Tuesday, 15 September 2015

A turbulent summer, an even more turbulent autumn

As you may have noticed, blogging has been particularly slow over the past few months. From the beginning of the year as well, compared to previous years. This is due to a number of commitments I have bestowed upon myself (including a lot of new research I've been doing), and it will likely continue until the end of the year, so expect regular blogging to continue as it has in the past as of 2016.

In the mean time I will write an occasional comment on a burning issue, but due to many outstanding obligations I will again be rather slow. It will be quality, not quantity in the next few months. 

So, let's recap what has happened over the summer, and what awaits in the forthcoming months.

Keeping up with the Greeks

A whole number of things happened in Greece. The most important one was the referendum on the new austerity package ("the bailout referendum") in July which the Greeks overwhelmingly rejected. In the immediate aftermath their Finance Minister Varoufakis resigned, while PM Tsipras, although happy with the outcome which was supposed to hand him greater bargaining power in negotiations with the EU, decided to disregard the will of the people and signed a deal even worse than the one rejected at the referendum. 

This is to show that one can play hardball as much as one wants, but must eventually face the reality of financial markets. As I have foretold back in February:
"Prime Minister Tsipras therefore has two options; one is to follow the rules of the Troika and respect the realistic constraints of financial markets. This would necessitate entering into various compromises which could be interpreted as a betrayal of his voters. The other option is to use the same populist policies responsible for the crisis in the first place, and descend the country into bankruptcy and subsequently an even bigger recession.
Tsipras will probably choose the first option, coupled with a few benign populist decisions such as rehiring cleaning ladies and firing ministerial advisers, in order to maintain a signal of intransigency towards his voters."
It took him a while but in the end he was cornered - by logic. The disturbing part of this story is a big hit on democratic decision-making. The Greeks expressed their opinions about the bailout directly and explicitly. However despite having the backing of their PM into fulfilling their decision, he simply couldn't do it. It would mean he would have to bear the responsibility for the country's subsequent exit from the Euro and terrible economic turmoil. He had no choice but to disobey the democratic choice made by his people. In the era of globalization governed by the logic of financial markets, democracy loses. No matter how bad this sounds, it doesn't necessarily have to be so. But that's a different topic for another time. 

It is also fair to say that Europe ruined Greece, exactly as I said they would back in October 2011 when Greece agreed to the bailout plan. The hardcore austerity was not the proper solution for a country that has yet to get sober. The proper solution was a long-lasting pledge for institutional reform which would slowly and gradually change mentality, i.e. the informal institutions in Greece. It would take a lot of time before we could start expecting the Greeks to stop avoiding their taxes and stop demanding so much entitlements from its governments.

Things will continue to be interesting in Greece, as the new elections are scheduled to be held this weekend. Syriza has let down many of its supporters, but it still seems to be holding on to first place. The problem now is that they definitely won't be securing a landslide victory as they did back in January, and will be faced to form coalitions with its main adversary New Democracy. All in all, it doesn't look too good for Greece, as more political turmoil awaits.

Refugees at Europe's boarders 

In the mean time, after a few weeks of panic over the Greek referendum in July, something else caught widespread attention in Europe: the refugees problem (I will avoid referring to it as an "immigration" problem, as these people are not immigrants, they are refugees of war - not the same thing!).

The refugees crisis is far from an economic issue. It is a political and humanitarian issue. People caught in the midst of an escalating war with ISIS, literally running for their lives and seeking asylum in Europe, only to find themselves at the mercy of the Mediterranean sea. It's hard even to ponder on the hypocrisy of Europe and the West in this crisis, so I'll refrain from any further comments on this. 

The most dire economic consequence is that the EU is closing its borders. The Schengen area has been compromised. Germany, of all countries, closed its borders this week imposing strict controls on asylum seekers. A country that was long a symbol of openness, praised for having economic arguments triumph over ideological ones in the immigration debate, has succumb to the panic after tens of thousands of refugees entered the country each day. They claim to have exhausted their logistical capacities. Some are praising this move as a well designed tactical maneuver that will force neighboring countries to take on their fair share of incoming refugees, as predicted by Juncker's plan of solving this crisis. If the Schengen borders stay closed for too long this will surely hamper trade in the Union and will present a drag on economic growth this year. But hardly anyone is concerned with the short-term consequences in this case. The focus of attention is cultural, not economic. 

Chinese slowdown? 

Moving beyond Europe, things have started to look bad for China. The economy is losing steam, and will probably go below the 7% target growth rate. It is amazing that this will be China's lowest growth rate in 25 years. However China has indeed been growing massively over that period, so now even a 7% growth rate seems to look poor. It really isn't. The Chinese bubble will happen, but not quite yet. Not this year definitely. 

