Tuesday, December 23, 2008

Renters are getting some too

Consider the folowing three pieces of information which we can use for some crude mathematics.

• The Department of the Environment reports (Excel) that there are 188,152 private rented accommodations registered in Ireland.
• Daft.ie estimates that in October the average rent in Ireland was €1,300
• In the latest CPI release the CSO reports that rents fell by 6.1% in November.

A quick calculation shows that this reduction results in a saving of €15 million per month in the rental sector for consumers, coming in at €180 million for a full year.

How accurate is this? Let's see.

The total number of rented accomodations is based on registrations with the Private Residential Tenancies Board (PRTB). Not every tenancy is registered so this is the lower bound of the total.

The calculation from Daft.ie is based on asking rents on their website which may be different from the actual rent on the tenancy. This is an average of a small subet of rents, i.e. those advertisied on Daft. Also most tenancies will be in place for a period of time which means that actual rent may be different from the asking or agreed rent in tenancies starting now. Finally, this average doesn't take into account the size or number of residents in each tenancy.

The CSO figure stands up to scrutiny (apparentlty!).

Still, the point remains. The reduction in rent, and any further reductions, result in substantial savings for renters. And it's likely that landlords have been gaining too as interest rate reductions should more than offset the drop in rents.

Monday, December 22, 2008

How much interest are we saving?

Since October the ECB has cut their main refinancing rate from 4.25% to 2.5%. This rate is the driver of variable and tracker mortgage interest rates in Ireland. So how much are households benefitting as a result of the rate cuts?

The Central Bank reports in their Statistical Bulletin that in October there was about €123.5 billion of residential mortgages outstanding in Ireland. Of this about €90 billion was for principal dwellings and €33 billion was for buy-to-let residential properties.

Let's look at the mortgages for principal dwellings. Some of these properties are on fixed rate mortgages so the interest rate changes have no impact on the repayments. In 2007 Bank of Ireland reported the following breakdown for its mortgages

• Fixed - 26%
• Variable Tracker - 68%
• Standard Variable - 6%

Bank of Ireland represented about 20% of the overall mortgage market so we can take them as being fairly representative. They did note, however, that fixed rates of between 2 and 5 years were becoming increasing popular. According to the Department of the Environment 38% of new loans issued in the second quarter of 2008 were on fixed interest rates.

We'll take it that 66% of mortgages are on tracker or standard variable rates. Although a conservative estimate it means that €60 billion of household mortgages now have lower interest payments. The savings?

Let'ss assume that the outstanding debt must be paid off over a 20 year term and that the average interest rate has dropped from 5.75% to 4%.

This means the monthly repayment on this debt has fallen by about €58 million per month. Over a full year this will give a saving of close to €700 million which will increase if interest rates fall again as expected. And this excludes savings in the buy-to-let sector which will bring the full amount closer to €1 billion. Now we're stimulating!

Automatic Stimulation?

The average price of a litre of petrol in Ireland has fallen below 1 euro for the first time since the the start of 2005.

In the middle of this year the price per litre peaked at an average of €1.34. In the space of a few weeks the price has dropped dramatically. This follows the pattern in commodity markets where the price of a barrel of oil peaked at \$147 but has recently been below \$40.

AA Ireland reports (via rte.ie) that "if you're putting 40 litres of petrol in your car, you are now spending €40.40 per tank instead of €53.60 - a significant saving." This is indeed a significant saving. But what is the saving for the economy as a whole?

In a full year Ireland consumes about 2 billion litres of petrol. Let's assume that the average price at the pump in 2008 was €1.20 (about right) and that the average price in 2009 will be €1.00. (as good as guess as any if the price changes follow a random walk).

With a consumption of 2 billion litres this means an aggregate saving of €400 million! That is €400 million extra that Irish consumers have to spend on other goods and services that would otherwise have (mostly) been spent on importing oil.

And there's more! The 2009 price includes an additional 8c per litre excise duty that only applied since the middle of October in 2008. So not only will the consumers have to spend less on petrol, the Exchequer will actually collect more. The increase in excise duty will bring in about an extra €160 million for the government. This gives a total gain of €560 million.

