From The Economist:

TWENTY YEARS OF reform in Australia did not roll off without resistance, so sweeteners were needed to buy off opposition. One of the most inspired was superannuation, a long word meaning private pension provision that the all-abbreviating Aussies call their “super”. Used in the 1970s and 1980s to please trade unionists (and helping to keep a lid on inflation), it has turned into the financial equivalent of the Swiss army knife, with a multiplicity of benefits.

In 1992 the Keating government made it mandatory for employers to pay a proportion of the wages of all but the very lowest-paid workers into a superannuation account. The payment, which was tax-deductible, was to rise in annual steps to 9%, where it is today, though by 2019 it should be 12%. Employees choose the funds that receive their payments.

The upshot is that most Australian workers, over 8m in total, now have a private nest-egg for their old age. No tax is paid when members withdraw from their fund; they can take all they want as a lump sum, subject to a limit, or buy an annuity. Aussies are now a nation of capitalists.

At the same time the state pension system, and therefore the taxpayer, is being progressively relieved of most of the burden of retirement provision, since eligibility for the state pension depends on both assets and income. As supers take over, the provision for old folks’ incomes will be almost entirely based on defined contributions, not defined benefits. So Australia is in the happy position of not having to worry too much about the pension implications of an ageing population, though it may have a problem for six or seven years after 2014 when the post-war baby-boomers stop work with supers only half filled.

The entitlement problems facing the West are not difficult to solve (in a technical sense.)  They’re easy to solve.  You just have to get on with doing it.  My commenters always dismiss the Singapore model because their society is so different from ours.  But there are few countries in the world more similar to America than Australia (I’ve lived there.)

And here’s the impact on equality:

Mr Howard claims Australia has a unique form of egalitarianism, and David Alexander, who used to work for Mr Howard’s treasurer, recently argued in Policy magazine that Australia has developed a model of small-government egalitarianism that uniquely combines economic liberalism and egalitarian policy structures. Citing figures from the Organisation for Economic Co-operation and Development’s 2010 Survey, he points out that, among rich countries, Australia had the lowest government spending and the lowest taxes. At the same time it ranked below average for income inequality and close to bottom for inequality of wealth, using the standard (Gini coefficient) measures.

Two factors, he says, contribute to these “fair dos” positions. One is Australia’s system for making welfare and other transfers to the less well off, which is the most progressive in the world. The second is its tax system, one of the most progressive in the OECD. The upshot is what Mr Alexander calls a platypus model. Just like its egg-laying mammal, Australia defies the categorisers by being neither small-government and inequality-tolerant, as America is, nor high-taxing and egalitarian, as the Scandinavians are. This exceptionalism, believes Mr Alexander, makes Australia a happy and harmonious society in which populism is less likely and the chances for difficult reforms and real competition are better.  (Italics added)

But does all this egalitarianism hurt growth?

Only a dozen economies are bigger, and only six nations are richer””of which Switzerland alone has even a third as many people. Australia is rich, tranquil and mostly overlooked, yet it has a story to tell. Its current prosperity was far from inevitable. Twenty-five years ago Paul Keating, the country’s treasurer (finance minister), declared that if Australia failed to reform it would become a banana republic. Barely five years later, after a nasty recession, the country began a period of uninterrupted economic expansion matched by no other rich country. It continues to this day. This special report will explain how this has come about and ask whether it can last.

Those with a passing acquaintance of Australia will attribute its success to its luck in having such an abundance of minerals that its booming Asian neighbours want to buy. That is certainly part of the story. Yet Australia was not dragged down when a financial crisis struck Asia in 1997. And commodity exports have not always been fashionable. In the 1990s many thought they were evidence of an incorrigibly “old”, low-tech economy doomed to decline. Australia’s terms of trade””the ratio of its export prices to its import prices””seemed stuck at unfavourably low levels. Not until 2003 did minerals begin to boom again, though by then Australia had escaped both the Asian crisis and the recession that hit America in 2001. Five years later came the GFC, Oz-speak for global financial crisis. Yet that, too, failed to drive Australia into recession. Someone, other than Lady Luck, must have been doing something right.

