When Metaphors Fail

Consider this nonsense:

What if borrowing money made you so much richer over the long-term that it paid for itself? It’s not crazy. Millions of families make such a decision every year when they take on debt to pay for school. Indeed, investing in yourself is a bet that often pays off. But can the same be true for an entire country?

Brad DeLong and Larry Summers say yes. In a provocative new paper, they argue that when the economy is depressed like today, government spending can be a free lunch. It can pay for itself.

Except here’s the thing: families don’t borrow from themselves; they borrow from other holders of capital. The government, on the other hand, basically borrows from itself. Now, economists like to get technical and explain that the Fed is not the same as the treasury. It’s also true that the department of the interior is not the same as the department of defense, but no one would suggest that the former loaning to the latter would constitute anything other than the government loaning money to itself.

Now, to answer the question at hand: yes, investing in the country over the long term should pay off. But let’s not kid ourselves. When the government borrows from itself, and particularly when the method for doing so is having the central bank purchase bonds from another department, all that happens is inflation. Inflation and investment are two different things. The latter, for example, is productive while the other is destructive. And it takes a significant amount of ignorance, deceit, or stupidity to call inflation a form of investment.

Does a Resource Rent Tax Solve the Problem of Sovereign Risk?

I have been a supporter of resource rent taxes for as long as I can remember. More precisely, my view has been that taxes on rents are better than most other taxes because they extract funds with minimal distortion to production and investment decisions.

I think the best way to think your way around the question of resource rent taxes is to imagine initially that you are the sovereign of a territory in which there has been no previous mining or exploration. You want to obtain revenue from the minerals in your territory by the inducing mining firms to use their expertise to explore and to mine.

One way of obtaining revenue from minerals is to auction off mining rights and promise mining companies that there will be no further taxes on the minerals they find. A major problem with such a ‘finders keepers’ policy is that on the basis of past experience mining firms have good reason to be skeptical that sovereigns will keep their promises to let them keep what they find. When valuable resources are found sovereigns (and democratic governments) have a habit of changing their minds and wanting more revenue. As a consequence of this ‘sovereign risk’, mining companies are not likely to be willing to pay anything like what an exploration lease would be worth to them if they could believe the sovereign’s promise of finder’s keepers.

Another way that governments can obtain revenue from minerals is through a system of royalty payments based on the volume or value of minerals extracted. This is like imposing an additional cost on mining activities and can deter mining that would otherwise be commercially viable.

By contrast, under a well-designed resource rent tax the sovereign is, in effect, a silent partner in the venture. The sovereign shares in the rents and risks of the project without distorting investment and production decisions in the process.

So far so good, but Australia is not a country in which there has been no previous mining or exploration. There is currently a great deal of mining being undertaken in this country under long-established systems in which state governments obtain revenue from royalties. In that situation it becomes important to consider how to make the transition from royalty payments systems to a resource rent tax without disturbing the reasonable expectations of miners of rewards that they are entitled to receive for the risks that they have taken. If the transition to a new tax is used by the government to grab a larger slice of rents from successful mines, the miners are likely to perceive that they have under-estimated sovereign risk in this country. They will also perceive that there is a chance that the rate of resource rent tax could be increased in future, particularly if there are further increases in mineral prices. If they factor that into their calculations of expected returns they will reduce their investment in further exploration and new mines – even if the structure of the new tax minimizes disincentives to investment.

As is well known, the Australian Government has recently announced the introduction of a resource rent tax and its intention to grab a substantial additional slice of mining profits on top of revenue raised from existing mining royalties. The main source of this sovereign risk, Kevin Rudd, has defended the tax grab on the grounds that ‘what we are doing is to recover national sovereignty over our own resources’. Actually, I must confess that I don’t think Mr Rudd has actually used those words. Those words were used by Hugo Chavez, president of Venezuela. As far as I can see, however, the main difference is that Hugo is less verbose than Kevin. Here is what Kevin Rudd has been saying:

‘Over the last decade the mining companies generated $80 billion in higher profits. At the same time governments, on behalf of the Australian people, received only an additional $9 billion over that period of time. What we’re saying is that the mining companies deserve a fair return on their investment – that’s important – but we also believe the Australian people deserve a fair return on the resources which they themselves own, and remember, these companies- you mention in your introduction BHP and Rio. BHP’s 40 percent foreign owned. Rio Tinto’s more than 70 percent foreign owned. That means these massively increased profits, the $80 billion that I referred to before, built on Australian resources, are mostly in fact going overseas’ (Interview on AM, ABC radio, 3 May, 2010).

