Using Economy Theory to Answer Few Important Questions in Life 1

I plan to write this in a while but i now currently packed with tonnes of work on my shoulder. However recently i went to watch "Wall Street Money Never Sleep" and inspired by it to give my opinion of basic questions in our life using economic theory.

Lot of people think that economic theory is plainly theory and can't be applied in real world (although economist always prove a hypothesis using empirical study). My response to them are simple: they do not understand economics well and they do not understand economy in general.

Currently I am lecturing on the subject of Economics in a business school and the student can't see the reason why they need to learn economic. In their world, Business is everything and they think business subjects such as marketing, human resource management and logistic management are much more important than economics.

Well are they?

Recently I did a simple research on the correlation between the management quality and profit. To my surprise, no matter how I manipulate the data, the best correlation I get is +0.17. In other word, Management quality only 17% related to the profit of a firm. So where are the rest (83%)?

Predictably economy factor (GDP) has a correlation of +0.79 to the profit of firms.

It means no matter hard good is the management quality of a firm, Economy factors(such as GDP and inflation rate) are the dominant factor in determining the profit of a firm.

Back to our topic, I plan to give my opinion of basic questions in our life using economic theory. This is based on my knowledge in economics (hopefully enough lol) and experience in the financial markets. Note that the answer i give may vary according to the demographic and economic environment.

The first question i want to discuss is this: should you buy or rent a house?

Many people will immediately say we should buy. In fact many websites including Yahoo Finance have their analysis on the topic and conclude that you should own house(s).

However, is that true?

I will answer the question according to the variables in my country. However you can all apply the analysis in your own country perspective.

Let say we use a simple example as our focus of analysis. The price of an expensive house (300 square meter) in my area is around $ 750,600 and the average rent in that type of houses is $ 3,657

So which is better, buy or rent?

So we will calculate the monthly cost of each option and determine which is better option.

If I buy:

Interest cost (The base lending rate in commercial banks in my country is 5.75% p.a. and they will usually charge BLR + 1 to 5% depend on their evaluation. The normal mortgage rate is BLR + 2% which is 7.75% p.a.)

= (750,600 x 7.75%) / 12
= $4,847.625 or $ 4847.63 per month

Property Assessment tax

= (3657 x 12 months) x 4.5%
= 43884 x 4.5%
= $1974.78

Opportunity cost. Since you used your money to buy house (and forfeit the opportunity of investing in other financial instruments), opportunity cost occurred. Let say we use average 30 years T-bill rate for the last 5 years.

Average 30 years t-bill rate (last 5 year) = 5.32%

(750,600 x 5.32%) / 12 months
= $ 3327.66

Monthly cost of buying a house (not including principles) = 4847.63 + 1974.78 + 3327.66

= $ 10150.07 per month which is much higher than renting a house (average = $ 3,657 per month)


Furthermore there many costs and risks involved when you own a house. Tenant do not have to bear the cost of maintaining the house while landlord have to bear all the expenses involved.

Besides that, house owner need to bear risk of uncertainty (natural disaster etc) as well.

In conclusion, the theory is simple: if the marginal cost of renting a house vs lower than the marginal cost of buying a house, RENT IT.

Using our example, we should rent.

Mukhriz blames opposition for FDI plunge????

(Bernama) - Measures taken by the federal government have helped to attract foreign direct investment (FDI) this year contrary to the poor showing in 2008 and 2009 resulting from the opposition's disparaging remarks about the country, Mukhriz Mahathir said yesterday.

The Deputy International Trade and Industry Minister said the disparaging remarks directed at the BN government had instilled fear in foreign investors, so much so that FDI in 2008 and 2009 dropped by up to 81 percent.

When the investors kept away, the opposition blamed the federal government for what they claimed to be inefficiency in drawing investments.

"They cause the problem and they blame us for it. However, the government always does its best to attract foreign investors," he told reporters when met at the Aidilfitri open house of Pendang Umno Youth head Akrom Abdul Hamid in Pendang.

Mukhriz said the government measures had yielded RM5.6 billion in FDI in the first three months of this year, almost as much as the RM5.66 billion in FDI for the whole of last year.

He said the government, through the ministry, always held promotions for foreign investors regardless of which state, even those administered by the opposition parties, they wanted to invest in.

Rational Expectation, Irrational Decision Making

Today is the first day of school (for primary and secondary level) in my country. We just had a long year end break of about 6 weeks. (yes we have winter break which is different than western countries where they have summer break)

Education...... can it really help us? Can they guide us towards a rational person?

Well......

In Economics, agents are assumed to be rational. We choose the alternative that are best for us and this whole concept were discussed in Wealth of Nations. (rational self interest)

Rational expectation gains its popularity in recent years with the monetarism (chicago school). It is an economics theory which states that economic agents (consumers, firms, government and international sector) predictions of the future value of economically relevant variables, is not systematically wrong in that all errors are random. In other word, it means that agents in economy will use all information to select the best choices and the outcome will be more significant in the future.