Chinese growth fundamentals are slowly being exhausted, this is undoubtedly true. But it will take some time before they finally burst. Its leaders are doing little to change that, despite some encouraging signs. So what we can expect to hear from China is another bad day at the stock market every now and then (more frequent than before), but a crisis is still not on the horizon. Bubble bursts are hard to predict, but I still feel China will continue this not-so-worrying slowdown a bit further, before they reach an impasse. Not until then will the rest of the world feel China's problems, when the second largest economy creates its own negative spilovers. Hopefully this will happen after the West embarks on a more robust recovery, so the drag on the rest of the world could be lower than was the case in 2008/09. 

Anti-establishment movements have found their way into the US and the UK - at the biggest stage 

In politics two very interesting developments, one in the US, another one in the UK. 

In the US, one contender for the Republican race yielded a huge boost in popularity, so much that he seems a shoe-in to tie the nomination at this stage (if you don't buy it, just check the latest polls - Trump is leading in all the early primaries - even Florida). The miraculous and inexplicable rise of Donald Trump has left many political analysts in the US perplexed. Any yet his story is quite simple: he epitomizes the american dream and wants to "make America great again". A man who picked himself up from four bankruptcies says he knows how to do the same for the "moral bankruptcy of the US" - whatever that might mean. 

It's actually quite easy to understand why Trump has experienced a surge in popularity. More than anyone he embodies the 1980s spirit many in the country still crave about. Plus he is a winner, and a showbiz star. And if there is anything Americans love it's show-business and winners.

Donald Trump, raising his right arm...
Which is why I disagree with those saying Trump will be a bubble, regardless of many of his ridiculous outbursts, outrageous ideas and proposals, and the fact that he has yet to deliver an economic program fit for a presidential candidate. I will go so far to claim that he will win the Republican nomination (yes, I'm being a bit bold with this statement, but what the heck). On the other hand Hillary Clinton seemed much more comfortable before the summer. Now she is likely to face an anti-establishemnt candidate within her own party - Sanders, maybe even another establishement candidate - Biden, before she can take on the Republicans. It will be a very interesting political year for the US, that's for sure. 

In the UK, a remarkable victory of a marginalized outsider as the leader of the opposition has redefined the meaning of grass-routs movements in the country's political history. A radical leftist Jeremy Corbyn secured a landslide victory in the Labour party's primary elections, winning 59% of first-preference voters. He did it with the help of many new incoming members and supporters who all joined the Labour party in the past few months with an aim to elect Corbyn as its leader. This represents an unprecedented success of the grass-routs movement on the left in Britain. They managed to nominate and elect a complete outsider, a hard-line oddball salon socialist, whose ideas about the economy are still trapped in the 1970s when the Labour party, together with the unions, was a fortress of Marxism. It is so strange to see the UK's official opposition leader advocating ludicrous ideas like printing money "for the people" (!), rent controls (!), a cap on wages (the maximum wage), the renationalization of railways and energy companies, not to mention his radical views on foreign policy. It's easy to see why Corbyn was a marginal figure throughout his 32 year political career.

...Jeremy Corbyn, raising his left arm.
However, this is nothing new in Europe. Extremist leftists have risen in strength following Syriza's victory in Greece and the upsurge of Podemos in Spain, but to do the same in the UK seems almost surreal. Particularly since it took Tony Blair a great effort to reform the Labour party in the 1990s and move it towards the political center, landing him and Labour 13 years in power during which many political commentators in the UK were questioning whether the Conservatives will ever recover. A regression back to the 1970s-style Labour party could secure the same, if not longer, longevity in office for the Conservatives. Particularly if the leftist movements across Europe crumble as Syriza did when they were brutally pulled away from their utopism and became faced with the reality of financial markets. It won't be long before some of Corbyn's backers start yelling: "betrayal!" It took a month for that to happen to Tsipras. 

Looking at both of these candidates, there is one thing they have in common: they are both anti-establishment candidates. Despite the fact that Corbyn has been an active politician for 32 years, and that Trump is a symbol of big business, they both seemed to have positioned themselves as fighters against the establishment status quo. The way Trump keeps denouncing the Republicans is very similar to how Corbyn fought against New Labor. They both may seem way too extremist to the average median voter, or at least to the average centrist voter, but they both seem to successfully (thus far) ride the wave of dissatisfaction with mainstream politics. 

It would be really bizarre, but also quite amusing to see these two in a meeting as the President and Prime Minister - the descendants of the famous US-UK partnerships: Thatcher and Reagan, Bush and Blair ... Corbyn and Trump? Perhaps in a parallel universe. 

Wednesday, 17 June 2015

A hard time for Keynesians?

