Saturday, 28 November 2015

In memoriam: Douglass North

Douglass C. North, one of the greatest economists of our time, a Nobel prize winner responsible for reinventing institutional economics, died this week at the age of 95. His passing follows those of other notable institutional and political economists in the past few years, such as Elinor Ostrom, James Buchanan, Ronald Coase, and his Nobel co-recipient Robert Fogel, all champions of the new approach to examining economic interactions, and all, just like North, with groundbreaking contributions to the field. Together with Olivier Williamson and Ronald Coase, he was attributed as the pivotal co-founder of the New Institutional Economics school of thought, a school of thought I personally favor and advocate. 

Out of all academics North arguably led the most exciting life. He was a navigator for the US Merchant Marines during WWII, a passionate photographer, a deep-sea fisherman, an heir to an insurance fortune, a pilot (he had his own plane), a ranch owner, fancied fine dining and music - in short, a man who enjoyed life (read his detailed autobiography here). A Marxists in his youth ("as were many of us at a certain age", as Deirdre McCloskey put it), he changed his political economy standpoints after studying economics, political science and philosophy at the University of California, Berkeley, where he also received his PhD in economics. In 1952 he became an assistant professor at the University of Washington, while in 1983 he moved to Washington University in St Louis, where he remained throughout the rest of his career. 

Cleometrics and the buildup to the examination of institutional change

North's contributions to economics and in particular economic history are monumental. His first big contribution came in the 1960s where he helped found cliometrics, an application of quantitative techniques in the study of history (named after the mythological Clio, the muse of history). His first book The Economic Growth of the United States from 1790 to 1860 had the transformative influence on the field of economic history. In his own words, "it was a straightforward analysis of how markets work in the context of an export staple model of growth." Throughout that decade North was focused on transforming economic history into cliometrics, something he proved to be very successful at, organizing conferences and even a graduate program in economic history at the University of Washington in the early 70-ies.  

Interestingly, his work at the time on cost reductions in the shipping industry turned him towards examining transaction costs and institutions. He realized that the neoclassical theory is too restrictive on its assumptions over zero transaction costs and exogenous, efficient institutions. So he went on to change that as well: “What we need is a body of theory which encompasses the traditional models of the economist and both widens its scope and allows us to include an explanation of the formation, mutation and decay of organisational forms within which man cooperates or competes.”

Institutions thus became the forefront of his research from thereon. In particular he focused on how and why institutions change and evolve over time, and he did it all within the realms of neoclassical theory. It was the perfect way to combine history and economics. By many his best book Structure and Change in Economic History (1981) came as a result:
"In Structure and Change in Economic History (1981) I abandoned the notion that institutions were efficient and attempted to explain why "inefficient" rules would tend to exist and be perpetuated. This was tied to a very simple and still neo-classical theory of the state which could explain why the state could produce rules that did not encourage economic growth. I was still dissatisfied with our understanding of the political process, and indeed searched for colleagues who were interested in developing political-economic models."
From here also follows his criticism of neoclassical economics in that it cannot explain all the factors necessarily for the understanding of the extremely complex process of economic change. He argued that political systems do not design institutions that promote growth, quite the contrary. Because of high transaction costs in the process of changing the political status quo, political elites lack the motivation to do it. They become entrenched in a low equilibrium, happy with their current levels of rent-extraction, and perfectly unwilling to initiate the process of institutional change that would be beneficial to their societies. 

To further understand why this is the case, North started to examine a system of beliefs and social norms, or in other words - informal institutions. 


In that search for answers to explain the process of institutional change, another monumental piece was published, Institutions, Institutional Change and Economic Performance (1990), in which North for the first time very precisely defines what institutions are. In his own words:
Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction...Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change.” (North, 1990, pg. 3)
He furthermore makes a very important distinction in defining formal and informal institutions. Formal institutions represent the aforementioned "rules of the game": rule of law, enforcement of contracts, property rights and the constitution. Their goal is to promote political stability and ensure the proper functionality of markets. The complete implementation of such institutional arrangements will lead to a good and stable political system. Informal institutions, on the other hand, imply social norms, traditions, customs and code of conduct. They are embedded in a person’s mentality and system of beliefs and will influence the nation’s view on the optimal political system. 

