Friday, 19 August 2016

Physics meets Economics: "Why Information Grows?" (or What I've been reading, vol. 7)

I haven't posted any book reviews for a while now. It's not that I haven't been reading the books, it's just that I failed to find the time to write the reviews. So now, in the next three, four blog posts, I will be writing a series of reviews about 8 or so books (with more to come in the following months). I will start with Cesar Hidalgo's Why Information Grows for today's single book review (it's a big one, since this is an exciting new theory), and then I move on to 4 economic history books (in two separate posts), and close with three inequality/cronyism books. After all of that, in September I will continue with my standard ramblings about economic stagnation, the role of technology and the third industrial revolution, inequality and social mobility, the endless austerity vs stimulus debates, etc. Enjoy! 

Hidalgo, Cesar (2015) Why Information Grows. The Evolution of Order, from Atoms to Economies. Basic Books

Cesar Hidalgo, a physicist from MIT, in one of the most lucid books I have read so far, presents a new fascinating theory of economic growth. One of the most fundamental issues in the field of economics – why some nations tend to be rich while others stay poor – has been given a huge amount of attention in the field over the past 60 years. A number of theories have arisen and have been tested to account for and explain economic growth and development. From Sollow to Romer and Mankiw, from Kuznets to Leontief, from Porter to Acemoglu and Robinson, many have given their unique contributions, each having its own merits and being probably true to some extent. Hidalgo joins this group by producing a synthesis of social and natural sciences in the study of networks and information. He moves beyond the simple factors like land, labor, and capital, and replaces them with matter, energy, and information. It may sound puzzling at first, but once you dwell into the argument, it’s actually very simple and quite intuitive. Basically, in order to understand how economies grow, we need to first understand how information grows. Hidalgo’s theory is where physics meets economics.


Before I descend into the detailed flow of his argument, here is a brief summary of the basic idea relating networks, energy and information to economic growth. His theory relies on the novel concept of economic complexity. Economic complexity, in simple terms, is the diversity, the number, and the ubiquity of products a country exports.  It is not surprising to notice a positive relationship between economic complexity and economic growth, but what’s even more important is that this measure of economic complexity allows us to predict long-run economic growth. So based on the structure of our economy, and which kinds of products we are specialized in today, we can quantify economic growth ten to fifteen years from now. This makes sense, as the total production structure of an economy determines its long-run equilibrium path – i.e. potential output. Countries which are evolving in their complexity are able to catch up with the countries which have already reached the same equilibrium path. This explains faster growth of developing nations, and slower growth of developed nations – or in other words, convergence theory. E.g. consider China and India - they are evolving the complexity of their economies which is why they are more likely to keep high levels of economic growth in the future.

The theory is still in its infancy, as the research on economic complexity has just started (here's the link to the Observatory of Economic Complexity). However, the ingenuity behind some of the concepts makes it a worthwhile effort and may bring us closer to understanding cross-country inequality. The only thing that the book fails to uncover in greater detail is the initial difference in trade specialization patterns. Yes, the current export and production patterns may be good predictors of future growth, and good explanations over why the US is more complex and hence richer than Brazil, and why is Brazil more complex and richer than Chad. But, there is no systematic answer to how and why some products and industries originated in one place, and not the other. This is beyond the scope of the book, intentionally so. Even though it isn’t big in volume it does attempt to do a difficult task of explaining the interconnection between matter, energy, information, and economic growth. So let's dive in. 

Information vol. 1 (the physics behind the idea)

The first part of the book, the one explaining the origin of order from atoms is pure physics. Fascinating, a bit complex, but given the intuitive explanations the ideas tend to stick as you read more and more.

When an average layman hears the word information he or she thinks of it in standard terms; it is digital, immaterial, weightless, easily transferable, a message of some sort – essentially, a man-made phenomenon. However, Hidalgo emphasizes that information is physical. It is not a thing per se, but rather an arrangement of several physical things. Basically, information implies order. The concept of information therefore needs to be detached from its colloquial meaning in order to understand its usage in the book. The capacity to process information and sustain order which involves computation (in addition to a few other conditions) is what he defines as the accumulation of knowledge and knowhow. In this sense information (knowledge and knowhow) is embodied in the products we produce: how complex they are, how widespread they are, and who knows how to produce them. It is this difference in the accumulation of knowledge and knowhow across countries that gives rise to global inequality between nations. In other words, our patterns of production and exports will determine our different levels of development and economic growth.

To understand how information represents physical order, the author gives an interesting example. Consider smashing a $2.5m Bugatti against a wall. It will still be a sum of all its parts, except now the atoms that made the car will be arranged differently. This different arrangement of the same atoms makes the car lose its value. And significantly so. Furthermore, destroying a Bugatti means increasing the multiplicity of its states (increasing entropy), which implies less information about what these parts were. Creating a Bugatti from scratch implies combining iron, aluminum, plastic, and rubber (with of course some engineering and designer knowledge and knowhow), where all of them individually convey less information that their collective final usage. Therefore, destroying a product means destroying information, whereas the creation of a product implies creating information. So regardless of all the inputs we have at our disposal as a nation, our ability to use our knowledge and knowhow to turn these inputs into tangible and valuable outputs (products – pockets of information) is what will define our success as a nation.

