Perspective Unlimited

Thursday, February 28, 2008

The Pressures of Excessive Do-Goodness

Even though this year's budget contains many giveaways, there are the predictable complaints that it has not done enough - not enough for the poor, not enough for the middle class, not enough for businesses. The responses from some office holders are also quite predictable. Singapore Angle has two rather good discussions about the budget debate (here and here).

There are always some good causes that the government should spend money on, but has not. There are always some arguments for the government to intervene in the market. There is always pressure for the government to do more. But let me pick on one specific episode in this post. The background to this post is as follows.

Hospital for the Rich

Parkway won the tender to build a hospital at a Novena site. Anyone who has been to the site will know that it is a rather small and narrow site. Parkway bid more than a billion dollars for the land and its share price actually dipped since analysts felt that the company has overpaid. The company later revealed that it had put in a high bid because it had wanted to build a A-class only private hospital. On the face of it, it was a fairly straightforward tendering process, but it prompted Dr Huang's criticism of Parkway's business plans and the tendering process (here).

I believe Dr Huang had written the letter with good intentions. However, good intention itself is hardly a sufficient condition for good public policies, or indeed, raison d'etre for government intervention. Before a policy-maker decides to intervene in the market, this is the number one question he has to answer: where is the market failure?*

Why the Government should not Intervene

A a healthcare provider in the marketplace, Parkway is in a better position than any bureaucrat to understand where the demand is. There is really no compelling reason for the government to dictate to a private company how many class-A or class-B wards it should have. Where does the state end and the market begins? Should the government ban luxury apartments since they are large and ostentatious? Should the government ban first-class air travel because only the rich can afford it? Enough of poor analogies already, I am sure you catch my drift.

Secondly, Novena area is beginning to feel like a prime location - the surrounding condominiums are easily trading above $1000 psf. To have class-C wards there is insane from the opportunity cost perspective**. Good healthcare can be provided to the lower-income group irrespective of location. There is really no need to build a class-C hospital smack in the middle of downtown to show that we are taking care of our poor. It is far better to locate class-C wards on cheaper sites in the heartlands, and also where the need is.

Thirdly, the use of the land is not free - Parkway is not pocketing private profits at the expense of the public. A billion dollars flow into state coffer as a result, money that can be transferred to the poor. If the land had come with strings to build a certain number of lower-class wards, Parkway would obviously have bid a lot less for the land. What is the outcome then? The consumer surplus at the high end market is not captured, and there can be no transfers to the lower-income group as a result. From this perspective, the restrictions proposed by Dr Huang - well intentioned as they are - would in fact be detrimental to the interest of the public.

Common Misery

I could go on and on to rebut the letter from Dr Huang but that is really not the intention of this post. We live in a market economy - despite its many shortcomings, the market economy has proven over the past two centuries to be able to generate the most amount of wealth for the greatest number of people. As Churchill once said, "The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries". We must not let our good intentions create policy misery for every one.

* Even if the government can pin down the source of market failure, it is still not a sufficient basis for intervention. The government must ensure that its actions do remedy the failure without imposing even more cost the society!

** TTSH and the CDC were built there before that area became expensive.

Wednesday, February 20, 2008

Is the Budget Inflationary?

Even before the budget was announced last Friday, it was widely anticipated to deal with the thorny issue of inflation. Inflation in Singapore has reached multi-year highs. One of the contributing factors has been the rise in food prices. The price hikes of food and commodities could certainly have caused hardship for some Singaporean families, and also increased economic anxiety for all.

The highlight of the budget however is the return of much of the $6.4 billion surplus in the form of various rebates. For example, individuals are given growth dividends and also a one off 20 per cent rebate on their income taxes (capped at $2000). Furthermore, there are various handouts - particularly to poorer families - which all in all erased much of the budget surpluses.

Aggregate Demand

To fight inflation, policy makers should be crimping aggregate demand through tighter monetary conditions, tighter fiscal policies, or a combination of both. However, instead of reducing aggregate demand through higher tax collections, the government is in fact increasing the purchasing power of tax payers through the various forms of rebates.

The increase in disposable incomes through the rebates and handouts is expansionary since it will lead to increase in aggregate demand. Seen from a demand-supply perspective, this might even translate to higher inflation. The budget can therefore even be construed as inflationary, which means that it could be doing the economy more harm than good.

Inflation in a Small Open Economy

To truly understand the impact of the budget on inflation, one must first appreciate that Singapore is a small and highly open economy. Added to this is a highly flexible workforce, including the use of foreign workers and talent.

The first implication is that much of Singapore's inflation is imported. For example, oil and commodity prices - which have risen a lot over the past few years - are also not within Singapore's control. Since we are a small economy, our demand will have a negligible impact on world prices. The second implication is that the aggregate supply of Singapore is in principle is highly elastic. Flexibility in the labour market lessens the impact of wage-driven inflation. The conjecture here is that price-wage inflation spiral is less likely to take hold in Singapore.

The overall implication is that the budget - even though it is expansionary - will probably not give rise to too much inflationary pressures because we are a small, open and highly flexible economy. From this perspective, the objective of the budget is to help Singaporeans cope with the effects of inflation rather than fight it.

Saturday, February 02, 2008

Talking a Policy to Death

An Australian friend of mine once remarked - if the Singapore government wanted to do something, it would just announce the policy and get on with it. As Singaporeans would attest to, there is veracity in that statement. At its best, our government is often bold and decisive in implementing policies. The flipside of this boldness and decisiveness is that it will often be criticised for being authoritarian. But we should pause for a moment and reflect on the following question: if boldness and decisiveness are indeed virtues, where does it leave consultation and compromise?

The Importance of Consultation and Debate

Having lived in the UK for seven years, I fully understand the important role public consultation, discussion and debate play in a properly functioning democracy. If a policy affects the livelihoods or the fundamental rights of citizens, it is only right that its rationale be publicly aired and properly debated. There is no running away from the fact that public debate is the hallmark of an open and transparent government.

But as Master Ringisei wryly noted in his recent post, there is a difference between an "open" and "gaping" government. During my years in the UK, I also witnessed first hand how an open-ended discussion could also give exactly the wrong image of the government: one that lacked direction; unsure, dithering and equivocating; losing political capital without making any real policy progress. The end result can be depressing. When the debate is finally over, good policies become watered down and compromised to a point of doing more harm than good.

Compulsory Annuity

I have never made a secret of my enthusiasm for the compulsory annuity scheme (here and here). The economics are compelling: to have citizens pool risks into a national scheme that pays out a small but potentially crucial stipend to the advanced aged. The committee's recommendation is therefore a source of bafflement and disappointment. "Flexibility" and "Compulsory" are not exactly easy bed-fellows.

Emotionally, it does make a lot of sense to return the unconsumed part of the annuity. But it would mean two things. First, the insurance element across citizens would be eliminated, or at least greatly reduced. Second, it will mean that premiums will have to be considerably higher since the national fund would still have to pay out to the families. If everyone can collect (whether dead or alive) whatever he pays in, how does the fund reach a sustainable level of coverage against advanced old age without premiums being bitingly high? There is no escaping from the actuarial reality.

But of course I understand the difficulties faced by the committee - it must surely have tried hard to produce a formula that works while being palatable to citizens. But in trying to make the policy acceptable to everyone, we could well have reduced its effectiveness. After months of deliberation, we are back full circle. Either we make a hard choice or live with an inefficient compromise. It seems like in some cases at least, boldness and decisiveness do have a place above consultation and compromise.

Monday, January 21, 2008

Deadweight Loss of High Taxi Fare?