I haven't made any comments on the results of the 2015 UK elections (and by now it's a bit late), even though I'm pleased to say I was correct in predicting its final outcome back in January. I say this with particular pride since none of pollsters got it right. Some 'pundits' even said there was going to be a grand coalition between Conservatives and Labour (see their texts published in the Guardian, Sky, BBC, HuffPost). What a bunch of baloney. 

Anyway, what caught my attention in the economic debates regarding the electoral results was this FT column by economic historian and Harvard professor Niall Ferguson. He makes a compelling case that the main reason why the Conservatives won a landslide election, amid the polls saying it was going to be the closest election in decades, was the economy.

Economic voting

From an economic voting perspective it makes sense. There's a huge literature out there linking electoral results to economic performance of incumbent governments. And the findings are almost unanimous - the economy matters! (Or as Bill Clinton's 1992 campaign slogan would say: "It's the economy, stupid!"). If economic times are good; economic growth is high, unemployment and inflation are low (denouncing the Phillips curve are we?), it is almost certain that the government will be reelected. 

Ever since Kramer's (1971) seminal paper in economic voting where he modeled voter choice from a rational utility maximization perspective (voters comparing expected utilities for different candidates based on their intrinsic well-being - so basically, an application of the Downsian (1957) and/or Hottelling (1929) model), there is a unified consensus among economists and political scientists studying elections. From that point on economists and political scientists started testing the so-called incumbency hypothesis, to see whether or not the voters punish incumbents for poor economic performance, and reward them for good performance. A substantial amount of empirical and theoretical research has developed since then, mostly confirming the incumbency hypothesis, although also finding considerable heterogeneity in voter responses to economic performance, particularly for non-US examples. If you're more interested in the topic I recommend Duch and Stevenson (2008) "The Economic Vote", Cambridge University Press. In it they summarize some of the stylized facts on economic voting arising from the vast, expanding research done on this subject in the past 40 years.  

Back to the UK elections. There are many parallels linking this election to that held in 1992 right after Thatcher was deposed by her own party, and when John Major was running for PM for the Conservatives. At the time the Conservatives were facing a resurgent Labour and a currency-induced crisis, with the election polls also predicting a tight race. With a huge turnout of 77%, the Conservatives secured a landslide victory (they got 14 million votes, more than Thatcher or Blair at their respective peaks). Many have said that Major benefited from the favorable economic consequences of Thatcher's government. However this result is still strange since we know that the UK was facing an economic crisis at the time. Plus there was the issue of the Community charge (poll tax) that the Thatcher government introduced, not a very popular move at the time. And still, despite the tax and despite the lackluster economic environment, the Conservatives secured a landslide victory. How's that for economic voting? 

Has austerity succeeded?

In line with the economic vote arguments Ferguson fires a dart at Krugman pulling out his statement from 2011 where he "denounced the “delusions” of the chancellor whose “experiment in austerity” was “going really, really badly". He continues in saying that Krugman predicted the UK would end up worse than during the Great Depression and that the disastrous austerity policy will cripple the UK economy for some time. This obviously didn't happen:
"The UK had the best performing of the G7 economies last year, with a real gross domestic product growth rate of 2.6 per cent. In 2009, the last full year of Labour government, the figure was minus 4.3 per cent. Moreover, far from being in depression, the UK economy has generated more than 1.9m jobs since May 2010. UK unemployment is now 5.6 per cent, roughly half the rates in Italy and France. Weekly earnings are up by more than 8 per cent; in the private sector, the figure is above 10 per cent. Inflation is below 2 per cent and falling."
Ok, so this is obviously a bit of cherry-picking. It's wrong to say that austerity caused higher GDP growth, or that it caused a re-bounce of employment. To determine that we would have to see what would have happened if it had not been for austerity, if the Keynesian solution was being applied from day one (as it has been in 2008 and 2009 during the Brown government). One can also make the claim that Brown's policies pushed the UK in a recession, or that they prevented an even larger slump (recall the similar debates surrounding the Obama stimulus package in the US in 2009). Ideally this could be done by comparing both scenarios across the same period of time (treatment and control group), but in macro this is impossible. In macro it's hard to determine any causal relationship, Prof Ferguson should know this. However the fact remains that the economy was performing well, even above expectations in the last year and a half. 

Fiscal stabilization was a success in Britain, there's no doubt about it. And there's no doubt that this is precisely what the UK needed. A country facing a 13% deficit to GDP and close to 90% debt-to-GDP, after applying a Keynesian stimulus during 2008 and 2009, couldn't face such unsustainable public finances any more. Britain is not your average small open economy whose bad public finances could affect its borrowing costs (or its credit rating), but still, having such high levels of debt and deficit is surely crippling for growth. 