But how does information grow? How does it differ across nations?

Essentially, the author defines three conditions necessary for information to grow, necessary for it to ascend from disorder into order (to oppose the second law of thermodynamics of closed physical systems). The first condition is a non-equilibrium system in a steady-state (I’ll explain), the second is the existence of solids in order to store information in them, and the third is the ability of matter to compute.

The simplest example of a steady-state of a non-equilibrium system (used in the book) is the whirlpool that forms when you empty a bath tub. It is easily created (just remove the stopper and the water starts flowing), and easily stopped (do the opposite). So it’s dynamic, and it requires energy to persist (out of equilibrium). The point of such a state is that once in it, the production of entropy is minimized. Think of this as a bowl where if you put a marble it will eventually end up at the minimum of its potential energy (this is also known as a thermodynamic potential – I actually co-authored a paper explaining high and low corrupt systems through double-well thermodynamic potentials). So in an out-of-equilibrium steady state, order will spontaneously emerge and by doing so it will minimize the destruction of information.

Once we have the system flowing from disorder into order, to preserve the newly formed information, it has to be stored in packages. In other words, it has to be stored in solids. Why? Because solids, unlike gases and fluids, are much better at crystallizing information. Information lasts much longer in solids. Finally, in order to have information grow, matter (and its evolution into life forms) needs to be able to process information, it needs to be able to compute. Compute doesn’t necessarily mean making calculations. It can be limited to the very simple perception of animals and even plants, all of which adapt and adjust to the environment around them. Basically, life itself and where we are today is due to our ability to compute (adapt/evolve). So the combination/existence of these three factors is the key determinant of information growth.

(Gosh, I hope I explained this correctly and intuitively enough. If you find it too cumbersome, read the book)

Information vol. 2 (the economics behind the idea)

Ok, so now that we know the physics behind it, let’s see how this information paradigm fits into the economic life.

First and foremost, our capacity to compute isn’t limitless. If it were, there would be no differences between countries. In addition to our intrinsic individual limitations, there are also societal limitations, such as institutions and the availability of technology. These can prove to be essential in limiting the networking capacity necessary for knowledge and knowhow to expand. The economy itself is an amplification engine of knowledge and knowhow. It is within the complex socio-economic network through which we learn how to produce products and in essence – make information grow. We stand on the shoulders of giants – not only in ideas, but primarily in products. Writing this would not have been possible without the internet or the personal computer. Old products embody information to create new products out of them.

One way of showing the difference in knowledge and knowhow, or in other words the difference in accumulating and processing information, is a country’s export structure. As Hidalgo says, the export structure of a country “is a fingerprint that tells us about the ability of people in that country to create tangible instantiations of imaginary objects such as automobiles, espresso machines, subway cars… In fact the composition of a country’s exports informs us about the knowledge and knowhow that are embodied in that country’s population”.

This is the point – the product structure of a country is defined by the population’s capacity to imagine and produce a wide range of products. The greater the available knowledge and knowhow in a country (economists would call this human capital), the better and more complex the range of products, and hence the more advanced a country will be. The export structure also tells you something else. Countries that are well off but only export raw materials which they have due to their access to abundant natural resources are not economically complex. They are actually quite fragile in their structure, as the first sign of a resource price shock, their economies end up in shambles (there is no better contemporary example for this than Venezuela in the past two years; Taleb’s favorite example of this fragility based on natural resources is Saudi Arabia – if the world switches from oil to renewable energies, Saudi Arabia is destined to follow in Venezuela’s footsteps).

Hidalgo shows that the resource curse is due to a lack of imagination (knowledge) to use the resources at their disposal in better fashion. Resource curse leads to a rent-seeking society, which works well as long as the people can all be well-off from the money flowing from the resource abundance. Smarter countries (e.g. Qatar, UAE, Norway) will use the opportunity to invest the money from the natural resources into something else, that will ensure their high living standards even after they drain their resource. This way they improve their knowledge and knowhow, they build their imagination to design more complex products and thus more advanced economies.
                                                                 
However information growth will be prevented if people lack the opportunity to document knowledge and knowhow. If you have a brilliant, life-altering idea, it really matters where you will have the chance to develop it. This is where institutions come in. In many countries having the proper opportunity to even gain knowledge not to mention to use it, is unfortunately unimaginable. Poor institutions and poor governance of such countries makes it hard for people within them to improve them. It is a reinforcing negative cycle. Breaking it up from within is immensely difficult, and breaking them up from the outside is often unfeasible. Going back to thermodynamics, low-income countries are stuck at the bottom of a thermodynamic potential, and unfortunately the only way to break this up is purely random. And the chances of the right combination of factors to occur for a country to break out of a low-income equilibrium are decreasing with the size of the corrupt network within a country. This leads to a very pessimistic conclusion that some countries are doomed (this is the pessimistic conclusion of my paper).