The issue of taxi pricing has been a subject of some debate recently. Before the recent changes to the fee structure, the perennial complaint was too few taxis (particularly during peak hours in the city). After the increase in the structured fare, there are many empty taxis around waiting for customers.

Nevertheless, many taxi drivers have reported that though the number of trips they make are down, it is made up for by higher fares, and that overall takings per day have remained roughly the same as before. The question here is whether this situation optimal?

Simple Demand and Supply

We can use a very simple demand and supply structure to answer this question. The caveat here is that some important and complicated factors - such as waiting times, differential demands at different times of the day, effects on congestion, market power - are ignored. The simple demand and supply diagram is presented below.

The market for taxis is subjected to two important forces - the fixed supply of taxis and the controlled price structure. As every economic student can tell, one can either set prices or quantities. It is never possible (in general) to set both prices and quantities and expect demand to be equal to supply (or market clearing).

The demand for taxi is the downward sloping line in the diagram. Suppose the supply of taxis is fixed at Qf. The price before recent changes is at Pl. Total revenue is given by the area O-Pl-F-Ql (simply price Pl times the constrained quantity Qf). At this price however, there is excess demand. Taxi prices are way too low and there aren't enough taxis to go around. This of course explains why you previously could never get a taxi when you needed one.

Recent prices changes have pushed the price to Ph. At this price, the total revenue for taxis becomes the area O-Ph-H-Qh. This area is drawn with the same size as before, which shows that taxi takings have remained unchanged after the price hike. Taxi drivers are not worse or better off than before since they now pick up fewer customers but get more per customer.

Deadweight Loss

But what is wrong with this equilibrium? Excess supply. At this high price, there are way too many empty taxis on the roads. This is a loss to society (jargon: deadweight loss). Empty taxis are plying the roads when they should be picking up customers. It is an inefficient outcome since precious resources (taxis) are using up precious road space but providing no value to potential customers who might want to use their services if only prices are more reasonable.

I stress however, that this is the benefit of hindsight. Given that fares had been fixed for a long period of time before recent changes, there was previously no telling how consumers would react. In other words, there was too little information on consumer demand. With the benefit of the new knowledge about consumer demand, we now know that current prices are set too high to clear the market, resulting in the inefficient use of resources.

Bring Prices Down

Obviously, we cannot return to the old price level of Pl since it will create the same excess demand as before. However, there are obvious benefits from lowering prices from Ph. Firstly, consumer surplus would increase since there will be more passengers filling the empty taxis. Secondly, if you look at diagram above, setting a price between Ph and Pl may actually increase the revenue of taxi drivers since the area characterised by price times quantity increases*.

Therefore if the situation of excess supply persists, taxi companies should consider bringing the price down.

* Except in the case where the demand curve is unit-elastic. Taxi takings will remain constant if that is the case but still, consumer surplus will increase.

Tuesday, December 25, 2007

The Christmas Fog

This is probably the last year I am in the UK. This Christmas, my wife Grace had planned to bring the family - including baby Elena - on a pilgrimage to Rome. She had booked the tickets and accommodation. More importantly, she had secured the tickets to the midnight Mass at St Peter's.

The big fog on the 23rd Dec however put paid to these carefully laid out plans. We were stuck for 7 hours at the Heathrow airport (including 4 hours in the plane sitting on the tarmac) before the flight was officially cancelled. So we find ourselves, back in our little apartment, just the three of us, eating a Marks and Spencer pre-prepared Christmas dinner.

Some flights managed to leave. Some friends travelling on another flight arrived in Rome and texted us last night when they were heading to the mass. We are naturally disappointed and frustrated, asking the inevitable question "Why us?" But during this important season for Christainity, we hold on tightly to our faith and trust that God has His reasons for this too.

Tony Blair's Conversion

Besides the big fog, one of the more interesting piece of news that emerged during this festive season was the conversion of former prime minister Tony Blair to Catholicism (and here). Of course, what religion he chooses is entirely a private matter, but such is his stature that his religious views have become national news. Most catholics welcomed his conversion, but there were some who were less generous even during this festive season.

Among them was a Conservative MP Ann Widdecombe (herself a Catholic), "If you look at Tony Blair's voting record in the House of Commons, he's gone against Church teaching on more than one occasion. On things, for example, like abortion," she said. "My question would be, 'has he changed his mind on that?'"

Not only on the issue of abortion had Tony Blair gone against the teaching of the Church. He supported stem cell research. He too supported civil unions for gay couples, and his government had passed an anti-discrimination legislation that granted gay couples equal rights to adoption despite the Church's loud protestations. Mr Blair famously said he was sick of "effing prelates getting involved in politics and pretending it was nothing to do with politics".

Separate Religion and Politics

Ms Widdecombe however glossed over perhaps what I thought was the most important point: many catholics support the separation of Church from politics. Even though I am personally aghast at the idea of abortion, I recognise that it is on balance better to keep abortion legal than to criminalise it and drive it underground. Likewise, though homosexuality is against the Church's teaching, many catholics are strongly against homophobia.

The Church is the guardian of Christian morality, it rightly has to take a public stand on many issues. But the prime minister has to care about the good of all citizens. Public policy should be made with public interest in mind, which includes the interest of atheists and agnostics, and not be pigeon-holed into the doctrines of any religious groups. Tony Blair should not have to apologise (not to us anyway) for policies that are against the Church's teaching.

Thursday, December 06, 2007

The Post-Bureaucratic Age

When I first returned to London in late September for the new school term, the new Prime Minister Gordon Brown was still riding the crest of a wave of popular support. It was the so-called honeymoon period for the new office holder. Since then, he has become the subject of much political ridicule.

Brown's Troubles

First, Brown prepared for a surprise election to cash in on his popularity. Except that the surprise was how he “bottled it”, after it emerged that the Conservatives’ promise to cut inheritance tax made them popular with voters. The opposition leader David Cameron threw down the gauntlet and Brown blinked.

Second, there was the case of the government miscounting immigrants. What was more shocking was that it emerged that illegal immigrants were even contracted to work for the government security services such as the police. Brown’s car was in fact guarded by an illegal immigrant. Then came another shocking announcement that the personal data and bank account details of 25 million child support recipients were lost (including mine!). Last week, I received a letter from the British government to apologise. The letter said that they suspected, but could not confirm, that the data discs to be still within some government office. The government is now putting up a reward of 20,000 pounds for the missing discs, which in my opinion is ill-advised. Given how easily data can now be transferred, downloaded and uploaded, this reward simply creates for more temptation for mischief.

All these occurred while the economy was deteriorating, house prices falling, and the bailout of Northern Rock swelling with no resolution in sight. The bailout of Northern Rock is costing the British government almost 30 billion pounds (or 90 billion Singapore dollars). It is an astonishingly large number, which means that every man, woman and child in the UK has incurred a debt of 500 pounds to bail the bank. There is no guarantee that this loan to the bank will ever be repaid.

Finally, there was this political scandal where the Labour party and Labour ministers were found taking campaign contributions without properly declaring the source, thereby breaking the very laws they themselves wrote. Last week, the acting leader of the Liberals almost brought the roof of parliament down when he likened Gordon Brown to Mr Bean. According to the polls, Conservatives’ support rose to the highest level since Margaret Thatcher.

But do all these really constitute a sea change in British politics?

A New Philosophy?

The fact that the government is in a rut does not necessarily mean that the opposition is ready to govern, or that people would trust the opposition enough to vote for it. David Cameron has often been branded as a policy lightweight. However, Brown’s troubles have presented Cameron with an opportunity to shake off his timidity. In recent weeks, the Conservatives are announcing more policies, and a political and governing philosophy is gradually emerging.

