudi fiscal policy after it projected a record Budget deficit in 2015, following the slump in oil prices".

    - ""We have reached the danger point...after starting to withdraw from the reserves" to meet the Budget shortfall, Prince Alwaleed said in a letter addressed to the finance minister".

    - "Last week, the world's biggest crude exporter announced an expansionary 2015 budget with a deficit of US$38.6 billion, with revenues at US$190.7 billion, sharply down from US$228 billion projected last year".

    - "Prince Alwaleed....the wealthiest Arab private investor, said Riyadh should not have let spending rise above projections, especially after oil prices began to decline. Oil income contributes about 90 per cent of public revenues in the Opec kingpin..."

    - "If the government had contained last year's spending within projections, a surplus of at least US$50 billion would have been posted, the prince said".

    - "As a result of failing to check rising spending, a total of US$53 billion will be withdrawn from fiscal reserves - estimated at US$750 billion - in just two years, he said".

    - "If oil prices remain at the current level of under US$60 a barrel for benchmark Brent crude, Saudi Arabia is expected to lose half of its oil revenues of US$276 billion posted in 2013. Oil income last year was estimated at US$248 billion'.

    - "Plunging oil prices are the biggest challenge to the kingdom, caused in part by Saudi insistence on maintaining current high production levels in an effort to drive out higher-cost producers elsewhere and gain more control over the global market."

  2. Three points immediately spring to mind:

    - do Prince Alwaleed's criticisms of Saudi fiscal policy make sense and can they be relevant in the Malaysian context?

    - is there a possible scenario where the Malaysian government will have to draw on the country's financial reserves to finance shortfalls in revenue?

    - will the Saudi strategy of "driving out higher-cost (oil) producers elsewhere" affect Petronas adversely, especially if it's oil assets are "higher-cost"?

    1. @bee farseer

      1. No
      2. No
      3. Not particularly

      The Middle East oil producers are completely different animals, economically and politically. The Emirates (Kuwait, UAE, Qatar, Bahrain) and Saudi Arabia all rely much more on oil revenue than Malaysia or virtually anyone else does. We're talking 80%-90% (Kuwait IIRC is around 95%), compared to Malaysia's 30%. There's almost no other forms of revenue such as income taxes. Budget balances are therefore much more sensitive to oil prices.

      These are also almost exclusively absolute monarchies, so government finances are actually also household finances, or more specifically, one household's finances. When Prince Alwaleed complains about government finances, it's because it's quite literally coming from his own pocket.

      Lastly, all these economies peg their currencies against the USD, which means changes in global oil prices feeds directly into their bottom line, one-to-one. If this goes on much longer, we may see some crack and devalue their currencies.

    2. It makes more sense for Malaysia to borrow than to run down Khazanah's portfolio, as Malaysia has a decently liquid capital market, and almost none of the ME economies do.

      Khazanah is growing at double digit rates, while 10 year MGS, even with the recent spike in rates, only costs the government 4.1% a year. Simply doesn't make any financial sense.

    3. I am not so sure, Hisham.

      Brent crude has dropped to US$55 per barrel. It may go lower.

      The Malaysian government has done it's Budget calculations based on crude oil prices at what level? US$60 per barrel? US$80? US$100?

      Surely, something has got to give?

      The government's finances can't escape scot-free, for sure?

      The argument is how large the shortfall is going to be and whether it is a tenable situation.

      I think that many economists are of the opinion that the jury is still out on this issue.

    4. @bee farseer,

      Comparing Malaysia with the situation facing Saudi Arabia is like saying a tabby cat is a tiger. We're worlds apart in terms of the impact of oil on the budget:

      Will there be an impact? Sure, but nothing like what people are thinking. MoF has publicly stated that they won't have to make any cuts until Brent falls below USD60 per barrel.

      Even then, its still a manageable situation. Most of Malaysia's oil related revenue actually comes from LNG, contract prices of which are imperfectly correlated with spot LNG. much less with oil.

  3. Tuan Hisham, do you foresee a potential recession in Malaysia this year if oil price remains at this level (<= $60) for the next 6 months?

    1. @Lousy Engineer

      I'm not even expecting real GDP growth to drop much, much less turn negative. Nominal GDP growth might be halved though, but should still be positive.

  4. I never tought of this from this point of view