Informal institutions can provide an explanation of why the system fails to consolidate even when there exists a set of formal institutions. More importantly it will tell us why this set of formal institutions will still yield inefficient results if set up in a system of values not ready for democracy, or whatever social system we are envisioning. Informal institutions don’t change overnight as do the formal institutions and laws; rather they accumulate over time and by doing so form the necessary conditions for the formal institutional reforms to yield efficient results. However, the relationship between them is mutual. A continuous influence of formal institutions tends to be a prerequisite for a proper reshaping of informal institutions.

Although a substantial amount of variables that differ across countries affect how its citizens will feel about a particular political system and the proper institutional setting, an assumption is that whatever affects them, informal institutions are unlikely to be changed in the course of a single generation. Due to this characteristic they might be a constraining factor once a rapid change of formal institutions occurs. On the other hand they might also enhance a democratic order but only in the long run and always followed by a long and gradual accumulation of democratic capital. A positive influence can be generated if informal institutions are changing long enough (under the influence of pro-democratic formal institutions) so that they become widely accepted social norms. The example is the length of democracy in the West where a long and continuous democratic tradition embedded on the assumptions of pro-democratic formal institutions generated a spontaneous change of informal institutions.

All of these findings and efforts landed North the Nobel prize in economics in 1993, jointly with another brilliant economic historian Robert Fogel. Officially they were rewarded "for having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change". Read his Nobel prize lecture here.

Violence and Social Orders

As Arnold Kling has put it, there is no other Nobel laureate that has produced anything as good as his book Violence and Social Orders (co-authored with Wallis and Weingast), after receiving the prize (read Kling's excellent review here). It is truly remarkable that a man in his late 80-ies/early 90-ies can produce such an astonishing piece of work (and if you're doubting the scope of his contribution just hear him give this interview three years ago). 

The central theme of the book is to offer a comprehensive theory of a society's institutional development with respect to how it reacts to and deals with the problem of violence. The authors present an institutional framework in which well-organized ruling elites manipulate the economy by generating privileges based on the personalization of governing institutions. They define such societies as natural states, or the more precise limited access orders, in which intrapersonal relationships between the powerful and the political elites serve as the base of all political and economic outcomes. The elites are then successful in preventing the development of the civil society and ensure a long-run constellation of existing political relationships. When the institutions of a system are de-personalized it is much harder to evoke clientelistic relationships, making it easier to develop an open access order. In an open access order, the basis of all interactions is a well-defined, de-personalized legal framework, not politically generated privileges, and it is only through such a system that countries can achieve prosperity. I wholeheartedly recommend not only this book, but the majority of his scientific opus. 

Here, as always, is a list of North's most important publications:

  • The Economic Growth of the United States, 1790–1860, Prentice Hall, 1961.
  • "The State of Economic History," American Economic Review, 55(1/2) 1965.
  • Institutional Change and American Economic Growth, Cambridge University Press, 1971 (with Lance Davis).
  • Structure and Change in Economic History, Norton, 1981. 
  • Institutions and economic growth: An historical introduction, Elsevier, 1989
  • Institutions, Institutional Change and Economic Performance, Cambridge University Press, 1990.
  • Institutions, 1991, The Journal of Economic Perspectives, 5(1), pp. 97–112
  • "Economic Performance through Time," American Economic Review, 1994, 84(3) (the Nobel prize lecture)
  • Understanding the Process of Economic Change, Princeton University Press, 2005.
  • Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History, Cambridge University Press, 2009 (with J.J. Wallis and B.R. Weingast).