Cameron calls it the Post-Bureaucratic Age (here, here and here). This is his indictment of the Labour government, "No longer committed to nationalisation of the economy, Labour instead devoted their energy to the nationalisation of our society. No social problem, no public service was considered immune to the magic touch of the master bureaucrats. Everything would be achieved through the benign intervention of a new army of technocrats, equipped with the latest in bureaucratic weaponry, initiatives, units, tsars, strategies, partnerships, pilot programmes, roll-outs, co-ordination and evaluation. At the head of this army of interventionism was the bureaucrat-in-chief, Gordon Brown."

My instinct is that Cameron is right. Blair, as the chief of New Labour, probably understands how the world, the economy and people's aspirations have changed while Brown doesn't.

The New Third Way

In style, what Cameron is now doing very much reminds people how Clinton and Blair wrapped themselves in the Third Way agenda to break out of the left vs right ideological logjam of that era. In short, David Cameron is styling himself to be Blair’s heir – constructing a political narrative to fundamentally change the relationship between the state and citizens. The government is essentially a network of bureaucracies, and bureaucracies do not improve people’s lives in the long run. While Brown wants more power to the state to help change your life, Cameron will cut back the state to let you change yours.

Though Cameron has yet to give enough policy substance to this ideology or done enough to convince the voters to trust him, I suggest that the political pendulum in Britain – after years of rising taxation and ever greater interference of government in daily lives – might just be ready for the turning. There is a good chance this chap Cameron will become the next British Prime Minister.

[This post was discussed with, and approved by Grace.]

Monday, November 26, 2007

The Price of Failure

I watched England knock themselves out of the European Championship last week - when they needed only a draw, on home ground, gifted the first goal to the visitors, a team that had already qualified. One could not have imagined a worst manner to lose. The head coach, Steve McClaren, must undoubtedly take much of the blame. If I were to discuss his ineptitude, I could easily go on for hours. But that is not the point here.

Mr McClaren defiantly refused to resign after the debacle when it was clearly the honorable thing for him to do. At least Kevin Keegan had the integrity to admit that he was not up to the job and resigned on his own accord. Instead, Mr McClaren waited for the FA to sack him the next morning, which was a foregone conclusion.

Where is the honour, Steve?

It was later revealed that Mr McClaren stood to receive 2.5 million pounds as compensation - or more than 7 million Singapore dollars for failing to get England past a supposedly easy qualifying group. The next morning at the press conference, a reporter questioned whether financial motivations were behind his refusal to step down. He denied it of course, what else could he have said? But his almost immediate purchase of a villa in the Carribean (reportedly costing 1.9 million pounds) spoke volumes of this man - one without honour. But McClaren was not an isolated case. Sven Goran Eriksson also received a large payout for his early termination of the contract, in the region of 6,500 pounds per day over a year for not working!

Golden Parachutes

Large as these payouts seem, they are truly peanuts compared to the Golden Parachutes in the financial sector. Merill Lynch's ex CEO received an astronomical US$160 million for getting the bank into the subprime mess. Citi's Charles Prince received a mere US$42 million but it was still too many zeros in my opinion. Never mind the large salaries society awards to superstar atheletes, movie celebrities or corporate movers and shakers. How on earth can people tolerate these kinds of payout for failing is something that truly escapes me.

Wednesday, November 14, 2007

The Measures of Inflation

Inflation in Singapore has gone up in recent quarters, prompting understandable anxiety amongst consumers. In the answer to a parliamentary question, the minister stated that consumers could choose cheaper alternatives to minimise the impact of rising prices. I shall not wade into the big debate whether it is a good enough or adequate answer, people have perhaps already made their minds up. But just to highlight some pertinent points concerning inflation measure since I have been reading some pretty inaccurate economics.

Suppose the price of pork goes up relative to fish, the rational utility maximising consumer will switch from pork to fish consumption. This is simply the substitution effect. But the basket of goods making up the Consumer Price Index (CPI) is often kept constant, and hence do not capture this substitution effect (Laspeyres Index). This is true therefore that this measure overstates the impact of price increase on the standard of living.

In other words, holding income constant, the standard of living does not fall as much as the increase in CPI suggests. The only case where the Laspeyres Index does not overstate actual inflation is when all goods in the basket have the same percentage price increase. In that case, there is no substitution effect since relative prices remain unchanged. Political considerations aside, the parliametary answer is essentially sound. Further reading can be found here.

Friday, November 09, 2007

Inflationary or Disinflationary?

Rising oil prices, falling US dollar, skyrocketing commodity prices all point to more inflation for the US economy, or do they? What about the effects of a slowing economy and falling house prices? Just a couple of years ago, the world was toasting to the Goldilocks US economy, growing without inflation, not too hot and not too cold. Now, it is a case of one foot hot and one foot cold, a real dilemma for central bankers.

Asymmetric Monetary Responses

The story went like this. The benign global economy transformed by the supply side revolution of China and other developing economies had brought great benefits in terms of output expansion. Interest rate stayed as low and for as long as they had been for a long time. Even though general consumer price inflation was low, asset prices like housing started to bubble over worldwide. The Greenspan doctrine was that it was too dangerous for central bankers to try to target asset prices, so they were left completely unchecked as the rest of the economy coasted along.

Suddenly there was the realisation that asset prices could no longer be sustained, and the bust came at a time when the world was beginning to face a supply side shortage. Commodity and consumer inflation started to rise, but assets began to deflate. It is easy to treat a patient with fever, give the medicine to bring the temperature down. It is equally easy to treat a patient with hypothermia, just warm him up. But what do you do to a patient with fever and hypothermia at different parts of the body at the same time? This is exactly Tinbergen's dilemma, how do you hit two targets with one arrow? You pray!

Cutting interest rates to support asset prices would risk sending inflation even higher. Not cutting would risk making the post-bubble financial turmoil worse. By December, we will know if Fed is indeed serious about the inflation fighting or is it really an emperor with no clothes. My personal assessment is that Fed will have to make more cuts, even if it strenuously denies it at the moment.

It is also here that the Greenspan doctrine ties itself to intellectual knots. To leave asset price rises unchecked, while opening the door for interest rate cuts and bailouts when asset prices fall is exactly the kind of policy asymmetry that leads the market into making one-sided bets. Revisionist talk this is not, many economists have long been arguing that monetary policies were too loose too long.

Risks for Rest of the World

As difficult a job as the one Bernanke is doing, we have to remember this. When Fed weighs in on its monetary policy stance, it cares only of the risks facing the US economy. Given how dependent the rest of the world is on the US, this is an extraordinary situation. By cutting interest rates and driving US dollar ever lower, it places severe strains on economies elsewhere. Those countries pegged to US dollar will face either higher inflation, or will have to abandon the peg altogether, both of which will lead to more financial turmoil.

The Euro and Pound are both soaring relative to the US dollar at a time their own economies are too entering the down cycle. Just yesterday, French President Sarkozy fired off a warning shot that US could not expect to devalue its way out of trouble of its own making, and implicitly threatened competitive devaluation. While he in reality did not have control over the ECB, he very much captured the mood over in Europe. The sense was that the European economies were at the short end of it all, being punished for someone elses' sins.

What we have seen in the past three months is probably only the beginning act of a period of economic turbulence.