Why is the percentage of foreign ownership of BHP and Rio relevant to the issue of resource rent taxation? The unmistakeable message is that Kevin Rudd views foreign investors as fair game. Tax reform has become a cover for expropriation of rents from assets owned by foreigners. All we can hope is that the more sensible members of the Australian government will encourage second thoughts about the rate of resource rent tax that should be imposed – and urge Kevin to restrain his rhetoric – before too much harm is done to Australia’s reputation as a safe location for investment.

The Market Demand for Government Investment

In my previous article on the bloated private sector, I failed to adequately explain my main point.

For the past 3 decades faith in the free market powers of the private sector have led to a massive misallocation of resources away from public sector investment. A careful reading of price signals reveal a severe under investment in public goods relative to private sector goods. I would further argue that the unstable bubbly nature of financial markets is the result of excessive capital being allocated to the narrow range of goods and services in which the market works well.

The following contrasting sets of investments opportunities demonstrate how the private sector has become bloated while the public sector has been starved of necessary resources.

Public Education vs. Information Technology

The development and rapid proliferation technologies such as the internet, cell phones and other communication tools has brought undeniable benefits. But is the market calling for more resources to be dedicated to these industries. Not really. Over the past couple of decades, the price of computing power and communication technologies has been in nearly continuous free fall. New innovations quickly become commodities while many of the best and most popular innovations from Youtube to Facebook have failed to find a revenue stream.

If some of the investment in IT has been misplaced, what would be a better use of the bright mathematically inclined minds. Over the long run, human capital is the limiting factor in innovation and growth. The wage differential between educated and uneducated workers is a clear price signal indicating demand for education. Yet we have ignored this rapidly rising price signal by failing to provide adequate support to schools at all levels. The rapidly rising tuitions at public universities is another indicator of declining public support for education at precisely the time when this sort of investment is most needed.

Public Health vs. Processed food

Public health spending is one of the ultimate public goods as it benefits the society as a whole. There is no doubt that American’s spend a lot on healthcare, more per capita than any other country. Yet our health outcomes are hardly impressive. Investing a little more in creating an environment that promotes health could save far more in future healthcare and lost productivity due to preventable disease. From teaching basic nutrition principles to providing safe places for people to be physically active to preventing outbreaks of food borne illnesses our public health efforts have been pathetic due to a lack of commitment.

While, we have barely attempted to create a healthy environment, the food industry has had no trouble bringing new food like substances to market. Given this failure it is not surprising that today’s young people may be the first generation in American history that fails to outlive their parents.

Urban Infrastructure vs. Suburban housing

The housing collapse of the last couple of years makes the misallocation of resources in the housing sector abundantly clear. Yet the market has been sending out the same signals for years. Developers always justified suburban car based residential development as providing what the market. Yet a simple look at price data tells a different story. Real estate prices in walkable urban areas have consistently been far higher than in suburban car oriented areas. In the current crises real estate markets in places like Manhattan, DC and San Francisco have held up far better than the rest of the country.

Yet it would be impossible for private developers to recreate high quality urban environments. These places require significant investment in transit, law enforcement, parks and other amenities that require government support. Without public investment private developers could only create a limited range of housing options. Hence the appreciation of urban real estate prices relative to suburban areas.

The market is incapable of providing the full range of investments needed to maintain a healthy growing society. If we come out of the current economic crises with a more balanced distribution between public and private investment we will be in a better position to maintain long term growth.

Supply, Demand and Price

The CEO of the Perth Mint gave a presentation to the WA chapter of the Australian Institute of Company Directors on Wednesday that I thought I’d share with you. It was only three slides as it was a 10 minute slot. All of the figures behind these charts come from the World Gold Council.