But I digress. Hidalgo also discusses all the possible limitations of expanding knowledge and knowhow. These include intrinsic individual capabilities which then translate to geographically-biased accumulation of knowledge (as individuals spread their knowledge within their own social groups, narrow and broad). This is important to comprehend since complex products (like a car, machine, airplane, or computer), in order to be created, require much more knowledge than one person can have. Hidalgo defines the individual capacity of a single human as a personbyte. Complex products involve a lot of personbytes. In addition to personbytes he also defines a firmbyte – how knowledge and knowhow are distributed across a network of firms. Modern manufacturing is a global process – it involves the coexistence of many networks through which exchange takes place and a product is created (in the modern supply chain economy there is not a single complex product that is being produced in one country, not to mention one place, alone).

Firms, like humans, also have their limitations. Many fail to adapt and go bust. Others succeed if they uncover cheap links to expand their networks in order to accumulate more knowledge and knowhow. For example governments can be both helpful and burdensome in maintaining the costs of such links. They can introduce helpful standards and the proper infrastructure, but they can also impose unnecessary bureaucratic procedures and overreaching regulations that will make links and networks more expensive. This undermines the capacity of economies to accumulate knowledge and put it to good use in producing complex products.

Another important category that affects the accumulation of knowledge is a social network. In particular, culture and trust. In fact the level of trust in asociety will influence the organizational structure of its economy. Hidalgo draws this from Fukuyama who emphasizes the differences in low-trusting “familial” societies (you can only trust your family, not strangers) which tend to be dominated by many small family businesses and a few dominant family conglomerates, and high-trusting societies where professionally-run businesses give rise to large networks of firms and consequentially more complex industries and their products (pharmaceuticals, aircraft, high-tech, etc.).

Therefore, producing complex products implies a lot of personbytes and a lot of firmbytes who get assembled into large networks (which is to a large extent determined by a country’s social, or informal institutions), which consequentially implies a huge accumulation of knowledge at one place. The more complex products you tend to produce, the more knowledge you will accumulate, and vice versa. This is the example of a positive feedback loop. Not to mention that accumulating a lot of knowledge and knowhow at one single place constitutes a comparative advantage of a given country. It is now becoming clearer how this theory explains the development conundrum.

As knowledge and knowhow get geographically clustered there should be a way to visualize this. And here is where Hidalgo does his best. Along with several colleagues, including the famous Ricardo Hausmann from Harvard, they use trade data to show how large networks of accumulated knowledge grow by mapping them into something called a product space (pictured below) (all the visuals are really good, play with them here).


The product space is a network connecting similar products. The closer the products the more similar they are, and the more likely that they will be co-produced and co-exported from one country. For example, a country exporting knit t-shirts is also likely to export other garments and undergarments. Or if you export beef you’re also likely to export cheese. Car engines and motor engines. And so on.

The product space shows that while some industries, and hence products (like clothes) are present everywhere, others are limited to only a few places (like cars, airplanes, or computers). Obviously, the greater the distribution of such industries the less complex they are and the less knowledge they require. The opposite goes for the highly clustered (nested) industries which tend to produce the most complex products. It is therefore easy to see how developed, richer countries, with much larger networks, are able to attract and accumulate the necessary knowledge and knowhow to produce the most complex products. This further ensures their dominance in the global trade and specialization patterns and preserves their position of wealth (e.g. Germany, Japan, US, etc). As Hidalgo says, moving large networks from one country to another is almost inconceivable. Poor countries on the other hand are thus limited to producing only a small subset of products which don’t require a lot of information nor a large network to be produced. This basically means that economic growth is path-dependent. A country cannot just jump from growing crops to producing heavy machinery. It takes time to develop complexity, as countries can only move to products close to the initial ones on its product space.

The problem (and the only criticism I have) however is that the theory doesn’t provide a historical account as to why knowledge accumulated in one place, and not the other. We know why countries differ, this part the theory explains quite well, but we cannot explain its initial divergence – the initial critical point that led some countries to become rich, knowledge-accumulating large networks capable of producing the most complex products, and descended others to a low-equilibrium self-reinforcing negative cycle with a lack of imagination and the capacity to accumulate knowledge at all. On the other hand, I don’t think the author had this ambitious task in mind. Not quite yet I believe.

The answer here probably lies in the development of institutional patterns from the Industrial Revolution onward, and perhaps some historical antecedents we carried from as long as we were able to plow fields. But more on that in the next few books. 

Friday, 5 August 2016

The new political distinction is not left-right, but open-closed

It's holiday season, and the Olympic games have just started, I know, but I read this great piece in last week's the Economist and I just had to share it with my readers. It is possibly one of their best briefing articles to date, as it tackles a very important contemporary phenomenon of a newly arising political divide across the developed world (that was the cover of the entire issue, pictured below). The left vs right is passé, so 20th century. The new distinction is open vs closed. Or in other words, liberal vs national-socialist (OK, maybe not that far away from early 20th century). 