Thursday, November 08, 2007

Not a Short Downturn

Two months ago, I suggested that markets were overly exuberant after Fed's first rate cut, which if you recall sent US and local stock markets to record highs - as if the subprime problem never occurred. The market rallied, and for two months I was wondering if I was missing out on something. But the problems associated with the US housing market have not gone away. The US financial system and overall economy cannot return to good health before the housing market problems are worked off.

Property as a Collateral

Compared to other assets, housing property is very unique. A large section of the population own it, with most people taking out mortgages in the process, using the purchased property as the collateral. If you buy a $1 million house and borrow 80 per cent, your net worth is $200k. A 10 per cent increase house prices will increase your net worth by 50 per cent, while a 10 per cent fall in price has the opposite effect of minus 50 per cent.

Conversely, a 10 per cent decline in the stock market does not have the same macroeconomic ramification since not many people own shares directly. More pertinently, not many people borrow or leverage to buy shares.

The effect of using property as a collateral is that small changes in house prices can have a large impact on the net worth on many people, and its macroeconomic impact therefore significant. As the net worth of individuals falls, many activities in the economy are dragged down with it. For example, if an entrepreneur has taken out a loan against his property to fund his business (like many small businesses initially do), a housing downturn will have financial consequences for the business itself.

For most consumers, the wealth effect - and even the psychological impact of falling house prices - will lead many to cut back on consumption. The bad loans on the banks' books will force them to cut back on lending as well, hence the credit crunch.


What compounds the problem is the feedback effect. The effect of more foreclosure is to send housing prices even lower, hitting the net worth of families with previously healthy financial balances. A LSE Professor Kiyotaki - now in Princeton - modelled this effect. Because of this feedback effects, the initial shock is propagated, resulting in dramatic, and prolonged, negative impact on the rest of the economy which is unlike stock market corrections. It is for the same reasons why Japan took so long to recover from the asset bubble. If you recall, Singapore's economy also took rather long to work of the excess of the last property bubble.

Alan Greenspan has repeatedly warned that the housing inventory in the US is still very large. There is still an estimated 9 months' worth of excess supply, not including those property put on fire-sale in the market. Overall, US housing prices have fallen only very little (average of about 5 per cent or so), and there is therefore a long way to go potentially. Some metropolitan areas in the US are expected to see at least a 20 per cent price decline. It is going to hit the families, banks and financial system hard.

On and off, we will no doubt get some good news to push the markets up a little but have no illusions about it: this US downturn will not be a short one.

Thursday, October 11, 2007

Save the Generals, Save Burma

The moment the monks began openly defying the military regime in Myanmar, there was always going to be only one outcome - violent suppression. The fact that blood was spilled should not come as a surprise to anybody save the most idealistic and naive. The logic is perfectly simple - dictators who lose power often lose everything, and sometimes even end up in tribunals. Any rational person faced with this set of odds would always resort to violence to save himself.

A Heuristic Game Matrix

The above is a simple game matrix. On the left, we have the General, who has two courses of actions (Suppress, Not Suppress). On the top, we have the People, who can choose to (Revolt, Not Revolt). The payoffs are given in the 2x2 matrix, the number on the left denotes the General's payoff while the number on the right denotes the People's payoff. The payoffs applied here are very simple. If the General does not suppress (and his People do not revolt), his payoff is 100. Every time the General suppresses, he pays a political price and his payoff drops to 50. However, if the People revolt and the General does not suppress, he loses everything and gets 0. Whenever the General suppresses, the People's payoff becomes negative (bloodshed).

Clearly, the best outcome for the People is that they revolt, the General not suppress, and the revolution succeeds. In that case, the People gets 100. But is this a rational outcome? No, it cannot be. Faced with the outcome of losing everything when the People revolt, the General surely will suppress. Bloodshed is inevitable.

Rewarding the General

Can we ever find a way out of this logical jam so that the People can be better off? Yes, it is indeed possible but only if we come down from our moral high horse. Consider the next matrix.

There is only one number that I changed - in the lower left box where the General's payoff is changed from 0 to 75 (it has to be larger than 50). Immediately, the lower left box of (Not Suppress, Revolt) becomes established as a Nash equilibrium. When the People revolt, the General will choose not to suppress and get the payoff of 75, which is greater than the 50 he will get if he suppresses.

Logical Response

What does this simple analysis tell us? Short of a military intervention to carry out regime change, no amount of outside pressure or condemnation can ever help the Myanmese people. Sure, outside condemnation hurts but only as far as reducing their payoffs for the generals. But faced with the prospect of losing every thing should the revolt succeed, the only logical response is for them to suppress. The greater the threat, the more brutal the suppression.

Instead, the only way out is for the world to reach a settlement with the junta that rewards the generals for non-suppression. This may sound morally odious to those who believe that the generals should be punished for their crimes. But by cutting off the exit for the generals, we are in fact condemning the Myanmese people to more bloodshed. Herein lies the big moral dilemma. Should we reward the perpetrators of violence?

Swallow our Moral Indignation

Are there any historical precedents? Plenty. South Africa comes to mind first and foremost. Former white regime members were not tried for their crimes against the black people, there was merely the Truth and Reconciliation Tribunal where the whites were asked to confess their wrongdoings. Pinochet in Chile was made Senator-for-Life and continued controlling the armed forces even though the civilians were supposed to be in charge. Nearer to home, we have Marcos. As he was a key US ally during the Cold War, the US provided a safe haven for Marcos and his family to take their billions and comfortably retired to Hawaii.

Swallow our moral indignation, provide a safe haven for the generals with state protection, let them keep their billions, and guarantee that they never have to face any tribunals. To help the Myanmese people, we must consider rewarding the generals even if it is morally and politically difficult for us to do so.

Sunday, October 07, 2007

A Simple Welfare Analysis of Borrowers and Savers

One of the missing piece in the discussion on CPF returns is the peg to HDB housing loan. This is an important point of consideration since any increase in CPF rates will have considerable welfare consequences on these net borrowers - people who took out a HDB loan which is larger than the available balances they have in their CPF accounts. I too was once a net borrower, when I first got married, emptied my OA, and took out a loan of almost $200K from HDB for my flat.

As we know, HDB loans are granted at a concessionary rate of 2.6 per cent, pegged at 0.1 per cent above ordinary accounts (before new changes are introduced). We do not need to know the details about the intra-government financial arrangements, but it suffices to note that for HDB to grant the loans, the money has got to come from somewhere.

I set out then to compare two sets of outcomes using highly simplified assumptions. These assumptions are meant to follow closely to how the current system operates, but I ignore some complicating rules where they occur (I will tell you where they are in the course of the post).

The Life Cycle of a Hypothetical Couple

A young couple starts working at age 25 with a combined income of $35k per annum. Every year, they get a wage increment of 2 per cent until they are 50, after which their wage stagnates. For simplicity, they are assumed to be continuously employed from 25 to 65 until they are retired. They save 33 per cent of their income and consume the rest. At age 30, they make a major decision of their lives to buy a HDB flat and in the process take out a 30-year $250k loan to finance that purchase. How would they fare with and without the CPF system?

With the CPF system, their savings (which is 33 per cent of income) is split between OA (which pays 2.5 per cent returns on net balances) and SMA (which pays 4 per cent). I ignore the changes in contribution rates for different age groups and contribution cap for convenience, and savings is split 65/35 between OA and SMA. The mortgage payment can only be deducted from the OA account. The interest on their mortgage is 2.6 per cent. The rules I applied here are a good approximate of how the current system functions.

