Year: 2010

Hump-Shaped Dynamics

A few weeks back, Harvard’s David Laibson gave a fascinating keynote lecture at the Geary Institute’s Economics and Psychology Conference. A key theme was the way people form expectations when macroeconomic time series have what he calls “hump-shaped dynamics”. These dynamics and their implications for expectations are described in a recent paper for the Journal of Economic Perspectives:

Many macroeconomic time series have long‐horizon hump‐shaped dynamics – processes that show momentum in the short run and some degree of mean reversion in the long run.  Such dynamics will generally not be captured by simple growth‐regressions.  Hence, agents with natural expectations will make approximately accurate forecasts at short horizons, but poor forecasts at long horizons, because the economy has more long‐run mean reversion than the agents impute from their intuitive models. In other words, agents with natural expectations will overestimate the long‐term persistence of good news or bad news.

David explained how even a skilled econometrician facing relatively short time series will tend to miss the longer-term mean reversion. The difficulty of seeing the mean reversion can mislead us into believing that a string of good draws on the fundamentals reflects a permanent improvement – with Ireland’s property bubble a good candidate. But equally a string of bad news can lead us to excessive pessimism – Wolfgang Munchau’s expectation that Ireland’s nominal growth will not exceed 1 percent for a decade comes to mind as a possible example.

We have certainly experienced a string of bad news on both economic growth and fiscal cost of the banking losses. Just as during the boom, extrapolation has led to extreme expectations about the economy and solvency. Of course, this pessimism could turn out to be justified. But it is no harm to remember that mean reversion works both ways.

Today’s Q3 growth numbers can be considered mildly good news. It is still too early to tell if we will be “bumping along the bottom” for some time or have “turned the corner”. (See here for graphs of real and nominal GDP/GNP based on today’s release.) For a mild antidote to the competition for who can come up with the biggest number for the banking losses, it is worth taking a look at Ronan Lyons’ analysis of potential mortgage-related losses.

New targets for greenhouse gas emission reduction

Minister Gormley has announced new targets for greenhouse gas emission reduction: 2020 emissions are to be 10% below 1990 levels (29% below 2005 levels) , 2030 emissions 40% below 1990, and 2050 emissions 80% below 1990.

EU legislation has that Ireland should cut 2020 emissions by some 20% below 2005. The EU has committed itself to 30% if there is a meaningful global agreement on emission reduction (which is as unlikely as ever). The Environment Council has repeatedly tried to remove the conditionality of the 30%, but has been rebuffed by the European Council. The government now argues that Ireland should unilaterally adopt the 30% (well, 29%) target.

It will be hard enough to meet the EU target, as illustrated here (after Devitt et al., 2010). According to the low growth scenario, Ireland will fall short some 5.5 mln tonnes of CO2 equivalent of the EU target — and 13.5 mln tonnes of the new government target. Today’s permit price is 14 euro/tCO2. Under the EU target, Ireland would need to spend 80 million euro per year on importing permits (the model imposes a carbon tax equal to the permit price, so buying permits is cheaper than increasing domestic emission reduction). Under the new government target, this would by 190 mln euro.

The new government target is less stringent than that proposed by the Oireachtas Joint Committee on Climate Change and Energy Security.

The cost of wind (ctd)

Referring to my earlier remarks about an ESRI paper, here’s the verbatim conclusions of the paper.

Seán Diffney, John Fitz Gerald, Seán Lyons, Laura Malaguzzi Valeri, “Investment in electricity infrastructure in a small isolated market: the case of Ireland”, Oxford Review of Economic Policy, Volume 25, Number 3, 2009.

The new All-Island market structure appears to have performed broadly as expected. The rules provide for a transparent and efficient operation of the market, encouraging plant availability. Investors are clearly relying on the capacity payment regime to ensure that electricity is priced at long run marginal cost in the future. Lyons et al. (2007) suggest that the calibration of the capacity payments regime is broadly appropriate. The one area which may need further consideration is the handling of wind generation within the capacity payments regime.

In this article we evaluate the costs and benefits to the Irish system of meeting the government’s target for 2020 for 40 per cent of electricity to be generated by renewables, primarily wind. We find that high wind generation is economic when fuel prices are high and that a high level of wind penetration will occur without further expensive incentives. Unless fuel prices or carbon prices are low in 2020 consumers are likely to benefit from a high level of wind generation on the system. This is consistent with the results in DCENR and DETINI (2008) and CER and NIAUR (2008). The target for a high level of wind generation in the Republic will not adversely affect consumers in Northern Ireland and may actually benefit them in the case of high energy prices. While low fuel or carbon prices could see consumers in both jurisdictions paying a higher electricity price, this premium would be likely to be small. A high level of wind generation would provide a hedge against high fuel prices.

To be sure of the net effects of wind generation it would be important to not only measure its positive externalities, but also its negative externalities. In this study we have internalised part of the negative externalities wind generation imposes on existing thermal plants by curtailing wind generation to limit thermal plant cycling. We have not however attempted to estimate the possible negative environmental externalities of wind farms.

We find that investing in a lot of wind generation is economic only if there is also parallel investment in interconnection. This allows wind to generate whenever it is available instead of being curtailed at times of low demand or imposing additional costs on thermal plants by making them ramp up and down. This implies that the total capital costs associated with an investment in high wind generation will be substantial. Therefore, in order to minimize the cost of the system to the consumer policy should concentrate on minimising the cost of this investment. One measure to achieve this is already in place, regulatory certainty: because the establishment of the new market required co-ordinated legislation in two jurisdictions it will be difficult to change. This should provide additional reassurance to investors.