One group is against immigrants, in favor of closing the borders, advocates protectionism, and fears competition (a typical merger between left and right collectivism), while the other group is for open borders, in favor of free trade, in favor of competition and against protectionism. One group advocates and feeds from fear - fear of immigrants and foreign competition taking away domestic jobs, fear from globalization, and fear from terrorism (carried out by, obviously, immigrants). The other group welcomes immigrants, advocates globalization and stresses its benefits and long-term gains. The second group is supported by experts and the current establishment elites. The first group are losers from globalization, the low-skilled workers who lost their jobs and their good health, as well as the middle classes fed up with rising inequality and declining social mobility. They lost their belief in a just meritocratic world and have turned towards the extremes. So far these extremes are in most European countries still on opposite sides of the old left-right political spectrum (e.g. Syriza and Golden Dawn in Greece, AfD and Linke in Germany, National Front and the communists in France, etc.). But in some countries they are merging together. Poland is a good example. Its Law and Justice party served as an inspiration for the opening of the article:
"IS POLAND’S government right-wing or left-wing? Its leaders revere the Catholic church, vow to protect Poles from terrorism by not accepting any Muslim refugees and fulminate against “gender ideology” (by which they mean the notion that men can become women or marry other men). Yet the ruling Law and Justice party also rails against banks and foreign-owned businesses, and wants to cut the retirement age despite a rapidly ageing population. It offers budget-busting handouts to parents who have more than one child. These will partly be paid for with a tax on big supermarkets, which it insists will somehow not raise the price of groceries."
France's Marine Le Pen is hardly any different from this. As is Victor Orban in Hungary. Or Donald Trump, an anti-establishment billionaire (talk about political paradoxes!) with a stringent anti-globalization view, and an elementary misunderstanding of foreign policy, who became a nominee of a party that always supported free trade and a strong US global presence. The list goes on, with the one thing in common is that they all represent a strange mixture of traditionally leftist economic policies wrapped around in right-wing nationalism. One can also argue that Brexit aligned both the far-right voters opposing immigration as well as the far-left voters opposing the "neoliberal" EU (there were other types of Brexit voters as well, but more on that another time). In fact, "neoliberal", whatever it means, became the swear word for both extremes on the left-right axis. Just like in the post-Great Depression era of the 1930s, liberal economic ideas are again facing dangerous populist opposition. 

How do we explain this sudden outburst (or gradual ascent, see graph below) of closed-border, anti-immigrant, anti-globalization, protectionist national-socialists? The Economist summarizes: 
"Mr Trump’s charisma aside, the success of drawbridge-up parties in so many countries is driven by several underlying forces. The two main ones are economic dislocation and demographic change.
Economics first. Some 65-70% of households in rich countries saw their real incomes from wages and capital decline or stagnate between 2005 and 2014, compared with less than 2% in 1993-2005, says the McKinsey Global Institute, a think-tank. If the effects of lower taxes and government transfers are included, the picture is less grim: only 20-25% of households saw their disposable income fall or stay flat. In America nearly all households saw their disposable income rise, even if their headline wages stagnated. Such figures also fail to take full account of improvements in technology that make life easier and more entertaining. Nonetheless, it is clear that many mid- and less-skilled workers in rich countries feel hard-pressed. Among voters who backed Brexit, the share who think life is worse now than 30 years ago was 16 percentage points greater that the share who think it is better; Remainers disagreed by a margin of 46 points. A whopping 69% of Americans think their country is on the wrong track, according to RealClearPolitics; only 23% think it is on the right one. 
Many blame globalisation for their economic plight. Some are right. Although trade has made most countries and people better off, its rewards have been unevenly spread. For many blue-collar workers in rich countries, the benefits of cheaper, better goods have been outweighed by job losses in uncompetitive industries. For some formerly thriving industrial towns, the impact has been devastating (see article). Economic insecurity makes other fears loom larger. Where good jobs are plentiful, few people blame immigrants or trade for their absence. Hence the divide between college-educated folk, who feel confident about their ability to cope with change, and the less-schooled, who do not. 
... 
The second force pulling drawbridges up is demographic change. Rich countries today are the least fertile societies ever to have existed. In 33 of the 35 OECD nations, too few babies are born to maintain a stable population. As the native-born age, and their numbers shrink, immigrants from poorer places move in to pick strawberries, write software and empty bedpans. Large-scale immigration has brought cultural change that some natives welcome—ethnic food, vibrant city centres—but which others find unsettling. They are especially likely to object if the character of their community changes very rapidly. 
This does not make them racist. As Jonathan Haidt points out in the American Interest, a quarterly review, patriots “think their country and its culture are unique and worth preserving”. Some think their country is superior to all others, but most love it for the same reason that people love their spouse: “because she or he is yours”. He argues that immigration tends not to provoke social discord if it is modest in scale, or if immigrants assimilate quickly. When immigrants seem eager to embrace the language, values and customs of their new land, it affirms nationalists’ sense of pride that their nation is good, valuable and attractive to foreigners. But whenever a country has historically high levels of immigration from countries with very different moralities, and without a strong and successful assimilationist programme, it is virtually certain that there will be an authoritarian counter-reaction."
The Economist is right. There is a new political divide out there, and it doesn't look pretty. The traditional liberal-conservative debates (big vs small government, cutting taxes vs increasing spending, austerity vs fiscal stimulus) are still out there, but they are being replaced by the more dominant immigration and globalization debates. The far left and the far right are joining forces against the liberals, which are very much in retreat. This is all to familiar in Europe, and should not be taken lightly. The conclusion of the article is positive. It emphasizes that younger generations carry a much more open mindset and are thus much less prone to be on the losing side of globalization, meaning that in 10 years time, as more young voters mature and fully exploit their global opportunities, radicalism will once again be defeated and pushed aside. But in the mean time they will do their damage, that's for sure.