Saturday, 24 October 2015

"Does the Wage Gap between Private and Public Sectors Encourage Political Corruption?"

A paper of mine (co-authored with Boris Podobnik and H. Eugene Stanley) got published in PLOS ONE! Since PLOS is an open-access journal you can read the whole paper here.

It is primarily a theoretical paper focused on designing a model of corruption networks in democracies. The intuition for the model was a growing disparity between public sector and private sector wages and how this corresponds with greater corruption. This is, naturally, only a correlation, but it served as a motivation to search deeper and uncover how corrupt networks can sustain themselves within a democratic environment. 

There were three main findings/contributions in the paper:
  1. The greater the public sector wage premium (higher public sector wages than private sector wages) in a given country, the greater the possibility of corruption
  2. We design and propose a new reward-to-risk ratio for labor economics (taking into account the relative riskiness of working in each sector)
  3. Democracy does not create corruption, but it can serve as a mechanism to preserve it in the long run. A transition from a corrupt to a non-corrupt state, and vice-versa, can only be purely random. 
And here is the full abstract:
"We present a dynamic network model of corrupt and non-corrupt employees representing two states in the public and private sector. Corrupt employees are more connected to one another and are less willing to change their attitudes regarding corruption than non-corrupt employees. This behavior enables them to prevail and become the majority in the workforce through a first-order phase transition even though they initially represented a minority. In the model, democracy—understood as the principle of majority rule—does not create corruption, but it serves as a mechanism that preserves corruption in the long run. The motivation for our network model is a paradox that exists on the labor market. Although economic theory indicates that higher risk investments should lead to larger rewards, in many developed and developing countries workers in lower-risk public sector jobs are paid more than workers in higher-risk private sector jobs. To determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the public sector wage premium increases with the level of corruption."
Findings in depth 

Much research in labor economics has been focused on uncovering whether workers in public sector occupations are overpaid or underpaid relative to workers in the private sector. However, many of these research efforts failed to take into account that occupations in private and public sectors generally have different rights assigned to them and more importantly different risks of losing a job. This implies that in labor economics we are faced with a similar problem that has existed in finance before Markowitz and Sharpe, where risk was not taken explicitly into account when assessing an investment. Markowitz revolutionized both investment theory and practice by accounting expected return and risk in portfolio construction ("Portfolio Selection", The Journal of Finance 7 (1): 77-91). Inspired by the Markowitz mean-variance model and the Sharpe ratio (The Journal of Portfolio Management 21 (1): 49-58), and in order to quantify how well wages compensate employees for risk in a given sector, we propose an analogous reward-to-risk ratio for labor economics as the ratio between annual wage and sector risk. We define sector risk as the reciprocal business lifetime in a given sector. If it is inappropriate to evaluate an investment return without taking into account its risk, it is equally inappropriate to discuss whether a job in a given sector is underpaid or not without taking into account the risk of that sector. 

Furthermore, according to economic theory, and related to the previous issue, higher risk investments should lead to larger rewards. In contrast to economic and common sense, there is a paradox on the labor market: in many developed and developing countries lower-risk public sector jobs are paid more than higher-risk private sector jobs. In order to determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the wage gap between public sector and private sector jobs in a country increases with the level of corruption. This result inspired us to propose an intriguing hypothesis that the wage gap between public and  private sectors can serve as a motivation for corruption. The greater the public sector wage premium, the higher the motivation for those without adequate skills and education to enter the public sector to achieve private benefits. Even in the US, jobs in the public sector carry greater advantages than jobs in the private sector. They are more secure, less stressful, offer a wider selection of health-insurance plans, better retirement benefits, flexible work arrangements, and more holidays and vacation days per year. The question is: how is this discrepancy, in which the less riskier sector is rewarded with higher wages, sustainable in the long run?