Second, given the comparative youth of the SEM, avoidance of regulatory risk is at a premium. The regulators should avoid making unnecessary changes to the framework or parameters while market participants gain confidence and knowledge about how the system works.

Third, the financing of the essential network infrastructure, including interconnectors should be done on the basis that it is part of the regulated asset base of the state owned (or in the case of Northern Ireland mutual owned) company. As such it should attract a low cost of capital which will be crucial to ensure that the costs for consumers on the island of Ireland are minimised. In any event, merchant interconnectors would be unlikely to supply the socially optimal level of interconnection, given their higher cost of capital and decreasing returns to investment. It should be noted that these results are based on the assumption that interconnection operates as a perfect arbitrageur, allowing electricity to flow from the low price to the high price jurisdiction when ever there is a price difference. In practice this is unlikely to hold, so studying the specific behaviour of interconnection flow is important to assess the returns to the system. If the interconnector does not operate optimally a much larger infrastructure investment could be needed to obtain the same effect, possibly causing the high wind scenario to become too expensive. This highlights the importance of implementing an appropriate regulatory regime to cover all of the interconnectors between Ireland and Great Britain.

Finally, to facilitate the continued development of competition, the ownership of the transmission system in the Republic should be transferred to EirGrid, the government-owned operator of the electricity system, and the Irish government (as shareholder) should ensure that appropriate pressure is put on operating costs in the ESB.

QNA Release for 2010:Q3

The quarterly national accounts for 2010:Q3 have been released. They show seasonally adjusted real GDP increasing 0.5% quarter over quarter and seasonally adjusted real GNP up 1.1% over the same period. There are also some small upward revisions to the second quarter figures, with the change in real GDP revised from -1.2 percent to -1.0 percent and the change in real GNP revised from -0.3 percent to 0.1 percent. On a year-over-year basis, real GDP was down 0.5 percent in 2010:Q3 and real GNP was down 1.6 percent.

Nominal GDP perhaps matters more for fiscal policy and here the news is also better than we have seen in some time. Nominal GDP was up 0.8 percent in 2010:Q3 and the second quarter figure was revised up from a 0.3 percent decline to a 0.2 percent increase. Nominal GNP was up 1.9 percent in 2010:Q3 and the previous quarter was revised up from a 0.5 percent increase to a 1.9 percent increase.  Nominal GDP is down 1 percent year over year while nominal GNP is down 2.3 percent over the same period.

The growth in the third quarter was driven by a strong performance for net exports, with all component of domestic demand contracting.

Germany’s choices

All countries have choices — even our own, despite assertions to the contrary — but some countries have more choices than others.

Faced with solvency problems around the European periphery, and quite possibly in core banks as well, and also with the underlying reality of intra-Eurozone imbalances, how should Germany react?

Continuing to do as little as possible, and hoping that we can all muddle through, is one option. This risks destroying the euro.

Having the ECB step in via some sort of overt or covert QE is another.

Moving towards fiscal burden-sharing, implying deeper Eurozone integration, is another.

And a big-bang approach to restructuring debts in Europe is another.

In my view some combination of the last three options is probably optimal, if you want to keep the euro. But none of these options are particularly attractive, one assumes, from a German perspective. German industry would be a major loser if the Euro collapsed. The ECB option could undermine the credibility of the euro as a strong currency. Burden-sharing is going to cost the German taxpayer money. And as for the collective restructuring option, Germany is a creditor country.

Today’s article in the FT by Frank-Walter Steinmeier and Peer Steinbrück is a good contribution, from a pro-EU-integration perspective, that can help us see how one section of the German political spectrum views these trade-offs. They are attached to EMU, and so rule out doing nothing. Nor do they like the prospect of the ECB becoming ‘Europe’s “bad bank”‘, a nice political turn of phrase. Unlike Merkel, however, they understand that ruling out these two options has logical implications, pushing the burden of adjustment onto the other two options. For Steinmeier and Steinbrück, this means haircuts for the periphery and the introduction of Eurobonds:


In the case of Ireland, abolishing full state guarantees for private banks would allow their debt to be cut off at the root of the problem, while also letting private investors take their fair share of the burden. A new European framework for bankruptcies of financial institutions should support this.

There are conditions of course:


empowering European institutions to establish tighter controls over fiscal and economic stability, alongside common minimum standards on wage and welfare policies, as well as capital and corporate taxation. In short: we need European government bonds, but we must put an end to beggar-thy-neighbour policies and harmful tax competition within the eurozone too.

It is perfectly understandable that this would be the German position, and anyone who thinks these issues are going to go away is living in cloud cuckoo land. (What our position should be if presented with such a bargain is an interesting question: plenty of costs and benefits on both sides to be considered, which is why God gave economists two hands.)

On the other hand, the Steinmeier-Steinbrück reforms would probably require a new Treaty. Anyone on the Continent who thinks that there is a hope of getting a referendum passed in Ireland, so long as the ECB and EC continue to rule out burden-sharing with senior bondholders, is probably also living in cloud cuckoo land. Time is running out as regards the remaining unguaranteed debt: federalist Europeans should logically be arguing for this issue to be dealt with, satisfactorily, as quickly as possible.