Without the CPF system, they can invest their savings (again 33 per cent of their income). I posit several scenarios of long term returns (4 to 7 per cent). However, without the CPF system they can no longer borrow at 2.6 per cent for their property since the government can no longer supply that source of fund. The couple will have to borrow from the market at 4.5 per cent, which I believe is a fair estimate of long-term borrow cost. Of course, this parameter can be adjusted and the results re-evaluated in a sensitivity analysis.

Retirement Funds at Age 65

How would the couple fare under the two different systems at age 65? How much retirement funds would they have with the different systems? It turns out that the couple which starts out with $35k income is better off with the CPF system, mostly. Why is this so? In the earlier part of their life-cycle, they are net borrowers who take out a loan for their property. Since they have very little net balances in their OA account (because of mortgage deduction), any increase in CPF rates are not going to benefit them.

Conversely, they enjoy a 2.6 per cent interest rate on their property, which saves more than $3000 per year in mortgage payment each year over a 30-year period as compared to if they have to pay the assumed market rate of 4.5 per cent. Unless they are able to do very well with their investing their savings in the market, they are better off enjoying the concessionary housing rate that comes with the CPF scheme.

The High Income Couple

In the second spreadsheet, I change the couple's starting pay to $70k per annum. This is therefore a high income couple compared to the previous example. The high income couple is better off without the CPF system. Why? As they have high income, they become net savers much earlier in their life-cycle given the same loan they took out. As a result, the CPF accounts do not offer them a rate of return that matches the 4 - 7 per cent assumed to be offered by the market. They are better of without the CPF scheme - that is, to forego the concessionary loan rate and then be free to invest their savings in the market.

Winners and Losers

What does this whole exercise tell us? First, it confirms the simple microeconomics principle - borrowers lose when interest rate rises. On the other hand, the high income couple is mostly likely better off if their net savings is freed up to be invested in the market. The analysis between the two systems is sensitive to assumed rates of returns offered by the market, risks, income profiles and many other parameters. But within fairly reasonable estimates, the general result holds.

Second, if CPF has to increase its returns to members and at the same time passes on the cost of funds to other agencies including HDB, borrowers would have to fork out more for their mortgage. There is a real possibility of many poor families may end up net losers if that happens. The microeconomic consequences of pushing up CPF returns is therefore not clear cut. From whose perspective are we looking at when we say that CPF rates are too 'low', borrowers or savers? If indeed there is an element of welfare transfer, it is from the rich savers to the poor borrowers.

The fact that CPF has a net total balance of more than $120 billion may suggest to some that there are huge surplus savings. But remember, we have to knock off a couple of billions that belong to W Malaysians and not Singaporean households. And also that HDB obtains loan from the government at CPF rates in order to lend to purchasers (who borrow at 0.1 percentage point higher). How much does HDB 'owe' the government as a result of mortgage financing? $55 billion in total as of 2006. Let's assume all this is disbursed to borrowers. After accounting for all these, the net savings position falls significantly.

Furthermore, we are only talking about aggregate numbers and they mask the devils in the distributional details. How many net borrowing families are there? The number surely is not small. In fact, it is entirely possible that for every one rich net saver into the system, there are many more net borrowers. If that is indeed the case, and if rates of returns are pushed up, the number of losers will outnumber winners. Worse, the distribution will be in favour of the rich and against the poor.

It is really 'not so simple'.

Tuesday, September 25, 2007

CPF Reforms: Why Government's Critics Mostly Miss the Point

The major piece of CPF reform was supposed to be about the Compulsory Annuity Scheme (my views here and here). Nevertheless, the relationship between Government investment vehicles (namely GIC and Temasek) and CPF has received much of the attention instead. I was absolutely tickled with Chua Mui Hoong's quip, "The more you know, the more you realise you don't know."

Indeed, we do not have complete knowledge on how the government channels savings into the various investment vehicles. But the fundamental dissatisfaction with the CPF system is simple - the low returns relative to what the government reports on its investments. The bugbear is therefore the difference between the high investment returns of the government's investment vehicles (reported as 9.5 per cent for GIC and 18 per cent for Temasek) and low CPF interest rates.

The Famous Bank Analogy

When pressed on the difference, the Manpower Minister deflected the questions with the bank analogy - that depositors enjoy a fixed rate and cannot go to the bank to ask for higher returns. Not surprisingly, many bloggers disagree with this line of argument and continue to argue for CPF rates to be in some manner pegged to GIC or Temasek returns. Since some of these calls come from politicians, I shall refrain from making any explicit links here. My point is totally apolitical.

Why Returns are Not Low

My concern is strictly that of an economist. I maintain my stated view that CPF returns are not low on several accounts. First, it is risk-free, a position also reiterated by the government. Second, young Singaporeans also borrow at this preferential rate (0.1 percentage points above) to fund their housing purchase. Borrowers do benefit from this same cheap rate. Third, there are also other investment possibilities through CPFIS if a member is willing to tolerate higher risks and takes responsibilities for his own financial decisions. Fourth, property prices have seen a long run secular appreciation way in excess of 2.5 per cent. Those who borrowed at the cheap preferential rates would have made good excess returns, in addition to not having to pay rent.

Is a GIC Peg the Solution?

Let's just assume that there is one government investment vehicle, GIC. Let me then move on to address the pegging of CPF to GIC returns: Is this a good idea? Again, I am only concerned about the optimality of the institutional arrangement between CPF and GIC. I am therefore not addressing the socio-economic or even political consequence of the current relationship between GIC and CPF.

Let's take at face value that CPF board purchases government bonds that pay a 4 per cent return, risk-free, year on year. The government then, directly or through various channels, invests the proceeds which over the long run get 9 per cent returns. Is there an institutional arrangement that can somehow transfer these returns to the millions of CPF account holders?

A Principal-Agent Problem

The difficulty here lies in the principal-agent problem. Consider a simple example. The boss (principal) pays the worker a fixed wage for the worker (agent) to put in effort to maximise profits for the company, but the boss does not observe the amount of effort which the worker puts in. The optimal response of the worker is always to shirk since the boss cannot tell. Because of the asymmetry of information, this contractual arrangement results in suboptimal outcomes. The worker will never put in effort for the company.

The only way to overcome this is to make the worker the residual claimant or the profit owner. That is, the boss collects a fixed rent and leaves the rest of the profits to the worker. Since the worker now gains the benefits, he puts in effort and this arrangement results in optimal outcomes. The economic principle is simple: whoever controls the amount of unobservable effort must be made the final claimant of the rewards that come from this effort.

GIC and CPF: An Optimal Arrangement?

The institutional arrangement between CPF and GIC is therefore an optimal one. Here, the CPF Board, which is the custodian of people's savings, can be thought of as the principal. GIC, which invests the money, is the agent.

The optimal arrangement is therefore one that CPF receives a lower fixed amount while the GIC receives the higher excess. This point is further reinforced by the fact that the principal in this case is risk-averse. It therefore makes most economic sense for risk-averse citizens to get a fixed rate while allowing the government to bear the risk. To extend the argument a little, can CPF board demand a high fixed return, say 7 per cent, and leave GIC with the rest? Think about a real life principal-agent problem. If you pay the CEO with stock options that have very high strike price, the CEO simply takes on huge risks in order to have any chance of seeing the money, again to the detriment of the company. The principal-agent problem strikes again!

To peg CPF returns to GIC is therefore bad on several counts. First, it transfers investment risks to risk-averse citizens. Second, it potentially makes GIC behave sub-optimally. Worse, since investment assets are 'fungible' and returns not fully observable, it creates incentives for false-reporting. The agent will find ways to realise losses, postpone gains, and cook the accounts to reduce the payout to the principal.

