Monday, December 28, 2009

Some thoughts on the South African economy

Currently I’m vacationing in South Africa on the Indian Ocean side of the tip of Africa at a place called St. Francis Bay, which is near to Humansdorp, which in turn is west of Port Elizabeth. It’s a place I know quite well as I’ve been coming here now for years – my first visit being back in 1982 if you can believe it. South Africa, is a commodity-rich country with an extremely diverse population and a troubled past, although it is by far the most successful African country and has experienced a massive influx of workers in recent years.

Apart from the great weather and generally friendly people you encounter here, I usually pick up some interesting gifts at great prices, and often end up spending more money than I’d usually like, partially as prices here are so reasonable. Labor here is plentiful and this leads to low costs for goods and services produced in this country or imported from neighboring countries.

But this visit things are different. For the first time when I convert prices in South African Rands (SAR) into US dollars I’m finding that prices are at or above what I’d pay for comparable items in the US. Interestingly the Europeans I’ve run into are finding exactly the same, so the implication is that the Rand is out of line with what economists call the purchasing power parity.

(You can skip this next paragraph if you’re an economist).

So what is purchasing power parity or PPP? It is the idea ( - and probably the oldest idea in economics), that (identical) goods or services should cost the same wherever you buy them. When you use the same currency it’s called the “law of one price” as you’d expect the same item to have identical cost whether you buy it in Jo’burg or Cape Town. Obviously there are small variations in price within a country, but by and large, the “law” holds. When comparing things internationally you obviously have to use the exchange rate, which means that you convert the price in US$ by the current exchange rate into SAR and then compare it with what the price is in South Africa. If prices are generally higher in South Africa we’d say that the Rand is “overvalued” compared to PPP, and conversely if prices are generally lower in South Africa the Rand would be “undervalued”.

At any rate, it is clear to me that the Rand is definitely “overvalued” compared to what it’s been on my previous trips out here. That does not encourage me and other visitors to spend and will likely mean that tourist revenues from spending will be quite a bit lower this season than they were last season. It also means that South African exports of goods and services will likely be falling in value as well, as foreign importers decide to source the products they were buying from South Africa from somewhere else – China for example!

This beggars another question though - why is the Rand so strong? The answer most commentators will give is that South Africa is a commodity-exporting country, and that commodity prices are high right now as we are beginning to come out of the global recession and demand for these products is beginning to outstrip supply.

Given the rate of inflation that South Africa has compared to say the US dollar, the Rand should have been losing value, not holding roughly constant over the past year. Given this “inflation differential” continues into the future, the Rand will likely suddenly lose value at some point in the next 6 months or so, given that the foreign exchange market starts to divert its attention back to other issues other than recovery from the global recession! I’m wondering whether this will happen before or after the FIFA World Cup happens here…I would suspect after…

But more on that next time….in the meantime the beach is calling!!

Monday, December 14, 2009

What cycles in US consumption look like....

So what do cycles look like in something like US consumption?  Part of my recent research using a technique that originated in signal processing called "wavelet analysis", allows the researcher to separate out the different frequencies embedded in any economic variable.  The plot below is taken from a forthcoming paper with Andrew Hughes Hallett.

Below in the plot I've taken the year on year change in US consumption expenditures (from the US Bureau of Economic Research) and used wavelet analysis ( - for those of you interested MODWT with a Debauchies 8-tap wavelet) to extract the different cycles at different frequencies.  The first line (labelled "d1") are the cycles in the data at 2-4 quarters, the second line (d2) the cycles at 1-2 years, the third (d3) shows cycles at 2-4 years, the fourth (d4) shows cycles at 4-8 years, the fifth (d5) shows 8-16 year cycles and the sixth shows 16-32 year cycles.  The last (s6 - or what is known as the "smooth") shows what is left over when all the other cycles are removed from the series.

So what do we find here?  Well I hope you agree that the results here are quite revealing. 

First, we definitely see cycles at different frequencies, and clearly the strongest of these cycles is in the d3, d4 and d5 lines, although there are other cycles apparent in the data at other frequencies.  So these cycles correspond to 2 to 16 year cycles which is a little surprising as it implies that there are quite strong fluctuations in consumer expenditures at cycles outside what most economists would think of as the conventional "business cycle".

Second, economists have been intrigued about what they have termed "the Great Moderation", when refers to roughly the post-mid-1980s period when growth became much more stable.  Here when looking at these different frequency cycles we can see that this stability is due almost entirely to short cycles becoming less volatile - notably d2 and d3, so 1-4 year cycles, but that the longer cycles do not seem to have changed in their volatility. 

Third, economists have always hypothesized a long cycle of up to 50 years (or even beyond), but if we look at this analysis, it is clear that there's nothing beyond a 30 year cycle (which is clearly in the last line of the plot or s6). 

Lastly, look at the current recession.  It is clear that it has been caused by a coincident downturn in all of the cycles.  This leads to a new way of thinking about how recessions occur.  Instead of thinking of them as being caused by "shocks" hitting a stable growth trajectory, this view of the world thinks of them as being caused by the coincidence of fluctuations in growth occurring at a variety of different frequencies.

More on investment soon...

Saturday, December 12, 2009

Cycles in consumption expenditures

Why should we expect cycles to be part of macroeconomic dynamics? In short because spending increases often change cyclically, in investment and consumption in particular. Today let’s start with just looking at consumption. As a consumer, if the hottest new product arrives in the market, what will that likely do to a firm’s sales? Clearly there will be boost in spending as consumers get the information about the new products and decide to upgrade their technology or even the “look” of their wardrobe. Let’s take a few examples just to make this more concrete.