We hypothesize that a democratic system (understood under the principle majority rule), creates an enabling mechanism for corruption persistence, even though it is not responsible for creating corruption in the first place. If we operate under a plausible assumption that a large majority of people are generally uncorrupt, why can corrupt subjects in some countries prevail and take power? To resolve this question we apply a network concept based on the model recently published in Nature Physics (Majdandzic, Podobnik, Buldyrev, Kenett, Havlin & Stanley (2014) "Spontaneous recovery in dynamical networks." Nature Physics 10, 34-38). We propose a dynamic network model of corrupt and uncorrupt employees representing two states in the public and private sector. In our model, corrupt employees are more intra-connected to one another and more unwilling to switch their attitudes regarding corruption than the uncorrupt. Inter-links between corrupt and uncorrupt employees serve to switch the attitudes of agents in the competing group. With such inter- and intra-links, corrupt subjects can prevail and become a majority through sudden transitions even though they initially represented a minority. This way it is obvious that in many democracies corruption can be persistent over a long period of time, and the only way to break the mold and flip from a corrupt to a non-corrupt state is via random selection of a non-corrupt individual as head of state.

Wage gap and corruption

A potential criticism may be directed at the assumption of modelling the labor market as a securities market. This is a mere allegory. The point is to suggest that wages in any job have to take into account the relative riskiness of that job (potential of job loss, benefits received, industry risk, etc.), not just the usual factors like location, hours or level of education. Furthermore the standard economics literature linking the wage gap to corruption finds an opposite conclusion to our own - countries which have a greater public sector wage premium usually have lower corruption. These findings are however limited primarily to low-income, developing countries. Naturally, we factor for this difference and observe all types; low-income, middle-income and high-income countries. Here is how that looks:

Source: Podobnik, Vukovic, Stanley (2015) "Does the Wage Gap between Private 
and Public Sectors Encourage Political Corruption?" 
PLoS ONE 10(10): e0141211. doi:10.1371/journal.pone.0141211 
We can see three types of countries corresponding to a concave relationship between the public sector wage premium and the corruption index. There is a group of low-income countries where corruption is rampant and public sector wages are much lower than private sector wages. This phenomenon is well established and explained in the literature. Given the low public sector wages in these countries the bureaucrats, doctors, and teachers are naturally more open to corruption in order to earn some money on the side. However in the group of medium-income countries the situation is reversed; the public sector has higher wages than their private sector counterparts (read the methodological part of the paper to see how we make this comparison) and corruption is still high. Only in the group of high income countries where corruption is low is the wage gap low as well. Finally, only a few high-income countries have private sector wages higher than public sector wages (albeit by a small margin), and these countries are also the least corrupt in the world. Of course, we're talking about Scandinavian countries, Sweden, Denmark, Finland and Norway. Again, this isn't to say that their negative public sector wage premium is the cause of low corruption. But it is interesting to notice a trend in which rich countries with low levels of corruption do not bias domestic wages too much in favor of any sector. 

Saturday, 17 October 2015

Angus Deaton wins the 2015 Nobel prize in economics

Over the past two weeks, in the same schedule as always, we had the opportunity to enjoy the announcements of Nobel prize winners. Last but not least was the Nobel prize in economics (or to be more precise for all those doubters out there, the Sveriges Riksbank Prize in Economic Sciences in Memory of Albert Nobel). And once again the prize went into well-deserved hands. Angus Deaton from Princeton University, a brilliant academic with a distinguished career and list of contributions (recently a member of the National Academy of Sciences), a global fighter against poverty and inequality, and above all an economist with an eye for applicability of his research. What is surprising is that once again, the same as last year, the prize was awarded to a single recipient (a rare occurrence in the past 15 years in this field). However what hardly came as a surprise was the field of research that was finally acknowledged with a Nobel prize - inequality and development, for the first time since Amartya Sen in 1998. The public debate on inequality has gone long enough for the Nobel prize committee to overlook the major contributors in this field. Deaton is certainly one of the biggest. And what a great decision it was to recognize precisely Deaton as the man to shed some light on this enduring debate. After all, as The Economist has recognized a decade ago: "Mr Deaton is perhaps the only economist at work in this area who is acknowledged by all sides both as authoritative and as having no ideological axe to grind."