If the price continues to fall consumers will gain €100 million for every additional 5c decrease in the price per litre.

Sunday, December 21, 2008

The Broken Window of "Patriotic Duty"

In one of the best books on economics Henry Hazlitt gives us Economics in One Lesson. The book is available here. Hazlitt borrows from the 19th century French writer Federic Bastiat who wrote what is seen and what is not seen. Hazlitt uses this for the first chapter of part 2 in his book which is reproduced in full below. The first part is The Lesson.

The Broken Window

Let us begin with the simplest illustration possible: let us, emulating Bastiat, choose a broken pane of glass.

A young hoodlum, say, heaves a brick through the window of a baker’s shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sum.

After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have \$250 more to spend with other merchants, and these in turn will have \$250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out \$250 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and \$250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

So what has this got to do with us? Well, below I wrote how the flow of consumers North of the border may be an example of price discromination. In another intervention Minister for Finance Brian Lenihan has urged shoppers to do their “patriotic duty” and resist the urge to avail of bargains in the North. However if people can save €50 or €100 on their weekly shop this is extra money that they can spend in pubs, restaurants, cinemas and on taxis and other services in this country that can't be bought on a shopping trip to the North.

Brian Lenihan's patriotic duty involves reducing the incomes across a whole range of occupations. It just that these are unseen and not seen like traffic jams into Newry on a Saturday morning.

Multimarket price discrimination on an island

Could some of the price difference between goods in Northern Ireland and Ireland be down to price discrimination by retailers? Clearly, some of the difference is due to difference in VAT in the two states and a lot of it is accounted for by the recent depreciation (collapse?) in the value of sterling. However, the Irish government has written to British high street retailers in recent days expressing concern over the high prices of goods in their outlets in the Republic compared to the North. Is this what economists call third-degree price discrimination, i.e. charging different prices in different market segments?

The retailers are charging a higher price to those not willing to travel and a lower price to more price sensitive customers who are willing to travel to the North. Is the government moral outrage justified? Maybe, but then they should be also writing to the following:

• Cinemas who charge higher prices to adults than students.
• Retailers who charge higher prices to some shoppers than those who gather money off coupons and bring them to the shop.
• Restaurants who charge higher prices to diners than to those who arrive before 7pm.

I'm not a student, I don't clip coupons and the babysitter doesn't arrive early enough for me to avail of early bird specials. It is appaling that I have to pay a higher price than others for these exact same goods. The government should be writing letters ensuring that I get to these lower prices. Or maybe the moral outrage about cheaper prices in the North is not justified at all and the government is engaged in is patriotic tokenism?

Is there any good news?

The New York Times has a piece on finding good news in falling prices. A lot of it may also be true for Ireland. Here are some excerpts.

The cost of fruits, vegetables, clothing and vehicles are all dropping. Housing prices have been falling for more than two years, and a barrel of oil costs about \$45, down from \$145 in July.

The inflation report released by the government on Tuesday showed that the Consumer Price index was 3 percent lower last month than it had been three months earlier. It was the steepest such drop since 1933.

These declines have raised fears of a deflationary spiral — fears that help explain the Federal Reserve's’s surprisingly large interest rate reduction on Tuesday. And there is good reason to fear deflation.

Once prices start to fall, many consumers may decide to reduce their spending even more than they already have. Why buy a minivan today, after all, if it’s going to be cheaper in a few months? Multiplied by millions, such decisions weaken the economy further, forcing companies to reduce prices even more.

But a truly destructive cycle of deflation is still not the most likely outcome. For one thing, the price of oil cannot fall by another \$100 in the next few months. For another, the federal government will soon, finally, be fully engaged in trying to stimulate the economy.

So amid all the legitimate worries about deflation, it’s worth considering what may be the one silver lining in the incredibly bad run of recent economic news: The cost of living is falling.