Note to progressives:  Stop talking about France!  If the rich liberal states in the Northeast can’t even build high-speed rail in the Bos-Wash corridor, how the hell are we going to roll out the French model nationwide?  And will Americans pay 50% of GDP in taxes?  Australia’s the right model for progressives.  Americans will support egalitarian measures that don’t hurt growth, and don’t require high taxes.

More and more I think that the entire bubble/anti-EMH approach to economics is founded on nothing more than superstition.  Superstitions are caused by cognitive illusions; we think we notice more patterns than are actually there.  You dream your son got in a traffic accident, and the next day it happens.  You forget the other 10,000 dreams that didn’t predict the future.

In economics people notice bubbles bursting, but fail to pay much attention to bubbles not bursting.  But I admit I might be wrong, so I’ll give my opponents one more chance.  If it’s not really a cognitive illusion, then bubble deniers who are right ought to be just as famous as bubble predictors who are right.  Indeed as we will see they should be even more famous.

People who actually understand finance know that if the term “bubble” is to mean anything useful, it must contain an implied prediction of the future course of asset prices.  Not a precise prediction (everyone knows that would be impossible) but at least a better than a 50/50 prediction.  If someone said in 2005 that housing prices were a bubble, but still was unable to offer more than a 50/50 odds on whether real housing prices would rise or fall over the next 5 or 10 or 20 years, then what would their assertion actually mean?  Asset prices are very volatile; we know that at some point all markets will go down.  When I read predictions from people like Paul Krugman, I infer that there is an implied prediction that real prices will fall over some reasonable period of time—say 5 years.

And of course Krugman was right in predicting that real US housing prices would fall in the 5 years after 2005, as was Dean Baker, Nouriel Roubini, and some others who became well known and lauded for their predictions.

At the same time we also know that bubble-like patterns don’t always yield reliable predictions of future trends.  The Australian housing market looked just as bubbly as the US market in 2005, but since then has soared much higher.  Some day it will fall, but the 2005 prices no longer look excessive.

If people like Robert Shiller (another person who became famous from bubble predictions) are right about asset prices being too volatile, then it should be true that US-type cases are more common than the Australian case.  I don’t think that’s true— in most developed countries real housing prices have risen since 2005, despite real upswings before 2005.  But let’s say I’m wrong and Shiller’s right.  Then the easy prediction to make is that prices will fall after a big upswing.  The much harder prediction is that prices will keep rising, even from inflated levels.  Those cases would be much rarer, and those who correctly call them when they occur (as in the Australian housing case) should be lauded as great heros of the investment world.

So who are they?

If they don’t exist, I have a theory why.  Most people are convinced bubbles exist, regardless of the data.  Hence if the prediction doesn’t pan out, then the market was in some sense “wrong.”  Traders haven’t yet woken up to the stupidity of their behavior.  When they do, prices will crash and the bubble proponents will be proven right in the long run.  So most people would implicitly think; “Why praise someone for being right for the wrong reason?”  Of course this makes bubble theory into a near tautology, irrefutable in volatile asset markets that will almost always eventually show price decreases.

Perhaps I am wrong and there are lots of famous bubble deniers out there.  But if not, that would in my mind be the last nail in the anti-EMH coffin, pretty much confirming that people are seeing what they expect to see, indeed given the satisfaction we get from seeing the high and mighty brought low, perhaps what they want to see.

One final point; I also have noticed that lots of people are given credit for bubble predictions that were wrong.  John Kenneth Galbraith saying stocks were a bubble in January 1987.  Robert Shiller saying stocks were a bubble in 1996.  Dean Baker saying US housing was a bubble in 2002.  The Economist magazine touting its successful housing bubble predictions of 2003 in an ad, despite the predictions being incorrect for most of the countries listed.  That’s how strongly we want to believe in bubble predictions—we even assume that people who were wrong, were actually right.

PS.  For those interested in global housing prices, The Economist has a great interactive graph.  It helps to show the pattern from say 2000:1 to 2005:1, and then from 2005:1 to the present.  In the earlier period almost all countries showed gains in housing prices, even in real terms.  The two notable exceptions were Germany and Japan, where prices fell sharply.  If I was to use a Shiller-style model that predicts asset prices will self-correct after excessive swings, I would have predicted most housing markets to slump after 2005:1, but Germany and Japan to rise.  Instead almost the opposite happened.  Germany and Japan continued to do very poorly, while almost all other markets rose in nominal terms, and most rose even in real terms.