Needless to say, Ferguson's column received a great deal of criticism, most going in the direction that it was the global recovery itself (read: foreign trade) that led to Britain's boosted growth numbers. Some have even pointed out to OBRs forecasts that the economy would have been performing even better had it not been for austerity. They say GDP in 2014 would have been about 1.5 p.p. higher without austerity.

However just like Ferguson's numbers, this is cherry-picking as well. We have no idea what the situation would have been if the public finances weren't stabilized in 2011/12. It could have been a disaster if the deficit continued to be above 10% to GDP for the past five years, perhaps it could have affected Britain's borrowing costs and its credit ratings. We could only speculate on what could have happened, which is why these types of calculations are a bit naive.

Furthermore in those two years, in 2013 as well, Britain wasn't hailed for its growth performance at all. On the contrary, reports were of a triple-dip recession, and a prolonged Japanese-style recession. I made the same pessimistic projections back then not due to austerity, but due to certain policies that were failing to target the productivity problem in Britain (see here, here, here and here). The same problem is still there, despite the growth numbers. Britain has gone from jobless growth to a productivity-less growth. This is, in my humble opinion, the crucial economic problem the government will face in its next 5-year term. It will be clouded by issues such as immigration, the NHS (always a hot topic in Britain), and most of all the EU in/out referendum (and possibly Scotland again). Some economists will keep writing about the productivity problem, but in the wake of 'good economic performance' too few will care. 

Verdict: when you're a large open economy, you can get away with anything 

Therefore the jury is still out on the success of austerity. Britain has benefited from stable public finances which has evened out expectations, boosted confidence and reduced uncertainty. Just like Germany, Britain was reluctant to use its reinvigorated public finances and historically low interest rates to increase government spending (as many Keynesian economists have been advocating over the years). And just like Germany it has no regrets about this. Rightly so. They took an alternative route and it worked. Growth rates are small (again just like in Germany) but this hardly worries the people, as optimism over the economy has returned. Particularly in the housing market

As for the defeat of Keynesian policies, in Britain this has been declared back in 2009. Usually Keynesian fiscal stimuli are said to work well only in large open economies (see what LARGE means in this case). Otherwise, too much government spending, even as a typical counter-cyclical response to a downturn, can in most small open economies result in fiscal problems and high government bond yields, thus further diluting the government's options for taking on new debt. Running large deficits means taking on more and more debt each year. And if the price of taking this debt is too high, the negative spiral is quickly reinforced as higher interest payments only put more pressure on widening the deficit. Soon the country is in huge fiscal problems.

However this scenario rarely occurs in large open economies like the US, Germany, UK or Japan. In neither of these countries no matter how large the government debt is, they will always be able to borrow at 1% rates, simply because there will always be a huge demand for their debt (particularly when it's denominated in dollars). This happened during the crisis as well; none of these countries had their bond yields go up. However this is not a justification for taking on more debt. Britain and Germany decided to apply one strategy, while the US did a slightly different one. They all worked precisely because these countries are large, open economies. In other words, they are allowed to experiment and try different things (like QE), but this doesn't apply for the rest of us. For the rest of us fiscal prudence is still key, crisis or no crisis. 

Saturday, 30 May 2015

Austerity (and inequality) in corrupt countries - a conference with Joe Stiglitz

This week I had an opportunity to attend an international conference "Challenges of Europe: Growth, competitiveness and inequality", where the keynote speakers were none other than 2001 Nobel prize winner Joseph Stiglitz, and Columbia University professor Jan Svejnar

I went there to present a paper I co-authored with two Croatian economists, Dejan Kovac and Nikola Kleut. The paper is called "How do firms respond to anticipated shocks? Duration analysis of Croatian companies throughout the crisis". The paper is pretty good, but let's be honest, that was clearly not the main reason I went there - the main reason was to get to know people like Stiglitz and Svejnar. Which I can happily say I did. 

From left to right: myself, Prof Joseph Stiglitz, and my friend and
co-author Dejan Kovac
The keynote speeches from the two notable economists were both very interesting, but also quite different. Svejnar went first and presented his paper called "Do Billionaires Help or Hurt Economic Growth?", while Stiglitz followed with his more or less standard policy-oriented discussion on "The Euro, the European Crisis and Inequality". I actually found Svejnar's presentation more interesting, which is not surprising primarily because the stuff Stiglitz was saying on Europe isn't new to me, as I've extensively written on the subject myself. Stiglitz made a few excellent points on the Euro's fault for the Eurozone recession, on how Europe was never an optimal currency area which is why the Euro project was doomed from the start, attacking the way the idea of convergence was being executed, implicating external imbalances (CA deficits), and so on - all the things I absolutely agree with (see my in-depth analysis of the Eurozone sovereign debt crisis). 