Monday, 25 July 2016

Having more money helps the poor? Go figure!

The link between income and happiness has been one of the most hotly contested relationships among social scientists. Many researchers from various branches of social sciences have repeatedly denied the existence of a causal relationship between income and happiness (despite overwhelming evidence on how the great rise in living standards was led by the significant increase of post-Industrial Revolution incomes per capita), with the obvious normative conclusion being that having more money is not that important to us after all. 

Well it just happens that it is important.

In an article published last month in the New Yorker entitled "The Case for Free Money", the author James Surowiecki (the Wisdom of Crowds guy) makes a compelling case in favor of universal basic income - a policy proposal (rejected in a referendum in Switzerland earlier this year) where every adult citizen of a country would each year receive a guaranteed basic income. In the US this would be equivalent to $10,000. While there are many potential benefits to this idea (as well as some major obstacles - such as it being too expensive), I do not intend to contemplate on the basic income proposal in this post. I will leave that for another time. What caught my attention was the opening paragraph where Surowiecki calls upon a research paper from a Canadian economist Evelyn Forget who examined the effect of a field experiment being done in Canada in the 1970s. Here's the excerpt:
"In the mid-nineteen-seventies, the Canadian province of Manitoba ran an unusual experiment: it started just handing out money to some of its citizens. The town of Dauphin, for instance, sent checks to thousands of residents every month, in order to guarantee that all of them received a basic income. The goal of the project, called Mincome, was to see what happened. Did people stop working? Did poor people spend foolishly and stay in poverty? But, after a Conservative government ended the project, in 1979, Mincome was buried. Decades later, Evelyn Forget, an economist at the University of Manitoba, dug up the numbers. And what she found was that life in Dauphin improved markedly. Hospitalization rates fell. More teen-agers stayed in school. And researchers who looked at Mincome’s impact on work rates discovered that they had barely dropped at all. The program had worked about as well as anyone could have hoped."
I went through the paper and it was indeed a proper field experiment (lasting a total of 4 years): they had random selection of participants, paired control group from the same community, isolated families, etc. In other words, it was legit, making the conclusions of the paper correct. Having more studies and field experiments just like this one would make the case for the universal basic income even stronger (although, the main problem was the lack of money to carry out the experiment further than 4 years).

However, you can't tell any of this from the paragraph above as the author makes an inference mistake. He should have said that hospitalization and schooling outcomes improved compared to the relevant control group. This way a reader might suspect that the research was not done properly if it only looked at the pre- and post-basic income outcomes in that city alone (these alone would not tell you much about the causal relation). I, for example, had immediate doubts about the validity of the research, which is why I had to read the paper myself. But as I said, the paper is legit. 

For me the most interesting finding this experiment suggests is that by handing out more money to people, the policy entailed positive effects on their quality of life. The basic income improved peoples' health and social outcomes. In other words, it made them happier. So without any unnecessary quibbles about the existence or non-existence of the correlation between money and happiness, by using basic income experiments we can finally empirically establish a positive relationship between money and happiness. Not directly, as few people enjoy money just for the sake of money, but indirectly, as money helps us attain a better living standard. 

My point is, if you advocate universal basic income, don't contradict yourself by saying that money doesn't make people happy. I certainly does. If not directly, than indirectly (just look at the leftist propaganda meme below). For one thing having money means less worries about it. That fact alone improves happiness.  

Tuesday, 12 July 2016

Why is the US white middle class going rouge? ... and voting for Trump

A recent paper published in PNAS by Princeton professors Anne Case and Angus Deaton (last year's Nobel prize winner) reported a stunning finding: there has been a significant increase in mortality and morbidity among middle-aged non-Hispanic white men and women in the US over the past 15 years. The causes have been attributed to suicide, and drug and alcohol abuse. The graphs below summarize the findings:
Mortality in selected countries, 1990-2013.
USW stands for US white. USH stands for US hispanics.
Source: Case & Deaton (2015) "Rising morbidity and mortality in
midlife among white non-Hispanic Americans in the 21st century."
Proceedings of the National Academy of Sciences Vol. 112(49)
December 8th 2015.
Mortality by cause, US white non-Hispanics, 49-54. Source: Case & Deaton
(2015) "Rising morbidity and mortality in midlife among white non-Hispanic
Americans in the 21st century." Proceedings of the National
Academy of Sciences
112(49) December 8th 2015.
Every comparable developed country has experienced a steady decrease in midlife mortality over the past two decades, while the trend for whites in the US has suddenly switched upwards in 1999 and has been steadily increasing ever since. The second graph illustrates why this is so. Deaths from poisonings have gone way up (over 300%) over a time span of only 15 years. Liver diseases and suicides have also gone up. Furthermore, the turnaround in mortality has been driven primarily by whites with a high school degree or less. Those with college education or less remained the same, while those with BA or higher have had death rates decrease. All this suggests that mid-life low-skilled workers, after experiencing job losses, have descended into personal depression and are trying to cure this with drug and alcohol abuse. And if you think that drugs are too expensive for an average unemployed person in the US, think again. The popular TV series Breaking Bad has showed that getting your hands on things like crystal meth is becoming widespread across the low and middle classes in the US (I know it's a fictional TV show, but it does draw implications from the real world). 