The two nominal decliners (in addition to Germany and Japan) were the US and Ireland—which is why people assume they had had a bubble.  But why didn’t all the other bubbles collapse?  Perhaps because asset prices are not as easily forecasted as most people naively assume.

BTW, if you can’t get a 2000:1 starting date, then white out all the country boxes and start over.  That worked for me.

In 2005 Paul Krugman called the US housing bubble.  A couple weeks ago he reminded us that he called the bubble, and implied only a fool (or a brainy right-wing ideologue?) could have failed to see it.  He presented a graph showing that housing prices in the US had been rising rapidly.  Interestingly, housing prices had been rising rapidly in lots of countries, but relatively few turned out to have housing bubbles.  Here’s a graph Tyler Cowen linked to recently:

Let’s use the archive list of months as a vertical line to estimate prices in 2005 when Krugman made the call, and compare them to today’s price:

US   2005 = 300,  2010 = 250

UK  2005 = 375,  2010 = 395

NZ  2005 = 330,  2010 = 430

Aus 2005 = 390,  2010 = 550

I don’t know about you, but to me only the US looks like a clear-cut bubble.  Yes there were some rises and falls in other countries, but it wasn’t obvious (ex ante) in 2005 whether prices in the other three countries were above or below their long run equilibrium.  Indeed it still isn’t, as Australian housing prices could crash at any time.

I’ve consistently argued that the bubble theory is only useful if it leads to good predictions.  Krugman did make a good prediction, that housing prices would be lower in the not too distant future.   BTW, I’d say you at least need to provide some sort of time frame—say 5 years out.  It’s not enough to say “I predict prices will keep rising, and then eventually fall.”  That’s true of any market.  Although Krugman did not provide a specific number in the post I linked to, I am pretty sure that the actual drop in the US occurred over the sort of time frame he envisioned, if he had been forced to name a date.  So I give him complete credit for a correct prediction.

But here’s my question.  Given that the other three markets did not decline over the same time period, is it really true that we could be confident, ex ante, that US houses were overpriced in 2005?  It certainly seems so given everything that has happened since, but might that be a cognitive illusion?  Confirmation bias?  I doubt Krugman thought NGDP would suddenly fall 8% below trend in the 12 months after mid-2008.  Where would housing prices be today if NGDP had kept growing at 5%.  I don’t know.

I’m inclined to believe there was some irrationality in the 2005 housing market, but I am less confident than Krugman that price bubbles are easy to spot.  In the next post I’ll provide one reason why, despite the undeniable excesses that swept the housing market, investors with rational expectations about NGDP growth and immigration might not have spotted the oncoming collapse in US housing prices.

BTW, look at housing prices in Australia; the one country on the list that did not experience a recession in 2008, and which has very rapid immigration.

PS.  This interactive graph in The Economist shows that among 20 countries, only the US and Ireland showed a clear bubble-like pattern after 2005.  In most countries prices are now higher than in 2005, and in the few other exceptions (Germany, Japan) there had been no run-up in prices prior to 2005.  So my results don’t come from cherry-picking these four anglophone nations, bubbles really are hard to spot.  (I’m puzzled by the Spanish price graph, but even if it is inaccurate and Spain was a bubble, that just makes three clear bubbles in The Economist group of 20.)

You can adjust the horizontal scale to get different starting dates.   Many countries saw steep price run-ups prior to 2005.  If you start at 2005:Q2, it’s easy to compare current prices to mid-2005 prices.

PPS:  Compare Krugman’s mea culpa post, with these Japan predictions dredged up by David Henderson.  The second paragraph shows Krugman at his best.  What happened to that guy?

As you know, I have relentlessly argued that the Fed made a huge mistake in mid-2008 by not targeting NGDP at about a 5% growth trajectory, level targeting.  If they had done so, NGDP almost certainly would not have fallen last year, and the recession would have been far milder.  But 5% NGDP growth, which implies about 2% trend inflation, almost certainly is not the optimal monetary target in the long run.  I picked it because the Fed had been implicitly targeting NGDP at around 5% for several decades, and since all sorts of wage and debt contracts in 2008 had been negotiated under the reasonable assumption that we would continue to have roughly 5% NGDP growth, it didn’t seem like a good idea to enact a highly deflationary policy in the midst of a financial crisis.  But I’m not running the Fed.