Wealth inequality and economic growth 

Svejnar on the other hand caught my attention immediately when he started to present his research paper. He gathered information from Forbes on the world's richest individuals across countries and was trying to test whether they have a positive effect on growth (the right-wing argument) or a negative one (the left-wing argument). The main explanatory variable measuring wealth inequality was the share of billionaire wealth to total GDP, to total physical capital stock, and to total population, measured only for those countries that had billionaires (in $ terms). He found that the overall effect is actually negative, however he decided to decompose the wealth inequality measure into billionaires that were politically unconnected and politically connected to see what drives the total effect. It turns out that it is the politically connected billionaires that are causing the adverse effect on economic growth. See the table below (click to enlarge):

Source: Bagchi, Svejnar (2013) "Does Wealth Inequality Matter for
Growth? The Effect of Billionaire Wealth, Income Distribution
and Poverty." IZA discussion paper
Notice that the significance levels for the politically connected measure of wealth inequality are much higher than for the overall effect (particularly when looking at billionaire wealth to total capital stock - columns (2) and (5) - which I consider to be the best measure of wealth inequality out of the three used). The story is clear; in countries where billionaires made their fortune thanks to political connections allowing them to control and build monopolies, the effect of their accumulated wealth and the consequential inequality on economic growth is extremely negative. In cases where the billionaires weren't politically connected there is no effect between inequality and growth.

Comparing the top 5 and bottom 5 countries in their ranking of politically connected wealth inequality with respect to their corruption levels, the clustering is quite obvious: the more unequal countries (the higher their billionaires' wealth) are the ones with the highest levels of corruption:

Source: Bagchi, Svejnar (2013) "Does Wealth Inequality Matter for
Growth? The Effect of Billionaire Wealth, Income Distribution
and Poverty." IZA discussion paper
The full paper is here, co-authored with Sutirtha Bagchi. 

The real European problem

This is a very important finding in terms of the whole austerity debate. Going back to Stiglitz and his keynote presentation, what he said on the conference was more or less standard and expected stuff. However, what he said in an interview for the Croatian television the day before was what I found slightly problematic. Stgilitz is a famous critic of austerity policies. And who can blame him when austerity all across Europe was mostly being done from a wrong, tax-based approach. Just look at the average income tax, VAT and corporate tax rates across Europe and how they all increased by a few percentage points during the crisis. Europe became obsessed with cutting the budget deficit, and from a political perspective cutting the deficit is always better to do with tax hikes than with spending cuts - because when you cut spending you're hurting some groups directly, which don't like it and will probably protest (unless you make linear cuts which is always the worse solution with the most negative effect on consumption), but when you raise taxes you virtually create the same effect as with linear spending cuts (a drag on consumption), but people don't seem to be as bothered with tax hikes as with spending cuts. How often do you see people protesting after a tax hike? In terms of electoral chances it's much more dangerous to cut spending to various socio-economic groups (pensions, various benefits, subsidies, public sector wages, etc.), than to raise taxes for all consumers for example. 

Anyway, the problem with how austerity was being conducted in Europe is obvious: it had a negative effect on economic growth, as tax rates depressed consumption in times of great deleveraging (people and companies paying off their debts). Naturally the economies were doing bad. Countries like Germany, driven by their own example of unification and the 2003 Hartz reforms, were saying it is necessary to bear the pain during which time countries should engage in reforms. But this never happened. The peripheral Eurozone countries (including Croatia) never really did any reforms during the crisis. And this is the real problem. Not all of these countries are the same, nor should they all engage in the same set of reforms, but they all have one important characteristic: they are all corrupt. Their governments used the favorable pre-crisis economic times (low borrowing costs) to accumulate huge debt levels and to finance various political concessions. Greece, Italy, Spain, Portugal, Cyprus or Croatia - they all had political elites driving their countries to the slump by applying a faulty growth model based on debt, and misusing the convergence mechanism Stiglitz was addressing. Citizens and companies seized the same opportunity; consumer debt levels went sky-high in peripheral Europe. This is why they were all running large current account deficits - imports of consumer goods swamped domestic markets. Living standards were fueled by debt, and it was only a matter of time before this unsustainable system was brought to a halt. The Euro crisis simply brought all the existing domestic instabilities of these countries to the fore. And Stiglitz is right - the Euro is to take a large blame for enabling this type of a growth model.  

Austerity and corruption 

However the response to this type of growth model in peripheral Europe is hardly more government spending. Classical counter-recessionary measures imply that in crisis times countries should boost government spending in the short run to offset the lack of spending in other sectors of the economy. However this type of policy can to some extent be applied in countries like the US, UK, Germany or Japan (whose borrowing costs will never get affected by too much debt, since the demand for their debt is always high), even though this too is debatable. In countries of peripheral Europe, Croatia in particular, the asymmetry of information and adverse selection are simply too high for these types of policies to work, even in the short run.