Why are these people descending to such states? Why are they killing themselves with alcohol and drugs? A simple explanation is economic, although not necessarily tied to the financial crisis since the trend started during favorable economic times. However the productivity slowdown and the outsourcing trend (a trend that accelerated in the 1990s and particularly in the 2000s), have made their own dents among the low-skilled population. These are not just job losses we are talking about. It's also the prospects of finding a new job for the low-skilled workers (which is perceived to be difficult given immigrants which are prepared to work for much less), as well as their lagging incomes, widening inequality, and disturbed social mobility. However most developed countries have experienced the same problems in recent decades, but these problems haven't manifested themselves into higher death rates for the mid-life low-skilled workers. 

So what gives? Perhaps the fault lies within the US health care system that is out of reach for the poor and middle classes (particularly if unemployed), making them more likely to die from the conditions they've imposed on themselves. In other words, perhaps European low-skilled workers are reacting the same way to globalization-induced job losses (via drugs and alcohol) but are simply more likely to be cured by their free-of-charge public health care systems. That still, however, doesn't explain the increase in suicide rates in the US. Perhaps the inequality and social mobility problems are even worse than we think which is forcing people over the edge. Financial insecurity could also be the issue, as pensions are traditionally tied to stock market earnings. But it's always been this way, and it wasn't a problem before. On the other hand, there has never been such a prolonged period of stagnating low and middle class incomes, so once a low-skilled worker losses his/her job, not having any significant savings accumulated (recall that the savings rate in the US is in steady decline since the 1980s), and possibly overburdened with a home loan, there isn't really much else he or she might hope for. Finally, perhaps the US cultural values emphasizing individual success are taking a psychological toll on its population for the first time in history (or since the Great Depression) as they are unprepared to deal with failure. I'm tapping in the dark here, but one thing is certain - something has definitely gone wrong in the US. 

It is therefore perfectly understandable why the white mid-aged US low and middle classes are switching to populism and are grouping behind Donald Trump. This has been long time coming. Populist messages blaming immigrants on job losses and a wrecked benefits system is exactly what the low-skilled workers have been craving for. Looking at these graphs it is easy to understand why Trump's support has been so high despite all of his political incorrectness and even his billionaire stature. Trump is delivering loud and clear messages that resonate with a part of the electorate that seems to be fighting with various forms of psychological depression and which represent clear losers of globalization (note: globalization certainly has a lot of benefits, but it also has its inevitable losers - for developed countries these are the holders of the scarce resource - the low-skilled workers). Furthermore, the political establishment has failed to hear these voices over the past decades (not only in the US). In such a state, where you lose your job and blame immigrants for it, where you have no savings and no long-term prospects, when you're faced with foreclosure on your home loan, when you realize your children will probably be facing the same bleak future, and finally when the politicians you never really liked anyway are not even hearing your messages, you very easily descend into populism and accept the first loud enough rhetoric that's expressing everything you're concerned about. It is no wonder these people "want to make America great again". For them, America has failed. Their intrinsic voter motivation is in this case actually quite rational. 

Europe is faced with the exact same problem of rising populism resonating to low-skilled losers of globalization, despite its lower mid-life death toll. The most dangerous way of fixing these problems facing low-skilled workers is descending into populism. Let's hope the establishment will realize this and offer realistic solutions before it's too late. 

Tuesday, 28 June 2016

BREXIT, THE REACTION: democratic deficit, the falling elites, and the future of the EU

After hearing the results of the Brexit referendum on early Friday morning, my initial reaction was this comment on Facebook:



After cooling down over the next few days and reading about Brexit from a number of perspectives, I have to say that everything I said initially - still holds. I will carefully explain each point.