In fact, the optimal inflation rate is probably either lower or higher than 2%.  If we were to assume the Fed adopted NGDP forecast targeting, level targeting, then we would not have to worry about “liquidity traps,” i.e. the zero-rate bound on conventional monetary policy.  In that case we’d be better off with a lower inflation rate.  Neither Bill Woolsey or George Selgin advocate inflation targeting; their proposals are somewhat closer to my NGDP idea, but Woolsey’s plan would likely lead to near-zero inflation in the long run, and Selgin’s plan would probably lead to slight deflation on average.  These are sensible ideas if we have sound monetary policy, as inflation is a tax on capital, and lowers the rate of economic growth.

On the other hand if we don’t have a sensible monetary policy regime, then low inflation makes an economy more susceptible to bumping against the zero-rate bound.  Nick Rowe compares the problem to balancing a tall pole in one hand.  If you want to make the top of the pole go left, you move your hand to the right.  If the Fed wants inflation to rise, it lowers the fed funds rate.  But suppose while balancing the pole you bump up against a wall, then you can’t move your hand further to the right, and thus can’t move the top of the pole to the left.  That’s a liquidity trap.  Of course both Nick and I realize that you aren’t really stuck, you can climb a ladder and directly pull the top of the pole in whatever direction you like.  But many central bankers are afraid of heights.

So let’s suppose you have a central bank full of meek, timid souls.  What sort of inflation rate is optimal?  I’ve mentioned that you’d probably be better off with an inflation rate even higher than 2%.  But I never really developed the idea, as I didn’t want people to associate my 5% NGDP rule with a policy of printing money to get out from under our debt burden.  I am not an “inflationist” or a monetary policy “dove.”  Still, I should have done a post and let the chips fall where they would. Fortunately, Andy Harless has done so, and much more elegantly than I could have.

In the 1980s we brought inflation down from double-digits to about 4%.  Should we have declared victory and stayed at that level?  In retrospect, we probably should have.  We did get inflation down to about 3% in the 1990s, and only 1.8% in terms of the GDP deflator from mid-2000 to mid-2008.  At the time I thought this was good, because it lowers the real tax rate on capital.  But in retrospect it was a big mistake, as the cost of the liquidity trap we stumbled into in late 2008 will vastly exceed the gains from 1% or 2% lower inflation.  Indeed one of the costs will be a massive increase in our national debt, which will almost certainly lead to much higher tax rates on saving and investment.

Interestingly, I know of only one country that stayed away from the ever lower inflation obsession of the major central banks.  The Bank of Australia.  Australia had about 4% inflation in their GDP deflator and 7.4% NGDP growth between 2000:2 and 2008:2.  With a much higher inflation and NGDP trend rate going into the crisis, they we able to avoid the zero interest rate bound.  And by the way, for those who think nominal shocks don’t explain real events like the recent recession, Australia was the only major developed economy to avoid a recession last year.  Indeed they haven’t had one since 1991.  They are called ‘the lucky country,” but I have argued that their culture lacks our puritanical obsession with inflation.  Perhaps each member of our FOMC should drink a 6-pack of Fosters before their policy meetings.

PS.  Matt Yglesias quoted Harless and then asked:

I would like to see more commentary on this matter from smart and informed people before I say I’m taking this account to the bank. But it seems to me to be an obvious enough question to ask especially since there are a variety of other reasons to think that something like a 3-4 percent inflation rate would be more desirable than a 2 percent inflation rate.

I don’t know if I am smart, but I think I am reasonably well-informed, so I’ll take a stab at the question.  If we ever get to NGDP targeting, a lower than 2% rate would be optimal.  Under our current far from perfect system, I’d say Yglesias and Harless are about right.

PPS.  Economic development is a much more important issue than monetary policy.  About the time he switched from money to development, Robert Lucas said that “once you start thinking about economic growth, it is hard to think about anything else.”  I sometimes feel guilty talking about these comparatively minor issues at a time when there is such a horrible tragedy in Haiti.  But I really don’t know enough about that issue to provide any useful ideas, and other bloggers like Tyler Cowen are covering the topic far better than I could.