Stiglitz made an excellent point that according to the efficient market hypothesis money should always flow to where it's most productive. However because of asymmetric information this doesn't always happen. Conclusion: markets are imperfect. This effect is even more profound when governments push money into the system. When the Croatian government increases public spending to build infrastructure projects, to subsidize public or private sector firms, or to boost investments, there is an immense adverse selection effect. Money flows to politically connected firms and individuals. This is something I prove empirically for Croatia: public procurement is highly subject to corruption, and the higher the corruption in public procurement, the greater the reelection chances of local politicians (up until a certain cut-off level). The interlink between corrupt politicians and quasi-entrepreneurs is just too big, and is creating a substantial drag on domestic growth. The same thing can be observed in Greece, Italy, or Spain. There is no substantial difference. Corruption is systemic. Conclusion: governments are imperfect.

From my experiences abroad, I realize this is difficult to grasp for people living in institutionally stable societies like the United States. To Americans (or any other person living in a country where rules are well-defined) the pinnacle of corruption is the FIFA probe - giving bribes to secure lucrative deals (like becoming the host nation of the World Cup). Corruption in Balkan and Mediterranean countries is much more than that - it is systemic and it is institutionalized. Laws are being changed to legalize criminal acts. Politicians literally have no sense of accountability. Very often they are the heads of organized crime themselves! It sounds impossible to believe, doesn't it? Not according to a multitude of examples from Italy, Greece or Croatia (not to go any further). 

Furthermore, systemic nepotism is affecting all spheres of society; under-qualified individuals (often party members) have taken over the public sector, thus driving away the more qualified ones. This is significantly affecting how the private sector conducts business as well. "There is simply no other way, this is how the system works", a discouraged Croatian entrepreneur will always say.

In the last decade more than 150,000 working force Croats left the country. And these are only those registered via the official statistics. Other peripheral economies are facing the same problem. Nepotism is so embedded in peripheral Europe, it's hard for anyone outside to realize this. It is the single most responsible cause of adverse selection on the labor market in these countries. And consequently on government efficiency and the performance of the domestic economy. Here's a good example: someone with an Ivy League degree cannot get a job in Croatia's public sector if they aren't "well connected" (read loyal party members - which Ivy League degree holders are usually not). Anyone who's slightly better than the domestic quacks in any field is immediately a threat the quacks are trying to protect themselves against. It is becoming almost impossible to change and fight this. 

In this kind of a systemically corrupt system, the only way to break the connection between quasi-entrepreneurs and politicians is to impose massive spending cuts aimed at breaking up the link between business and politics, followed by long-lasting reforms of the legal system. The problem is much deeper than depressed consumption. This will without doubt cause a huge negative effect on GDP (as the direct and indirect share of government-dependent entities in the economy is roughly 70% of GDP), but it is the only way to break the downward spiral of political connectivity, nepotism and economic depression. 

Sunday, 24 May 2015

In memoriam: John Nash

It is with great sorrow to report the news that one of the greatest minds in human history died yesterday in a car crash with his wife while they were returning home from an airport. John Forbes Nash Jr., to most widely known as one of the founders of cooperative game theory whose life story was captured by the 2001 film "A Beautiful Mind", is truly one of the greatest mathematicians of all time. His contributions in the field of game theory revolutionized the way we think about economics today, in addition to a whole number of fields - from evolutionary biology to mathematics, from computer science to political science. 

John Nash was born in 1928 in Bluefield, West Virgina. Even as a child he showed great potential and was taking advanced math courses in a local community college on his final year of high school. In 1945 he enrolled an undergraduate mathematics major at the Carnegie Institute of Technology (today Carnegie Mellon). He graduated in 1948 obtaining both a B.S. and an M.S. in mathematics and continued onto a PhD at the Department of Mathematics at Princeton University. There's a famous anecdote from that time where his CIT professor Richard Duffin wrote him a letter of recommendation containing a single sentence: "This man is a genius". Even though he got accepted into Harvard as well, he got a full scholarship from Princeton which convinced him that Princeton valued him more. 

While at Princeton, already on his first year (in 1949) he finished a paper called "Equilibrium Points in n-Person Games" (it's a single-page paper!) that got published in the Proceedings of the National Academy of Sciences (in January 1950). The next year he completed his PhD thesis entitled "Non-Cooperative Games", 28 pages in length, where he introduced the equilibrium notion that we now know as the Nash equilibrium, and for which he will be awarded the Nobel prize 34 years later. It took him only 18 months to get a PhD! He was 22 at the time. 