First, the democratic deficit problem. This is, sort of, my PhD topic, meaning that I'll be writing quite a lot about it over the next few years. Before explaining why this outcome is a deficit of democracy we must first define the concept of democratic deficit (or perhaps even - democracy failure). Basically, the democratic deficit concept concerns the interaction between politicians and partial interest groups, a legitimate consequence of electoral competition and political freedom to express and fight for one’s interests, and whether or not this interaction results in adverse economic outcomes (in my PhD I will be focusing on linking the failures of democracy to the rise in income and wealth inequality). The point is that in some cases democracies fail to erect the necessary institutions to prevent the favouritism of partial interests, the consequence of which are usually cronyism, corruption, nepotism, clientelism, etc. To make this a bit more relevant, consider the following excerpt from an earlier essay of mine
"The recent economic crisis has exposed all of democracy’s deficits. Dysfunctionality and political gridlocks that only worsened the crisis became a standard in the United States and Europe. Government bank bailouts and rapid accumulation of debt stroke a huge blow to the positive perception of Western democracy and capitalism itself. In addition, the Western model of democracy is facing a serious problem with rising inequality and to some extent the lack of social mobility. Various interest groups dominate the political spectrum in biasing budgetary expenditures towards their preferred goals leaving relatively less money for redistribution programs aimed at the poorer ends of the society, particularly in terms of education and health care. Politicians themselves engage in direct or indirect vote buying (either through gerrymandering or by giving direct concessions to their support groups), budget-maximizing bureaucrats add to the rise in government spending which isn't targeted towards the general population, while political campaigns are financed heavily by the corporate sector desiring prone legislation. All of this adds concerns over a poor image of the Western-style democracy. It has failed to become fully robust to cronyism."
So how is this linked to the Brexit? In two ways: first, the 'angry' Leave voters which consider themselves the losers of globalization (the 'immigrants taking our jobs argument'). Globalization always has its winners and losers, this is inevitable. As the theory of international trade teaches us the losers are usually the holders of the deficient resource within a country - in the case of the West: the blue-collar working class. Naturally as the working class keeps losing their jobs they have a tendency to blame both immigrants and their domestic political elites which have failed to protect them from these misfortunes. The European Union is a natural enemy of anti-globalizationalists. It represents everything they fear - in particular their intrinsic loss of competitiveness as the market attracts the better skilled workers to replace them. This is true for every country in the West, without exception. There is growing discontent from the working classes regarding the benefits of globalization and its prime manifestation - the European Union. They feel alienated as they did not reap any visible nor direct benefits from it. Naturally, they will rebel and oppose globalization and will support any political platform (far-right or far-left) that delivers the same bold criticism. 

However, the working class voters often fail to realize that the reason for their economic misfortunes lie beyond globalization itself and can be traced within their domestic institutions, in particular within their domestic political elites. How exactly? 

I've written about this before as well. Globalization, in addition to bringing enormous opportunities for wealth creation, in some instances led to the abrupt rise of new powerful elites - banking, political, and media - which threatened the sustainability of the system. The principles of competition were replaced by the rapid accumulation of power within a handful of selected business groups (recall the Leveson inquiry or the LIBOR scandal). British political elites forgot the distinction between being pro-business (favoring monopolies, oligopolies and picking winners) and pro-market (supporting competition and equal opportunity). This was not, as many falsely believe, a consequence of Thatcher's reign as she vehemently opposed any partial big business interests that undermined the interest of the customer, as well as the rapid accumulation of power within any industry, particularly within banking or politics. The post-Thatcher political leadership forgot those lessons and set the country on a path to increasing cronyism, rising inequality and declining social mobility, all of which was further emphasized by the financial crisis, the post-crisis austerity approach, and the subsequent long (double-dip) recovery. Luckily, none of these undermined Britain's vast accumulated wealth, but they had certainly limited its growth and split its population into the winners and losers of globalization. 

The second way in which Brexit represents a democratic failure is the huge political (and even constitutional) instability and economic uncertainty arising as a consequence. The markets' reaction is only a natural response to the huge uncertainty surrounding Britain and the EU. So the paradox here is that the legitimate (and direct) decision of the electorate (the very essence of democracy) has undermined the economic and political stability of the country. Some say this won't last too long and that the long term consequences are likely to be positive for Britain, however it's hard to see how that will be achieved given that the very country, the United Kingdom, may fall apart itself (if the Scottish and Northern Irish enact their independence referendums). 

So, the failure of elected political elites to suppress cronyism and the subsequent decision of the electorate that undermines the country's political and economic stability can both be considered good examples of how democracies need not always yield optimal outcomes. 

Second, the decline of trust in establishment elites, and the rise of populism. This is closely linked to the previous points. The failure of the political establishment to prevent cronyism and the rise of new powerful elites has severely deteriorated the people's trust in institutions and expert opinion. Whether domestic (the Treasury, Bank of England, prominent UK Universities,  and think tanks), or international (the IMF, World Bank, any EU-related institution) - they were all considered to be untrustworthy during the Brexit debate. Why? One reason was the use of populist ideology to unsettle the electorate accusing the experts (particularly the economists) of having a vested interest as they tend to receive a lot of money from the EU. This argument worked well having in mind the anger against the establishment, as expert opinion was seen as a justification of establishment policies and was therefore considered to be untrue. Whatever argument was being thrown into the debate, not a single one had the allure of impartiality. On the other hand the establishment (and the experts to some extent) made their own mistakes of ignoring the concerns of their electorate, in particular the low and middle classes. This led to the further deterioration in the relationship between the elites and the "non-elites", implying even lower levels of trust among the non-elites. Unfortunately, there seems to be no signs of this damaged relationship to be improved any time soon. 

Third, Cameron's political legacy. Boy, did he mess up! This time last year he was in heaven. He had just secured his second mandate by a landslide electoral victory, removing his Conservative party of the LibDem coalition shackles, and was on course to bring a truly positive political legacy to Britain. After winning two general elections, and securing a major political win with the Scottish referendum, he decided to tie his political career, not to mention the future of his country, to the Brexit referendum. Just like Blair destroyed his positive legacy with the Iraq war, Cameron did perhaps even worse with the EU referendum. A man who had it all he ever wanted, just lost everything in a crazy gamble with his own party and what is mostly his own electorate. Not unlucky, just plain stupid.