Deaton received the prize "for his analysis of consumption, poverty, and welfare". His research therefore focused around three seemingly different, yet very much interconnected issues: how consumers distribute spending between different goods, how much of society's income is spent and how much is saved, and what's the best way to measure and analyse poverty. Needless to say it's easy to see Deaton has applied methodological individualism to the study of consumption, welfare and poverty. 

The Committee summarized his main contributions: 
"How do consumers distribute their spending among different goods?Answering this question is not only necessary for explaining and forecasting actual consumption patterns, but also crucial in evaluating how policy reforms, like changes in consumption taxes, affect the welfare of different groups. In his early work around 1980, Deaton developed the Almost Ideal Demand System – a flexible, yet simple, way of estimating how the demand for each good depends on the prices of all goods and on individual incomes. His approach and its later modifications are now standard tools, both in academia and in practical policy evaluation. 
How much of society's income is spent and how much is saved? To explain capital formation and the magnitudes of business cycles, it is necessary to understand the interplay between income and consumption over time. In a few papers around 1990, Deaton showed that the prevailing consumption theory could not explain the actual relationships if the starting point was aggregate income and consumption. Instead, one should sum up how individuals adapt their own consumption to their individual income, which fluctuates in a very different way to aggregate income. This research clearly demonstrated why the analysis of individual data is key to untangling the patterns we see in aggregate data, an approach that has since become widely adopted in modern macroeconomics
How do we best measure and analyze welfare and poverty? In his more recent research, Deaton highlights how reliable measures of individual household consumption levels can be used to discern mechanisms behind economic development. His research has uncovered important pitfalls when comparing the extent of poverty across time and place. It has also exemplified how the clever use of household data may shed light on such issues as the relationships between income and calorie intake, and the extent of gender discrimination within the family. Deaton's focus on household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data."
A brief and very easy to understand explanation of Deaton's main contributions is available on the webpages of the Nobel prize committee, and a more technical explanation is here.

Poverty and inequality 

To present all of Deaton's main findings is quite a demanding task for a single article. His contributions vary from theoretical to empirical, from methodological to applicable. He had an important role in figuring out how to precisely measure poverty in some of the world's least developed countries. The World Bank database on developing countries relies to a large extent on his methodological solutions using household surveys to measure poverty. He basically transformed the field of development economics by giving it access to much better and far more reliable data than it had before. For example in his quest to improve the methodology of measuring poverty he was exploring how the amount of calories a person eats per day affects their productivity, and how the calorie intake will be affected as the poor get more money. Health was also an important part of his analyses of poverty, as was gender discrimination, and how to construct local market price indices to measure relative levels of poverty. 

His research on inequality testifies of his complete lack of any ideological bias. He realized that inequality is a necessary outcome of societal progress. However he never thought that more wealth in the hands of the elites is a good thing, not out of any envy for the rich, but purely from the possibilities of misuse of this power to serve particular interests at the expense of the rest of society. 

He refrained from doomsday predictions about how inequality is bigger then ever and particularly from proposing inapplicable policy solutions in dealing with it. In his fantastic, partially autobiographic (read this essay) book "The Great Escape: Health, Wealth, and the Origins of Inequality" (see here the NYT book review) published in 2013 he delivers a very important and quite an optimistic message:
"By the most meaningful measures — how long we live, how healthy and happy we are, how much we know — life has never been better. Just as important, it is continuing to improve."
A very true and very clear message. There is absolutely no doubt that living standards today are better than ever before (recall previous blog posts here, here and here), that the rate of people living below the poverty line is lower than ever and that even as inequality has increased in particular Western countries, the overall level of global inequality has declined - primarily due to the rapid growth of Asian countries. Deaton provides evidence for all of this. Just read his book

Perhaps it's due to his extensive scientific rigor and unwillingness to succumb to sensationalism that he avoided the media frenzy during the whole inequality debate. But as anyone who read any of his work would agree, Deaton is perhaps the biggest authority in the field precisely because he carries no bias and looks at everything from a purely scientific lens. 