In the end, the point is a simple one. The only way to make government watch over the country's money as best as it can is to let it behave as if it owns the money! Any other institutional arrangement will not achieve this optimality. Rather than increasing returns to CPF account holders, a GIC peg may become an institutional nightmare that creates more problems than it solves. The argument will run on.

Wednesday, September 19, 2007

Where Has the Exuberance Gone II?

Clearly, I spoke too soon. The exuberance is not gone from the market, it is in fact being stoked by the Fed ("Cheering Greets Fed Announcement"). I find myself to be a rather curious situation. I personally want a significant interest rate cut because it will be good for my portfolio, but I am against it in principle. I am probably not the only one feeling really mixed here. Even as the markets record the highest one-day jump in years, 2/3 of Financial Times readers are against the half-point cut.

Poor Growth or Poor Policies?

Over the past decade, the Fed has given the impression that it fears economic slowdowns more than it fears bad policies - a willingness to stomach all kinds of economic imbalances to promote growth. In 1998, it cut interest rates and organised a bailout on LTCM. In 2001, it slashed interest rates aggressively to contain the fallout from dot-com bubble.

Listen to what the Fed actually said - "Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

The disruption in the financial markets stemmed from the burst of the US housing bubble, a real problem created by excessively low interest rates and excessively high liquidity. Yet, in a reverse of logic, we are now hearing the Fed say that the interest rate cut is necessary to prevent the financial markets from hurting the real economy.

Whatever the problem, the solution is always the same: interest rate cut (the so-called Greenspan Put). It does not matter what the root of the problem is, such as excess liquidity in the housing sector. The Fed solution is always the same - more liquidity to ease a problem created by excess liquidity.

I am neither monetary economist nor central banker. But a Fed that has lost its stomach to take an economic slowdown is increasingly one that the markets have no respect for.

Monday, September 17, 2007

Where Has the Exuberance Gone?

Even though it is only September, June seems like such a long time ago. Back then, markets were on record highs every where, Dow crossed 14000 and STI almost reached 3700. Three months later, not only has the exburance evaporated, confidence in the global financial system has taken a serious hit.

Locally, a lot of hot air has also escaped from the property sector. People who were busy talking prices up three months ago are now talking about a correction. With the uncertainty, illiquid assets like property would be the first to see their ask-bid margin widen. Some units in my neighbourhood have slashed their asking prices by 15 per cent since August but are still left on the market unsold. Many sellers continue to ask for optimistically high prices given the illusion of a bullish market when you flip the ads, but the reality is that the number of transactions have fallen.

The global credit crunch, triggered by the subprime crisis, has produced the first bank run on Northern Rock in the UK. The case is interesting, and grave, for several reasons. Northern Rock did not have any known losses to the US housing market, its credit simply dried up due to events elsewhere. Most analysts continue to reckon the bank to be a viable business but the nature of bank run is always about confidence, rather than solvency. Though Northern Rock is a relatively small bank, the wider implications are already beginning to be felt. The UK housing market boom is now on wobbly legs. Forecasters are already saying that the financial and housing market turmoil could hit the UK economy in 2008 and 2009 by as much as 1 percentage point (which is significant for a mature economy like the UK).

A US recession (some would say long overdue) is also an increasing possibility. Stock markets actually rallied in the past month or so since that Friday, hoping for Fed to "ride to the rescue". The markets again got ahead of itself, STI crossed 3500 again as if the subprime crisis never happened. But as events in the UK show, confidence is clearly fragile. Any interest rate cut by the US carries risks of stagflation, unwinding of the Yen carry trade, and a further fall in the US dollar that will hurt export-dependent Asian economies. Meanwhile, Greenspan goes around hawking his own book as if determined to talk the economy down (more consultancy fees Alan?) and as if none of this has anything to do with him.

Where is the silver lining in all these? For years now we have been hearing about the great Asian growth story of China and India. Many analysts continue to believe that Asia will be stong enough to weather any US downturn. The next 12 months would be interesting. There is a good chance that this hypothesis would be put to the test.

Thursday, August 30, 2007

Insurance Misunderstood

In 2005, Liverpool reached the finals of the Champions League (European Cup) for the first time in 21 years. Liverpool was clearly underdog to the stylish AC Milan. Big underdog. A lot was riding on that one match - Liverpool was 5th in the league that year, which meant they would not qualify for the competition the next season if they didn't win. Their captain, Steven Gerrard, would probably have gone to Chelski if that happened. These were terrible prospects for a Liverpool supporter like myself.

Should I Bet on My Team?

The question was: Should a Liverpool supporter bet on Liverpool or AC Milan? (do answer or make a guess before you read on).

Suppose I was risk-averse and that I placed a bet with AC Milan. If AC Milan won, I would be compensated monetarily instead by winning the bet. If Liverpool won, the amount I placed on the bet would be lost, but it would hardly matter since the joy of seeing my team win would be great. Effectively, placing a bet against my favourite team Liverpool (and on AC Milan) became an insurance policy for me. On the other hand, placing a bet on Liverpool would have exposed me to more risk since I could potentially suffer the double agony of losing both game and bet.

What appears counter-intuitive to the lay person becomes perfectly rational for a trained economist - betting against your favourite team is the route to greater happiness! It sometimes comes as a surprise to me how few people understand this principle. Even when I pose this question to a class of economics undergraduates, 80 per cent would get it wrong despite hours of lectures and classes on insurance.

History would show that I didn't win my bet on AC Milan in 2005, but did it imply that I "lost"?

The Outcome You Do Not Want

The simple example provides an important lesson - always bet on the outcome you do not want for insurance. You buy a car insurance so that you can receive compensation when you get into an accident. If you "win" the bet with the car insurance company, you would have been involved in an accident already - clearly an outcome you do not want! When you "win", you have in fact already lost.

Therefore, my bet on AC Milan was actually one I would rather not win. Likewise, I would rather pay for healthcare insurance and never have to claim it. When it comes to insurance, it is not a good thing in general to "win" against the house (insurance provider)! The notion that we should buy insurance and try to win against the house is simply preposterous.

Purchasing an insurance guards the individual against downsides. For the risk-averse individual, the insurance offers a peace of mind which improves his welfare regardless whether the payout is claimed or not. A car insurance gives me the peace of mind to drive on the roads - knowing that my financial losses are covered. I buy because I am risk-averse. Whether I get a payout or not in the end - surprise surprise - is actually a moot point.

All Can Be Better Off

Let me turn to the longevity insurance proposed by the government (my writeup here). Many bloggers believe that if an individual does not live till 85 to get the payout, he would have "lost" the bet against the house and be worse off as a result of having paid the premium all those years. I hope by now the reader can see that this is an unsound understanding of insurance. Insurance is not a zero-sum game, one does not lose just because he is not getting the payout.

The idea of an insurance policy is that with a small payment, an individual can guard himself against desperate outcomes, thereby offering a peace of mind if he is risk-averse. The longevity insurance allows people to smooth consumption over their natural lives and not worry about money running out at 85. When risk-averse people pool their risks together, it is possible that everyone gains regardless of who gets the payout in the end.

To sum up, don't worry about kicking the bucket at 84. Living till 85 and collecting the payout does not mean you have "won" either. If you are desperate for $250 at age 85, it means your money has already run dry - hardly an outcome you want.

Tuesday, August 21, 2007

A Right Step Towards Risk Pooling

A couple of months ago, I suggested here (not wholly originally) that the major problem of the CPF system was not that returns were low, but the lack of risk-pooling to guard against "longevity risk".