While at Princeton he finished another seminal paper "The Bargaining Problem" (published in Econometrica in April 1950), the idea for which he got from an undergraduate elective course he took back at CIT. It was Oskar Morgenstern (the co-founder of game theory and the co-author of the von Neumann & Morgenstern (1944) Theory of Games and Economic Behavior) who convinced him to publish that bargaining paper. The finding from this paper will later be known as the Nash bargaining solution. Princeton was full of top academics at the time and Nash took full advantage of that, even though he didn't learn maths by attending classes, he did it by trying out his own ideas. As he came to Princeton he sought out Albert Einstein to discuss physics with him (as physics was also one of his interests). Einstein reportedly told him that he should study physics after Nash presented his ideas on gravity, friction and radiation. 

Illness and impact

After graduating he took an academic position at MIT, also in the Department of Mathematics, while simultaneously taking a consultant position at a cold war think tank, the RAND Corporation. He continued to publish remarkable papers (his PhD thesis in The Annals of Mathematics in 1951, another paper called "Two-Person Cooperative Games" in Econometrica in 1953, along with a few math papers). He was given a tenure position at MIT in 1958 (at the age of 30), while he married his wife Alicia the year before. However, things started to go wrong from that point on in his personal life and career. In 1959 he was diagnosed with paranoid schizophrenia, forcing him to resign from MIT. He spent the next decade in and out of mental hospitals. Even though he and his wife divorced in 1963, she took him in to live with her after his final hospital discharge in 1970. 

Nash spent the next two decades in relative obscurity, but his work was becoming more and more prominent. Textbooks and journal articles using and applying the Nash equilibrium concept were flying out during that period, while most scholars that built upon his work thought he was dead. It was not only the filed of economics - where the concepts of game theory were crucial in developing the theory of industrial organizations, the public choice school and the field of experimental economics (among many other applications) - it was a whole range of fields; biology, mathematics, political science, international relations, philosophy, sociology, computer science, etc. The applications went far beyond the academia; governments started auctioning public goods at the advice of game theorists, business schools used it to teach management strategies. 

Arguably the most famous applications were to the cold war games of deterrence that explain to us why the US and Russia kept on building more and more weapons. The Nash equilibrium concept explains it very simply - it all comes down to a credible threat. If Russia attacks the US it must know that the US will retaliate. And if it does, it will most likely retaliate with the same fire-power Russia has. Which will lead to mutual destruction of both countries. In order to prevent a full-scale nuclear war (i.e. in order to prevent the other country from attacking), the optimal strategy for both countries is to build up as much nuclear weapons as they can to signal to the other player what they're capable of. This will prevent the other player from attacking. If they are both rational (i.e. if they want to avoid a nuclear war and total destruction) they will both play the same strategy and no one will attack. Paradoxically, peace was actually a Nash equilibrium of the arms race!

Long-overdue recognition 

Little did Nash have from all this. He had no income, no University affiliation and hardly any recognition for his work (not counting the citations). But this all changed in the 1990s when he was finally awarded an overdue Nobel Prize in Economics in 1994, with fellow game theorists John Harsanyi and Reinhard Selten "for their pioneering analysis of equilibria in the theory of non-cooperative games". Here is the Nobel Prize lecture and here is an interview with him conducted 10 years after winning the prize. 

His remarkable and actually very painful life story was perfectly depicted by his autobiographer and journalist Sylvia Nasar in her two books; "A Beautiful Mind", based on which the movie was made, and an even better one "The Essential John Nash", which she co-edited with Nash's friend from college Harold Kuhn (also a renowned mathematician). As Chris Giles from the FT said in his praise of the book: "If you want to see a sugary Hollywood depiction of John Nash's life, go to the cinema. Afterwards, if you are curious about his insights, pick up a new book that explains his work and reprints his most famous papers. It is just as amazing as his personal story." The book contains a facsimile of his original PhD thesis, along with eight of his most important papers (from game theory and mathematics) reprinted. 

After the Nobel Prize success things got better for Nash. By 1995 he recovered completely from his "dream-like delusional hypotheses", stating that he was "thinking rationally again in the style that is characteristic of scientists." Refusing medical treatment since his last hospital intake, he claimed to have beaten his delusions by gradually, intellectually rejecting their influence over him. He rejected the politically-oriented thinking as "a hopeless waste of intellectual effort". He remarried his wife Alicia in 2001, and started teaching again at Princeton. He continued his work in advanced game theory and has moved to the fields of cosmology and gravitation

The Phantom of Fine Hall, as they used to call him in Princeton due to his mystique and the fact that he used to leave obscure math equations on blackboards in the middle of the night, will never cease to raise interest, praise and awe. Nash was another perfect example of a thin line between a genius and a madman. Luckily in the end the genius side prevailed.  