Jobs are disappearing, bonuses are shrinking and raises will be hard to come by. But the drop in prices, which isn’t over yet, will make life easier on millions of people. It’s possible, in fact, that the current recession will do less harm to the typical family’s income than it does to many other parts of the economy.

The reason is something called the sticky-wage theory. Economists have long been puzzled by the fact that most businesses simply will not cut their workers’ pay, even in a downturn. Businesses routinely lay off 10 percent of their workers to cut costs. They almost never cut pay by 10 percent across the board.

Traditional economic theory doesn’t do a good job of explaining this. During a recession, the price of hamburgers, shirts, cars and airline tickets falls. But the price of labor does not. It’s sticky.

In the 1990s, a Yale economist named Truman Bewley set out to solve this riddle by interviewing hundreds of executives, union officials and consultants. He emerged believing there was only one good explanation.

“Reducing the pay of existing employees was nearly unthinkable because of the impact of worker attitudes,” he wrote in his book “Why Wages Don’t Fall During a Recession,” summarizing the view of a typical executive he interviewed. “The advantage of layoffs over pay reduction was that they ‘get the misery out the door.’ ”

Companies resort to cutting jobs and giving only meager pay increases, increases that are even smaller than the low rate of inflation that’s typical during a recession. This recession may well be the worst in a generation — but thanks to the stickiness of wages, the pay drop for most families may not be much worse than that of a typical
recession.

I don’t mean to make things sound better than they are. The economy is bad and getting worse. A deflationary spiral remains a real threat, even if it’s not the most likely result. No matter what, unemployment is headed much higher.

But the drop in prices will still soften the blow. And at this point, American families can use any bit of economic help that they can get.

In Ireland the Central Statistics Office reports that prices as measured by the Consumer Price Index fell by 0.9% in November compared with October. While prices are still 2.5% higher when compared to November last year we can expect our annual inflation rate to drop close to and below zero over the next few months.

Prices are already cheaper in some categories than at this time last year; clothing and footwear (-7.2%), petrol (-6.6%), rent (-5.9%), furnishing and household equipment(-1.9%) and transport (-0.7%).

Also over the next few months households will begin to see the effect of the dramatic cut in ECB interest rates from 4.25% to 2.50%. For a 25 year €250,000 tracker rate mortgage of ECB +1% this will cause the monthly payment to drop from about €1,500 to €1,250 - a savings of €250 a month or €3,000 a year! Similar savings will be seen across other tracker and variable rate mortgages.

Parking, Driving, Drinking and Printing

On the 1st of December Dublin City Council increased city centre parking rates from €2.70 to €2.90 per hour. The council’s justification for this was to limit the congestion caused by people cruising around looking for a parking space. The increased cost aims to do this by discouraging commuter parking and encouraging short term parking. Looking at it another way they are trying to reduce congestion by allowing the cars that are moving to stop and getting the cars that are stopped to move. In the words of Thomas Schelling they have fallen foul of “the inescapable mathematics of musical chairs” as all they have done is change the categories while the total number of cars remains unchanged. More on congestion later.

On the 1st July the government introduced changes to the Vehicle Registration Tax (VRT) and annual motor tax on new cars that had been announced in the previous December's budget. The new rates are based on the carbon dioxide emissions of the car rather than the size of the engine which was the determining factor under the old system. When announced in Brian Cowen’s last budget the stated aim of this new system was to assist the environment by reducing carbon dioxide emissions. Granted the system may cause some people to alter their car buying decision but once a person has bought a high emissions car they can drive, and pollute, as much as they want and not face any additional cost.

The new system has changed the average cost of a polluting trip but it has not changed the cost of the next polluting trip, the marginal cost. Consider the example of student parties from Tim Harford’s book The Undercover Economist. The clubs and societies in Tim’s university organised large parties with two types of entry tickets; ‘Alcoholic’ tickets allow unlimited drinking and ‘Sober’ tickets made warm orange juice the tipple of choice. ‘Alcoholic’ tickets were sold for €20, while ‘Sober’ tickets were free.