Microfoundations: fixing the demand curve 

Another one of his essential contributions is to tempt economists to move away from aggregate macro variables and place a much higher emphasis on individual level data and evidence-based economics. He wanted to make economics look like a proper science (yes, moving it away from macro is precisely how you do it). The best example in how he managed to do so was via his first big breakthrough - his 1980 article with John Muellbauer called "An Almost Ideal Demand System" (the article was placed in the American Economic Review's top 20 published articles of all time - i.e. in its first 100 years). 

In this article the authors overcame the usual bias of aggregate demand models in which the center of the model would be a rational individual trying to maximize his utility, from which it follows that we can simply aggregate all of such rational individual preferences into an aggregate demand curve. However the theoretical construct was far from what the empirical evidence was showing. In particular older models failed to predict how demand varied with prices and income, nor was the empirical evidence consistent with the rationality assumption. This encouraged Deaton and Muellbauer to construct a better model, based on crude evidence, taking into consideration actual patterns of consumption and demand, and making it simple enough to be empirically tested. They describe how households allocate incomes towards different types of goods based on their total expenditures. With the difference in incomes for poor and rich households it is precisely this type of variation that corresponds to actual patterns of demand. 

The model's flexibility allowed for many modifications and improvements by a number of subsequent researchers and its end result was that it became a standard for evaluating some aspects of economic policy, for constructing price indices, simulating the effect of consumption tax changes, and even for estimating the effect of family size, age and gender on individual consumption choices. Their initial, simple model became a cornerstone for the rest of the academia in the study of consumer choice that was finally being done with micro-level data. And it revolutionized the economic science by making macroeconomic models more microfounded. 

Another big contribution was using individual behavior models to explain why aggregate consumption was less volatile than income (recall the following blog post). Opposed to Friedman's model which states that rational individuals should smooth out temporary income spikes and only react to permanent income increases, Deaton showed that consumption was more volatile than income. This was referred to as the Deaton paradox. 

In a number of other unique predictions and implications, he argued against foreign aid that can be very inefficient in eradicating poverty and famine if it is concentrated in delivering aid in terms of food (or money) to poor countries. He showed that only balanced economic growth achieved primarily by ensuring a proper institutional environment in poor countries will increase food consumption and hence eliminate famine (because ). Furthermore he doesn't believe that living standards and household wealth can be measured only via indicators such as income, but by a whole number of unobservable factors (like internet access for example) that altogether significantly improve living standards. 

In conclusion, a well-deserved prize for a brilliant economist. 

Selected publications:
  • Deaton, A. and J. Muellbauer (1980), “An Almost Ideal Demand System”, American Economic Review 70(3), 312-326.
  • Deaton, A. (1985), “Panel Data from Times Series of Cross-Sections”, Journal of Econometrics, 30(1-2), 109-126.
  • Deaton, A. and J. Muellbauer (1986), “On Measuring Child Costs: With Applications to Poor Countries”, Journal of Political Economy 94(4), 720-744
  • Deaton, A. and J. Campbell (1989), Why Is Consumption So Smooth?”, Review of Economic Studies, 56(3), 357-373.
  • Deaton, A. (1991), “Savings and Liquidity Constraints”, Econometrica 59(5), 1221-1248.
  • Subramanian, S. and A. Deaton (1996), “The Demand for Food and Calories”, Journal of Political Economy 104(1), 133-162.
  • Deaton, A. (2013) The Great Escape: Health, Wealth, and the Origins of Inequality. Princeton University Press

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.