So what is the Nash equilibrium? 

The reason why this concept was so revolutionary was because it significantly widened the scope of game theory at the time. In the beginning, following the von Neuman and Morgenstern setting, game theory was focused mostly on competitive games (when the players' interests are strictly opposed one to another). These types of games were known as zero-sum games, limiting to a significant extent the power of game theory. Nash changed that by introducing his solution concept so that basically any strategic interaction between two or more individuals can be modeled using game theory, where the most unique solution concept is the Nash equilibrium. Games are not zero-sum, they aren't pure cooperation nor pure competition. They are a mixture of both. 

The idea of the Nash equilibrium resonates from the simple assumption of rationality in economics. The term rationality in economics is not the same as common sense rationality we all think about upon hearing this term. It refers to the idea that each individual will act to achieve his or her own objective (maximize their utility), with respect to the information the person has at his/her disposal. The concept of rationality in economics is therefore idiosyncratic - it depends on whatever a particular individual deems rational for themselves at a given point of time. It rests upon the idea that a person will never apply an action that hurts him/her in any way (lowers his/her utility). 

The Nash equilibrium is the most general application of this idea. A non-cooperative game, according to Nash, is "a configuration of strategies, such that no player acting on his own can change his strategy to achieve a better outcome for himself". In other words if there exists another strategy that can make an at least one individual better off, then the outcome does not satisfy the condition for a Nash equilibrium. 

Let's look at an example. The most simplified example of how a Nash equilibrium solution concept works is the Prisoner's Dilemma game. Consider two robbers arrested for a crime. They are both being interrogated by the police in separate rooms. They are presented with two options (strategies): keep quiet (silent) or betray the other guy (betray). If they both remain silent, they both only get a light sentence of a year in prison for obstructing justice. If one betrays the other, and the other guy keeps silent, then the betrayer is released with zero imprisonment, and the other guy gets pinned for the whole crime and gets nine years in prison. If they both betray each other, they both get six years in prison. What's the optimal thing to do?

Applying the Nash equilibrium concept we need to find a strategy that is the best response of one player to whatever the other player may decide. When no players have any incentive to deviate from a set of strategies (strategies are always a pair in two-person games) we can say that this set of strategies is a Nash equilibrium. 

Consider the game depicted in the table below:

Prisoner 2
Silent (cooperate)
Betray (defect)
Prisoner 1
Silent (cooperate)
Betray (defect)
-6,-6 *

It would seem that the best strategy they can apply is for both to keep silent. If they do, they both get only a light sentence. However this strategy set (-1,-1) is not a Nash equilibrium since at least one person has an incentive to deviate. In fact, they both do. If Prisoner 1 decides to defect and betray Prisoner 2, he gets 0 years in prison, while Prisoner 2 gets 9 years (third cell, with payoffs 0,-9). Prisoner 2 applies the exact same reasoning (second cell with payoffs -9,0). In the end since the better strategy is always to betray, they both play the same strategy (betray, betray) and end up with payoffs (-6,-6) which is the Nash equilibrium of this game. From this point no player can deviate and make himself better off. If Prisoner 1 decides to go for silent he risks getting 9 years in prison instead of 6. There is no way for them to reach a cooperative equilibrium in this simplified scenario.

Naturally, cooperative games do exist (as I've discussed earlier on this blog) and they help us understand how game theory solves for example the free rider and the collective action problem. It was Elinor Ostrom (1990) who applied these concepts to reach her optimal solutions in solving the common pool resource problem in small groups with persistent interactions. Robert Axelrod (1984) is another, finding that even though the defection strategy is more rational, sometimes various other factors will result in a cooperative outcome between the players. The Nash equilibrium helped initiate a huge amount of research on these and many other problems within and outside the academia. The reason game theory is usually considered as the most applicable economic theory - in that it can be used to solve real-life problems - is purely thanks to John Nash. 

Rest in peace. 

Most notable papers: 

Wednesday, 20 May 2015

Video: How would a Nobel prize winner run the economy?

From LSE's You Tube channel:

If the video doesn't work (some browsers could do that), see it here.

LSE's Nobel professor Christopher Pissarides is being 'grilled' by Conor Gearty in his Gearty Grillings. The short video surprisingly includes a lot of good ideas on the size of state, labor markets, and the Eurozone troubles. Even though he declares him self an open social democrat, it's obvious he believes in the power institutions and doesn't succumb to any of the typical socialist fallacies. Nor is he being unrealistic about the solutions awaiting Europe. 

Just to remind the readers, Pissarides won the Nobel prize for his search frictions theory in the labor markets. Here's the Nobel prize lecture, and you can find some of his best papers here, and the newest ones here.