First up is quarterly known supply.

Key take away point is that while the various supply sources change from quarter to quarter, overall it is relatively consistent and more importantly, bears no correlation to the gold price. The second chart is known demand, with an emphasis on “known”.

Now this is a bit more variable than supply, but again there is no clear correlation to the gold price. I should note that known investment means coins, bars and ETFs but does not include over-the-counter professional trading.

The fact is that even if we did know the unknowable (such is the nature of the gold market, it is a secretive thing) demand would equal supply anyway. Also consider that the data is not perfect, that classifications may be wrong (eg how much of Indian jewellery demand is really investment demand).

So how to get through this. The next slide takes an admittedly simplistic approach and says lets look at non-investment supply (primary mine supply and scrap – we assume that scrap is not investment bars for example) and take away non-investment demand (industrial and jewellery – again not a perfect assumption about jewellery).

What this number then (approximately) represents is net investment. You’ll note that when it was negative the price was flat and when it was high the price rose. Not perfect correlation and it could be improved with more accurate source data, but hey, you’re getting what you pay for.

What Can the Art Market Tell Us About Our Economy?

When compared to more traditional investment options, the contemporary art market is highly inefficient – but this hasn’t dampened the enthusiasm of buyers and investors.

The contemporary art market has left its critics standing. Many presumed that it would be one of the crisis’ first victims as collectors tightened their purse strings and investors redirected their funds to safer areas. Yet somehow, the art market has boomed beyond expectation.

It is ironic that, in this period of economic turbulence, this inefficient little market has become more stable than the giant financial institutions. On the same day that Lehman Brothers filed for bankruptcy, Sotheby’s auction house raised nearly $100 million for the work of British artist Damien Hirst.

Many in the media have viewed the art market’s boom with suspicion since the start of the crisis, and they have been keen to pounce every time a market correction occurs – corrections are to be expected from any fast-growing market. They have presented the market’s success as a mystery and suggested that the market has somehow become disconnected from the underlying economy.

But the art market is not disconnected – it cannot be. Rather, it is a perfect reflection of the current state of the global economy.

New Art Investors

A new breed of collector is stalking the auction house: many corporate investors have increased their exposure to fine art in an attempt to diversify away from the financial markets. You would be forgiven for presuming that art is a high risk investment considering the subjective nature of art appreciation, yet corporate investors have brought with them more reliable valuation methods to an industry reliant on historical post-auction data.

A whole industry has sprung up around the needs of these corporate investors: there are now a number of fine art funds that trade artwork as you would any other commodity and indexes with which to more accurately anticipate future trends. Earlier this year, intelligence provider Artprice.com launched its Art Market Confidence Index, aimed at providing serious investors with more reliable metrics for the art market.

Many buyers are using art purely as a tool for financial gain which, in turn, has pushed up the price of the market. It is sad that the growth of the market has made it difficult for legitimate museums and public galleries to purchase new stock; a larger proportion of our international art heritage is finding its way into private collections. Of course, private collections are nothing new, but is the financial motivation behind the purchase (and therefore the price) changing the way we look at art? Should we be worried when art becomes nothing more than a commodity?

New Art Collectors

Salvation comes from an unlikely source. The image of the elitist western collector is slowly being eclipsed by the cash-rich Russian oligarch – reportedly, a third of the buyers at the Damien Hirst auction mentioned above were from the ex-Soviet Union.

These new Russian buyers have injected the art market with liquidity. Although the investment potential of art may influence their purchases, their primary interest is aesthetic – they are in search of unique and sophisticated items to complement their luxurious lifestyles and new-found wealth.

The art market has boomed because it has attracted these new breeds of investor and buyer. In this respect, the art market has not disconnected itself from the realities of the global economy – rather, it reflects the global shift in economic power: western capital is moving away from financial institutions into other areas, oil and gas-rich BRIC countries have a major economic advantage and investments from cash-rich countries are cushioning the downturn in certain sectors.

Perhaps the ultimate lesson to be learned about our economic system is that, given time, all bubbles burst. Time will tell.