Fourth, Boris Johnson as the new PM, the spread of populism, and the tectonic changes that await us. Boris Johnson is in a very difficult position currently. He appears to have gotten exactly what he wanted - Leave won and now he's the first favorite to take over the party and the Prime-ministership in October. Which is four years earlier than he'd hoped. However his victory seems awfully bitter to him as well (judging from his reactions and, well, his body language). It is as he had thought: "there is no way Leave will win, but I will make myself the leading figure of the campaign, and use this to take over the party with its looming euro-skeptics after Cameron quits" (which he announced to do prior to 2020, and said he was not seeking a third term). Sounds like a perfect plan, particularly as Boris would have no problem winning the generals in 2020 from the lackluster Labour leader Jeremy Corbyn (who is also likely to face a leadership challenge soon). Except that it backfired - Leave won! So Boris got what he wanted, he's becoming the PM, why isn't he happy? Perhaps because he realizes he probably won't be PM for too long. Time for another Batman quote (this time from the Joker's conversation with Harvey Dent):


As for the consequences and the spread of populism, my immediate fears are not with the EU, but on the upcoming Presidential elections in the US in November. There you have another typical establishment candidate, Hilary Clinton, which would in normal times, given her enormous experience (First Lady, Senator, Secretary of State, etc.) be a shoe-in to lock the victory. However she is going up against the worst possible manifestation of cheap populism, lies, and low-class appeal - Donald Trump. Who would have figured that an 80s style billionaire would speak to the mind of the poorest better than any socialist out there (including Bernie Sanders). Trump's messages are almost the same as those of the Leave campaign, as is his likely voting population. Perhaps the Democrats will learn from the mistakes of the Remainers by not having a negative campaign and not trying to scare the voters as to what will happen if Trump wins. A positive message is necessary. 

Fifth, the EU devolution, the reaction of EU policymakers, and the potential separation of Scotland and Northern Ireland from Britain (this last one I failed to touch upon in my initial comment). Despite the initial reaction of Europe's far-right and far-left parties demanding EU membership referendums in other countries, I am still confident that the EU will survive this shock. As it survived the sovereign debt crisis, the boiling point of November 2011 (which was several times worse in its destabilizing effect than the current referendum result), not to mention several highly likely Grexit possibilities. Europe's strength has been tested on a numerous occasions in the past 6-7 years, and even though this might seem as the decisive blow, I highly doubt it. Particularly given the reactions not only of Europe's leaders, but many others across the EU (this could however be selection bias, as only the most vocal express their concerns about the EU). 

This is not to forget that Europe needs a deep, deep reform of its institutions. I've personally been emphasizing this since I started the blog. The EU has completely alienated itself from the people. Even more so than any political leadership in any of its members. No one sees the EU as the convergence machine for prosperity anymore, while the benefits of the free trade area and the guarantee of peace on the continent are mostly being taken for granted. Instead the EU is, quite rightly, being portrayed as the bureaucratic leviathan with endless regulatory and legal requirements that stifle business and innovation, and that are to the common EU citizen nothing but an unnecessary burden. The EU's bureaucratic regime is turning into the worst manifestation of Kafka's and Orwell's novels. It is no wonder the people have an urge to fight against it. 

I sincerely hope the EU political elites get the message from Brexit. That could be the biggest positive that comes out of it - that the EU reforms and starts re-emphasizing innovation and trade, and starts to focus on lowering within-country (as well as between-country) inequality and increasing the living standards of its people. But that's certainly not all. EU law needs to be altered as the biggest objection against the EU is that it is being run by unelected technocrats. This is true, and it need to change. EU Parliament elections are not enough since Parliament has very little political clout in the EU. On the other hand the EU budget itself has a purely developmental goal (agricultural subsidies, EU funds, education and skills, etc.) and is not really a mechanism for economic policy. So despite being overreaching and intrusive in its regulatory patterns, the EU at the same time signals vast incompetence and inability to deal with the people's problems. Just recall its responsiveness to the sovereign debt crisis, or its reactions regarding the Ukraine crisis. 

In order to do all this, perhaps more federalism is needed. Now that the UK, the biggest opponent to "an ever closer Union", is out of the picture, this may very well be achieved. However, the danger is again the same - will this new federalism enable the unelected bureaucrats with more power which would imply more of the same or will it force them into promoting the true goals of Europe, as envisioned back in the 1950s? Given that the EU project is still evolving, meaning that it is still in the phase of trial and error, we can think of most efforts in the past 6-7 years as being an example of error. But that doesn't mean we should give up on it quite yet. 

Finally, what is to be left of the UK after this whole thing boils down? Possible just England and Wales. The biggest problem in the whole post-referendum debris is the vast political uncertainty. Literary no one knows what comes next: will Article 50 be invoked?; when and how?; what will the negotiations bring?; is the referendum outcome fully binding and will the "Bregret" crowd succeed in overturning it?; will Scotland block the Brexit vote?; will they have their own referendum which will bring them back into the EU?; will Northern Ireland do the same? - these are all questions no one has an answer to yet. One thing is certain though - in the short run, Britain will suffer. Political instability always gives rise to economic instability and possibly a recession, depending on how long it takes to resolve the situation. And from the signals we're currently getting, it will take quite some time to resolve it.