First, think about flat screen TVs: when they first came out most of them were relatively small at around 32”-40” and operating at 720mHz dynamic resolution, but many of us decided that they were a marked improvement over a regular TV, so decided to upgrade.  After a year or so, a new version of the flat screen came out with a 1080mHz dynamic resolution, so once again many of us decided to upgrade or to replace another of our non-flat screen TVs. Then they got (much) bigger and picture quality has improved as well, and once again many consumers changed out their TVs and upgraded to the better TV. If even a small number of consumers do this there will clearly be “growth cycles” created in the sales of these types of products, as spending will swell as this new technology hits the market. These cycles are clearly going to be irregular and will depend on the frequency at which breakthroughs in new technology occur, and how stable consumers expect the technology to be.

Second, think about non-iron shirts. I bought my first non-iron shirt about a year ago, and have been so thoroughly impressed, I’ve decided to upgrade my entire wardrobe. Now in the retail clothing sector there are clearly 4 seasons in the year, so we would expect there to be cycles on a quarterly basis in the data. But of course the data we prefer to use in economics is “seasonally adjusted”, meaning that systematic seasonal variations are adjusted for. But what happens if these variations are not systematic so that some seasons seem to do better than others. Clearly if this happens we can see cycles being created – indeed the season in which non-iron shirts were heavily marketed to men was a season where I spent much more on clothes than usual, and likely others did too, creating a spending cycle which the "seasonal adjustment" will not properly take into account.

Lastly, let’s think about vehicle sales. Many vehicles have not been replaced by owners recently because of the economic downturn, so apart from when the “cash for clunkers” program was in place, the general public has not been replacing vehicles. So when economic growth recovers, there will be a delayed demand to replace vehicles, and then there will be a larger number of vehicles of a certain vintage on the roads. Clearly they will likely be replaced at similar times in the future, leading to a bulge in expenditures at some point in the future, but the point is that these expenditures are likely to be more synchronized than they would have been as they were all purchased at a similar time.

Hopefully you've been convinced so far.  Next time I'll look at how some of the techniques I've been using in my own research break down consumption expenditures into cycles at different frequencies.

Wednesday, December 2, 2009

Some background on cycles in macroeconomics

One of the most interesting aspects of the history of economic thought is the "fads" and "fashions" that go with the ebb and flow of thinking about how the economy operates. If you look back to the early part of the last century it is clear that much of the effort of researchers working in the first part of the century on macroeconomics centred on understanding the cyclical nature of the macroeconomy. Perhaps the most famous contribution came from a distillation of research conducted by Arthur Burns and Wesley Mitchell in 1946 (see the NBER reference).

But although it's quite obvious that the business cycle ( - the cycle of boom and bust/positive growth and recession) is the most important cycle in the economy, many others have been hypothesized. Perhaps the most famous long cycle is that of
Kondratieff (who was executed during Stalin's purge) and his "long wave" of roughly 50 years in periodicity. But there were also others - among them names like Clement Juglar, Joseph Schumpeter, Joseph Kitchin and Simon Kuznets. There are also theories of credit cycles which largely originate from the Austrian school and also theories of financial instability (due to Hyman Minsky). The point though is that the business cycle is not the only cycle that exists in macroeconomics - it's just the cycle that hits the headlines most often because it has such drastic consequences.

For some reason (likely the Great Depression), the emphasis in economics shifted to economic policy and the role of government in stimulating the economy. In the post-WWII era, the emphasis shifted as events dictated - oil price shocks in the 1970s, inflation in the late 1970s and 1980s, etc. and never really returned to the idea of cycles in macroeconomics.

What's interesting here is that the fact that cycles in macroeconomics are not strictly "periodic" - in other words they don't have regular periodicity like a sine or cosine function, and don't have a regular amplitude (height of fluctuation) either, which makes them harder to detect. In addition changes in policy will likely change the nature of the cycles, distorting what we would otherwise observe. Also what's also interesting is that (as one might expect) there isn't necessarily just one cycle in economic growth - there is a combination of cycles all operating at different frequencies. So separating these out is no easy task.

Next I'll discuss why we should expect there to be cycles in macroeconomic data.

Tuesday, December 1, 2009

Cycles in macroeconomics

My main reason for starting this blog right now is to try and change the perception in economics that periodic cycles in macroeconomic activity do not exist. I'm sure that there are other comments on current issues will get posted here as well, but that's currently the central focus of my academic research.

One recent comment from a leading "mainstream" economist (who shall remain nameless, although he is on the NBER business cycle dating committee) that "there are no cycles with regular periodicities that show up in macroeconomic data" presents us with a conundrum, as we know there are irregular cycles in economic activity ( - why would anyone use the term "business cycle" if that wasn't the case). But the main philosophical point that this brings up is that most economists think that macroeconomic activity is not inherently cyclical - this is deeply engrained in our graduate school training, where economists talk about "steady-state growth paths" ( - meaning that the economy is growing at a constant fixed rate), with accompanying "shocks" which buffet the economy to create the cycles that we observe.

The main challenge for anyone working in this area is to explore whether these are naturally occurring cycles, or whether they are downturns caused by so-called random "shocks" ( - more on this later). Clearly one way to do this is to look and see if there are any long-term cycles in growth - if there are, as simple "shocks" cannot generate these types of cycles, this would suggest that there is cyclical activity inherent in economic growth, which of course suggests we should re-think the models that we use for macroeconomics.

But more about all of this later.

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