However, as far as I can see, the world is encountering a phenomenon i like to call "irrational decision making". Economic agents just do not select the best alternative based on available information. In other words, yes, they are selecting the alternative that they think is the best, but they are irrational to consider all the important information.

To demonstrate my point clearly, I will use 2 examples:

1. Most US consumers buy many unnecessary goods for Christmas as present. Although some of the goods are at discounted price (some are not), is that rational consumption? Do they rationally expect how they gonna finance it? How much marginal utility can they achieve?

2. The problem of ignoring opportunity cost. Most consumers think that buying house(s) is one of the best investment. According to them, price of houses will be higher in the long run because of inflation and problems with unlimited demand and scarce supply. However, in that circumstances, price of any goods will increase as well. Price of commodities such as food and energy will rise higher. (I already demonstrate renting is better than buying for house in my past post)

Furthermore, most of us are spending future expected income without consider the risk involved ie. higher interest, unemployment, decrease of future income etc. As a result, they get into debt and fall into the hands of lender(s).

The only way education can help us is when we become a rational person in decision making process. Otherwise it will be like winning lottery the day after we died, it means nothing.

Malaysian money head overseas in Q2

Malaysians invested more money abroad than what the country managed to attract as foreign direct investment in the second quarter of this year, said a report by CIMB released today.

Direct investment abroad (DIA) by Malaysian companies came in at RM6.2 billion, out-pacing the RM5.9 billion in foreign direct investment into the country.

The flow of money heading out in the second quarter saw a sharp increase from the first quarter of this year when only RM3.8 billion was recorded as DIA.

In the first quarter, Malaysia managed to attract RM5.1 billion in foreign investments, compared with the RM3.8 billions Malaysians invested abroad.

While Malaysians are sending more money abroad, Malaysia’s balance of payments deficit dropped sharply from RM19.6 billion in the first quarter to RM1.9 billion in the second quarter of the year.

“Overall, the strength of financial account remains weak and a sustained net inflow of capital would depend on the successful implementation of the New Economic Model (NEM) and Tenth Malaysia Plan,” said the CIMB report.

The Najib administration has been trying to open up the economy in a bid to make it a high income nation but was met with opposition from conservative vocal Malay rights group Perkasa which wants the status quo maintained despite widespread criticism that four decades of affirmative action has made the nation uncompetitive.

The government will also have to address the persistent net investment outflows as domestic private investment is a key element in its developed high income nation strategy.

The National Economic Advisory Council (NEAC) had submitted Part Two of the New Economic Model (NEM) to the Prime Minister today.

The second and final report from the NEAC was reported to contain 53 key policy measures aimed at eliminating cross-cutting barriers to a high income, sustainable and inclusive economy by 2020. It will be incorporated into the Economic Transformation Programme report to be released next month.

The research report noted that the reduction in balance of payments deficit was largely due to a marked reduction in errors and omission outflows (E&O).

The second quarter RM18.8 billion in E&O was down from RM30.5 billion in the first quarter, reflecting smaller foreign exchange revaluation losses as the ringgit appreciated moderately against major foreign currencies.

The CIMB report also noted that the nation’s current account surplus almost halved to RM16.2 billion in the second quarter from RM30.4 billion in the first quarter due to a lower trade surplus in goods amid widening services outflows.

“Reflecting a softer global demand, we expect the current account surplus will narrow further in the second half,” said the report.

It estimated current account surplus for 2010 to be RM103.2 billion or 13.7 per cent of GDP down from RM107.7 billion or 14.3 per cent of GDP previously.

The report said that E&O as a percentage of total merchandise trade and excluding foreign exchange revaluation had widened to between 4 and 6 per cent in the first half of the year as compared with 0.3 and 3 per cent during the period 2001-2009.

“As a rule of thumb, an “E&O” of not more than 5.0 per cent of total merchandise trade suggests no strong evidence of massive capital flight,” said the report.

Source: Malaysia Today.

Here is my analysis. Capital movement is easily tracked with capital account balance in balance of payment.

Malaysia is in deficit of capital account balance since 1974 and according to economics, interest differential is the main determinant of capital movement.

Malaysia's OPR is at 2.75% currently which is very low compare to other developing countries such as the BRIC, other south America countries and other east Asia countries.

That means Return for investing in Malaysia (Portfolio investment or Foreign direct investment) is too low relative to the risk (higher risk of uncertainty in developing countries).

Currently Malaysia is in a long streak of balance of payment surplus since 1999 as the current account balance surplus offset the deficit in capital account.

So, in conclusion, this is not a serious problem for Malaysia economy as most developing countries have deficit capital account balance (inflow of capital lower than outflow of capital) and current account surplus. Malaysia have much bigger problem in Government budget deficit as both central bank and government don't really know how to deal with it!