First on the issue of returns. Based on the sketchy information that has been brought to the public in the two days since N-Day rally, CPF returns would indeed be boosted by giving members a higher "expected" rate that would fluctuate according to market conditions. Obviously, higher expected returns would be accompanied by some risk. The interesting question is - if an individual is more risk averse, can he opt for a fixed 4% interest instead?

The bolder proposal being discussed is the "longevity insurance" - citizens contributing towards a national pot, from which senior citizens aged 85 and above would be paid from. The idea of this is simple enough but it represents a key shift for it is the first time a form of national insurance for retirement (either cross sectionally or inter-generationally) is introduced. When my mother-in-law (a youngish 52) heard the proposal as it rolled out at the 10 o'clock news, her first reaction was, "Why should I be paying for others above 85". As Singaporeans are brought up with the idea that CPF account belongs to the individual, it may be difficult to accept that setting aside a small fraction into a common pot for insurance is in fact beneficial to every one.

From an economic point of view, the proposed policy is indeed a right step forward - and a very smart one in fact. First, the scheme is likely to be mandatory. Otherwise, since an individual is most aware of his own health status, only those who think they can outlive 85 will participate in the scheme (averse selection) making it less sustainable. Some critics however argue that mandatory participation would in fact disadvantage the poor since they have a lower life expectancy and the scheme would be actuarially unfair to them. But my sense is that this problem is small compared to old age destitution when retirement funds run out.

Second, notice that the pay out age of 85 is also set above the average life expectancy. Suppose a worker stops working at 65, he would have to live on his own retirement funds for another 20 years before he could dip his finger into the common pot. In other words, the worker would still have to save up for his own retirement (of 20 years at least) before the insurance element kicks in.

In economic parlance, the 20 years is the "excess" - like how we often have to pay for the first $500 of damage when we file a car insurance claim. The purpose of this "excess" is to reduce the moral hazard problem that always occurs with insurance. Because he still have to worry about 20 years of his retirement, the worker still has strong incentives to build up his personal retirement account even though he is insured past 85.

As expected, the loss of control of a portion of retirement fund has given rise to some unease ("coerced annuity"). Rather than seeing it as coercion, a better way would be to understand the true nature of this proposal, which is essentially a social safety net for the advanced old. But the nature of having a social safety net is as such - there must be contributions by all to support and sustain this safety net. In principle therefore, building in some element of risk-pooling into our CPF system is the right step forward. The proposal also cleverly reduces the moral hazard problem. The government should be given some credit for creative thinking.

Friday, August 17, 2007

Market Hazards

Like Lucky, I have spent most of my last three weeks tracking the subprime crisis, the market and my portfolio. Blogging comes second to watching my housing and retirement funds. Perhaps I would write something about the economics of it some other day when things are calmer. When the market is in this mood, there is really not much point in talking about fundamentals. Even as I tried to offload stocks over the past weeks to stem the losses, my portfolio kept shrinking. I am not losing sleep yet, but it doesn't feel good.

This morning, the STI fell below 3000 points, a decline of nearly 5 per cent at one point. I searched and asked around for the 'trigger' - what new information came into market to trigger this morning's selloff. Apparently, there was none. One analyst said that the market was very frightened, but it was not entirely sure what it was frightened off. A friend of mine working in the finance industry told me that we were in the "tail chasing dog" territory. The sharp fall was trying to find a reason to justify itself !

Indeed, as I look at the balance sheets of some of the blue chip companies, their profits, the cash they hold, there simply isn't any credit or liquidity crunch of any sort. But I remember a quote, "The market can stay irrational longer than you can stay solvent." Nevertheless, the market cannot stay irrational forever. Looking at the valuations of some of these companies, it would be irrational of me not to put money in. So even though my trading screen was flushed with a sea of red, with trembling hands and a pounding heart, I clicked some buy buttons this afternoon.

[Latest: STI rallied from nearly 180 down to close with negative 20. US Fed has cut lending rate to banks.]

As the day closes, it appears that world markets might have just dodged a bullet today. But be warned, there would surely be more bullets to come. Like Lucky says, we are going through an interesting but terrifying time. My personal take is that one should never aim to eliminate all financial risks and forego all potential returns. Having a clear head about personal finances, staying invested and learning to cope with risks would be a better strategy.

Tuesday, August 07, 2007

Learning to Tie the Policy Hands

In this post, I argue, using the current red-hot property sector as an example, how too much policy discretion over the economic cycle may actually compromise long-term objectives. Some "tying of hands" or credible commitment on the part of policy-makers can sometimes be better for the economy. The full article can be found on Singapore Angle.

Wednesday, July 25, 2007

The Economics of Foreign Talent / Workers

This post was first written by Aaron Ng, who posed a really difficult question: whether immigration of skilled workers (talent) lowered the wages of native skilled workers. The same question could also be asked for unskilled workers, whether the influx of unskilled workers depressed the wages of the low-skill, low-income groups.

As we know, immigration is a hot-potato issue that has burnt the fingers of politicians every where from US, Europe to Singapore. The use of economic models are not particularly instructive here because different model settings provide dramatically different answers. At the risk of losing some readers, it is actually a good exercise to try to acquaint with some basic (and not so basic) economic concepts that can help us understand the labour market impact of immigration.

Neoclassical Theories

First, let's try to answer this question with neoclassical theories. By this, we are saying that markets are competitive, work without frictions and in addition, absent of any non-tradable goods. In this setting, all workers are paid the marginal value of the product they are producing.

In a small open economy like Singapore, a large part of what we produce are traded internationally. The influx of workers regardless of types will have no impact on wages (this may come as a surprise to non-economists). The logic is elegantly simple in fact. If more skilled workers enter Singapore, the economy shifts towards the production of goods with more skill content. If more unskilled workers enter Singapore, the economy shifts towards low skilled goods. Since the final prices of goods determine wages, and that Singapore has no influence on these prices internationally, wages are completely unaffected by whichever goods Singapore produces. Immigration has no impact on native wages (this was actually a final year exam question at the LSE recently, the famous Rybczynski Theorem).

For a large country, the effects can be dramatically different since which sector that country specialises in will obviously change international prices or terms of trade. The downward pressure on blue-collar wages here could have nothing to do with immigration. Rather, it is probably because a large producer (like China) has entered that market thereby lowering prices and wages (think electronics) everywhere. Conversely, whatever China demands, prices go up. Mining, pretty much a blue-collar type of industry, is doing really well in Australia precisely because of this China effect.

Depart from the neoclassical setting however, the effects of immigration can be completely different or even messy. Suppose not all goods produced are tradable internationally. There are some goods or services that are inherently non-tradable (think Balassa-Samuelson). If cheap foreign labour enters these non internationally traded markets, price will fall, and so will wages there. Similarly, if a segment of the economy has been protected from foreign competition, the natives there will be earning economic rent. The influx of foreign talent or firms into that sector will obviously reduce that rent and incomes of natives there (think lawyers, doctors etc). These groups surely would resist letting foreign talent or firms into their sector.

Bargaining Power

Lucky Tan suggests that the availability of foreign workers have made firms reluctant to hire native Singaporeans, depressing their wages. Again, this is entirely rationalisable economically. For example, the search and matching class of models (pioneered by a LSE professor Pissarides) tells us just that. When workers and firms meet, both sides have to agree on the wage rate before they enter into a productive relationship. Relative bargaining power will then determine how this economic surplus is split. Reducing workers' bargaining power, which presumably the availability of foreign worker does, will lead to lower wages.