After buying the more expensive ticket it makes little sense to have two or three drinks and leave as quietly as you entered. So people either bought the ‘Alcoholic’ ticket and drank as much as they could, or went for the ‘Sober’ option and left as quietly as they entered. Drinking in moderation was a rarely seen phenomenon. To counter this excessive drunkenness the college decided their only option was to make drinking more expensive so they mandated that the cost of ‘Alcoholic’ tickets be raised to €30. Can you guess what happened?

For some people this increase in price might cause them to go down the ‘Sober’ road. But most of the students would cobble together the €30 and get as drunk as they had got before. The university hadn’t solved its drinking problem at all. Replace ‘Alcoholic’ with gas guzzler and ‘Sober’ with fuel efficient and you will see that the government has made that exact same mistake in trying to curb carbon emissions that the university made in trying to curb excessive drinking.

Both thought correctly that the cure was to raise the price of the harmful activity; unfortunately they both raised the wrong price. By raising the up-front fee you are raising the average price of the activity. The government has raised the up-front fee on high emission cars with the VRT changes. However we don’t base our decision on average prices. Drivers ask what the next trip will cost them. With the emissions based VRT this is an up-front fee so the marginal or extra cost of the next trip is zero. Like the students who kept drinking the SUV drivers might as well keep on driving. The changes in VRT do little to help the environment.

An up-front fee does not change behaviour. Of course, it could be argued that the annual motor tax has also been changed to tie-in with carbon emissions and that this will solve the problem. But once again it is the case that when this is paid drivers are free to drive as much as they wish. And it can be assumed that the person would have considered the annual motor tax when they initially bought the car.

If you want to limit pollution the only effective way is to change the marginal cost of driving, the cost of additional trips. The changes to VRT and motor tax were introduced under the guise of “environmentally friendly” taxes but they are nothing of the sort. They are just taxes. If you want to curb pollution you must tax pollution. Cars don’t create pollution, driving cars does.

The government hasn’t always shown such a poor appreciation of how changing incentives affect behaviour and that people respond to marginal and not average prices. In 2002 the government looked to address the use of plastic bags for shopping. It was decided that a tax or charge was the best instrument to limit the use, and ensuing littering, of plastic bags. The tax resulted in a 94% drop in the use of plastic bags in Ireland.

The levy was initially set at 15c and increased to 22c in July 2007. How did such a small charge have such a large effect? The tax increased the average and the marginal price of plastic bags. Every time a person wanted to use an additional bag they had to pay an additional levy, the cost of the next bag was greater than zero. The tax was designed to change people’s behaviour and it achieved that.

University College, Cork looks like it hasn’t learned from their colleagues in Tim Harford’s university or the success of the plastic bag levy. The problem they face is not that students are drinking too much; it is that they are printing too much. There is unlimited free printing for students on campus. UCC wants to address this issue by introducing a charge for printing. In a recent piece in the University paper (University Express, 18th November) the registrar and Professor of Zoology Paul Giller showed a good grasp of basic economics when he stated that “a free good is be abused”. However, this is the limit of their understanding. The solution proposed by the bursar Diarmuid Collins to the printing problem is that an extra €15 charge to be added to students’ registration fee at the start of the year.

Increasing the pricing of ‘Alcoholic’ tickets at parties did nothing to stem the flow of drink. Charging students €15 at the start of the year will do nothing to stem the flow of ink. UCC may have raised the average price of printing but the marginal cost of the next page will still be zero so students will print as much as they did before. Of course, if the university is looking for a scheme to raise almost a quarter of million euro in revenue from the University’s 16,000 students they have hit on a winner.

So what of congestion? Well it’s actually not that much different from pollution. It is not parked cars that cause congestion; moving cars do that, even if they are moving at a snail’s pace. If you want to limit the number of cars on city streets you must charge for driving on city streets. Otherwise people are free to drive as much as they wish, and city centre traffic will testify that is exactly what they do.

Oh and make city centre parking cheaper not dearer (unless the only aim is to raise revenue that is).