Let me be quick to add that the rise of various emerging economies have also reduced Singapore's bargaining power. Transnational capital, footloose by definition, goes where returns is highest. Before China and India, Singapore was one of the few investment friendly places in Asia. The game has changed dramatically since. In the US for example, labour's share of GDP has fallen in recent years while capital's share has risen. Many commentators are quick to attribute the erosion of labour's bargining power to globalisation.

New Economic Geography

Let me finish this post with a positive spin - immigration can actually increase wages of natives. This is in fact a key prediction of new economic geography models. Firms (under suitable assumptions) have incentives to cluster and agglomerate, and immigration can be part of this agglomeration process. And where they do concentrate, they drive up productivity through various mechanisms. Because of the positive externality that they derive from clustering at certain locations, no firm then have an incentive to leave since they become far less productive elsewhere. When that happens, the location becomes sticky, commanding higher rent and wages. My favourite example is London obviously.

Two Handed Economist

President Harry S. Truman once said in exasperation that he wanted an economist who was one-handed because his economic advisors would typically give him economic advice stating, "On the one hand….And on the other...." This is even more true when it comes to the economic effects of immigration as different economic settings give rather different conclusions. But being a two-handed economist is no bad thing here. It is a sign of intellectual humility to recognise the complexities of the world and not make one-dimensional arguments.

Friday, July 13, 2007

The Lone Tree Hill Incident at Lim Chu Kang

This post has nothing to do with economics. It is about 2LT Lee's letter that skipped the chain of command, weaved into a story about my one major regret. This incident happened more than a decade ago, but I have carried the burden of a blemished conscience ever since.

It was a night in March 1996, my battalion was carrying out a routine exercise in Lim Chu Kang in preparation for the battalion proficiency test. My company was two months away from ORD, and that test would be our last exercise. Armed with a scholarship, I was eagerly looking to ORD and going overseas. In my battalion, there was this young scholar captain who was transferred from another unit. His aloofness also made it easy for others to gang up on him. Because of his lack of experience in our formation, he was only given a platoon commander's job rather than the OC appointment which a captain would usually be accorded with. I suspect other captains, OCs themselves, viewed this scholar with a mixture of contempt (since he transferred from a supposedly less tough unit) and career-envy (he was scholar-tracked, so to speak).

That fateful March night, my S3 asked that he became the point platoon to guide the battalion to the objective, which was the the so-called "lone-tree hill" in Lim Chu Kang. It was a very specific instruction that all officers understood. But in the middle of the battalion movement, my company commander - who was always out to impress - broke away from the battalion movement in order to find a shortcut to the target. Platoon commanders, including myself, tried to dissuade him since we would be going against S3's explicit instructions. But my OC was not to be moved. Our company broke off from the rest of the battalion, and went on a needless 3 km full combat order run just to show that we could reach the objective faster.

When the point platoon finally arrived twenty minutes later, that scholar captain was naturally surprised to see an entire company already at the RV point. He hadn't even realised that my company had broken contact from the rear. Understandably, he confronted my OC straightaway and the two, who never really liked each other, almost came to blows. The rest of the company, including the junior officers like myself, stood there not sure quite what to make of it.

Gradually, other companies arrived. What happened then was a blur - lots of shouting and shoving around to separate the two captains who by then were too steeped in the argument to back down. The rest of battalion just watched. S3 arrived and demanded to know that the commotion was about. My OC, in cahoot with other OCs there, turned around and accused the young captain of showing disrespect, and physically threatening a "senior" officer. Having not been a witness to that incident, S3 had to take the OCs words and reported the matter. Within a couple of days, the scholar captain was relieved of command and became a project officer. He did not take part in the battalion proficiency test, and his career became stunted as a result. The last I heard, he gave up on his army career.

At that time, I was very tempted to shoot an email to my formation chief and commanding officer to explain what happened - how my company commander pointedly violated commands to set up the scholar captain. The email was drafted, many versions, but all saved in my PC. I never did muster the courage to send, preferring to save myself from all the hassle. None of the other junior officers spoke up, they all probably made the same calculation like myself to ORD in peace than to end up in all kinds of trouble with the authorities. But I suspect they too carried the burden of not speaking up, for every time we met up, we would inevitably talk about the "lone-tree incident". I often wished I had the wisdom then to do the right thing. If I meet that captain on the streets again, I would apologise to him. This post, if he is reading, is just that - a belated apology from me for not speaking up all those years ago.

Whether 2LT Lee acted in cunning self-interest, in stupidity, naivety, or only because of his privileged background was largely irrelevant. Speaking up was the right thing to do. The rest were just details.

[Endnote: One of my army friends emailed me and mentioned that he met that captain recently, working in the insurance industry. My OC? I have been informed that he has since been promoted to battalion and then bridgade commmander. How would events have turned out if only one junior officer there spoke up? I often look back and wonder.]

Friday, July 06, 2007

Property Prices Spiraling Out of Reach? And Pitfalls of Property Price Index

Here I am back in Singapore. The effect of the property boom is clearly evident from the numerous construction sites and cranes dotting around downtown areas. The news media reports property market news almost every day. The classified ads screams at you - "Buy now before prices go up!", "Sure En Bloc, it's a matter of time!", "Don't miss the last chance for district 10!" - property agents appealing to both the greed and fear in you. Greed to make a pile from the current boom. And fear that your dream home will forever escape you if you do not act now. The latest URA data showed that property prices rose almost 8 per cent in the second quarter, on the back of a 6 per cent increase in the first.

But let's play a simple number game here. Imagine there are 100 units of property at Bishan, and another 100 units at Newton. They are of the same size, and they have the same starting price. Now, suppose that 10 units of Bishan units are transacted, all suffering a 10 per cent loss, while 10 units of Newton units are transacted with 10 per cent gain. What does the property price index show? If the property price index is based on the volume of transactions, it will show no movement. The gain in Newton is cancelled out by the loss in Bishan.

Now let's rewind and start again. There are 10 units transacted in Bishan, with a 10 per cent loss on each unit. But there are now 20 units transacted in Newton, all with 10 per cent rise. Look and behold. Weighted by the transaction volume, the index trends up, because Newton is now given more weight than Bishan. Come another quarter, if there are even more transactions in Newton, the price index will show even more upward increase, never mind the fact that all Newton units are selling only 10 per cent more - exactly the same as the first scenario. Before you know it, every one watching the price index becomes convinced that prices are shooting up and we have a frenzy in the making. And as they transact, their higher purchase price enters into the weighted index, further fuelling the impression that overall prices are rising.

Here, I thank an anonymous reader for pointing out to me URA's methods, which is something of a hybrid. Based on recorded transactions, the median for a location and housing type is picked. These then enter into the overall index using a value weight. Suppose again Bishan and Newton units are all sold at the same price initially. The transacted price for Bishan then falls 10 per cent, and the transacted price for Newton rises 10 per cent. Weighted by the moving value of the transactions, Newton will have a larger influence on the future direction of the index because it now has a higher value than Bishan. Again, there is a feedback effect where areas with rising prices are given an increasing weight in the index.

Of course, it is never easy to construct a summary statistic that can fully capture the overall price trends. This is even more so since housing property is highly heterogeneous (different) in locations, types and so many other attributes. It is often difficult to interpret the index given the thicket of statistical manipulation that is employed to create it.

But since the idea of this index is to reflect in some sense the affordability of housing space in Singapore, perhaps a good way is to use gross floor area as the weights - that is, Bishan and Newton be given the appropriate weights that reflect their total living space - thereby stripping away any components that might be endogenous in nature. Maybe this might give the lay person a much clearer picture just how affordable housing space in Singapore is.