Friday, 30 March 2012

An evening with Elinor Ostrom

Last night I attended the Annual IEA Hayek Memorial Lecture delivered by the brilliant Nobel prize winning economist Elinor Ostrom. The subject was one of my favourites; Market Failure and Government Regulation. To be more precise, the title was "Future of the Commons: Beyond Market Failure and Government Regulation". Steve Davies of the IEA has the summary here.

Elinor was amazing. Despite her age and a lovely-old-grandmother appearance she seems so vivid and sharp. This should hardly come as a surprise since most groundbreaking economists live up to be over 90 years old (Mises - 92, Hayek - 92, Friedman - 94, Samuelson - 94, North - 91, Tullock - 90 Buchanan - 92, Coase - 101; bear in mind that the last 4 of the list are still alive and active) without losing a bit of their brilliance or sharpness. In fact, I remember Paul Samuelson had an article on the current crisis published in a newspaper about two weeks before he died.

Anyway, her Nobel prize winning research concerns the governing of common resources where local social interactions solve the collective action problem of the commons. 

For those unfamiliar to the subject, the collective action problem of common resources is often referred to as the 'tragedy of the commons'. This term (devised by Garrett Hardin) describes a situation of resource overexploitation in which self-interested individuals will "ultimately deplete a shared limited resource, even when it is in no ones interest to do so". For example, with common goods like fish stock in a pond (or the ocean) it is believed that fishermen will extract more and more of the fish until they eventually run out of stock, while it is in neither ones interest for this to happen. Other common good examples include clean air, oil in the ocean or any good that is non-excludable and rivalrous (in the fish stock example, no one can be excluded from fishing while additional consumption by one individual reduces the amount of the resource left for others).

While usual solutions included either centralized regulatory and government control or privatization of the resource, Ostrom challenged this by introducing a third approach based on real world examples, in which local communities can overcome the knowledge problem by "designing cooperative institutions that are governed by the resource users themselves". She uses the term 'common pool resources' to describe these examples of cooperative behaviour; fisheries, groundwater basins and irrigation systems.
"The central question in this study is how a group of principals who are in an interdependent situation can organize and govern themselves to obtain continuing joint benefits when all face temptations to free-ride, shirk, or otherwise act opportunistically." Ostrom (1990)
Her case is basically an empirical verification of Mancur Olson's theory of collective action, where small groups are able to overcome the free rider problem as their gains of cooperation outmatch the gains of self-interested behaviour. However, as the size of the group increases, the incentive to cooperate decreases and more and more members decide to free ride.

The lecture was a detailed inquiry into the challenges of her extensive research. She wishes to move her study beyond the small common pool resources into the global environmental system. This would be a framework putting people and ecologies together into Social-Ecological Systems (SES). It is essential to develop the understanding of dynamic processes that lead to ecological problems and use this understanding to move towards a more sustainable social and ecological system. The diversity of the commons and the different cases of social interaction poses the main issue, as it is sometimes too hard to overcome the knowledge and the free rider problem. But the main point is to move further from centralized government solutions and find out what drives human behaviour to universal cooperation. Solving this problem is indeed a challenge and its solution would truly be a vital contribution to social sciences. Even though she already won the Nobel prize, based on last evening's lecture, I certainly expect even more essential contributions coming from Mrs Ostrom and her research team. 

Tuesday, 27 March 2012

The US budget focus

I got hooked up looking at budgets this past week, so now I'll divert my attention to the American budget, or at least a proposal for the American budget. 

Since I didn't go into analyzing the Obama budget as I did with the UK Budget (even though I did refer to it in one post on the US debt and deficit where I call on the Bowles-Simpson report), I decided to give some attention to the Paul Ryan Budget proposal (the Republican chair of the House Budget Committee in Congress). I'll try to draw comparisons with the Obama budget to see which one of these is a pro-growth and pro-reform, if any.

Note: Next year, I'll make sure to give the US budget the equal amount of attention as I gave to the UK one. Also, I'm removing the 'Red book' from the blog and posting it as a link to the post on the budget .

One one side there is President Obama's budget focused on higher taxes (on the rich to lower inequality), higher spending (on entitlements to keep his voter support) and higher deficits (even though the idea was to curb the deficit and debt), while on the other side there is a potential supply side budget calling for reforms in entitlements, spending and taxes.

Let's look at the Ryan budget more closely. It aims to cut total federal spending by 2015 to approx. 20% of GDP. The reductions in taxes (individual and corporate) would follow to restore the revenues to their post war average as well (again around 20%). The deficit by 2015 would amount to 1.7% of GDP, much less than the Obama estimate of approx. 9%. The balanced budget ('holy grail' of 21st century economics) would be achievable by 2017. The CBO has their estimates of the Ryan budget in comparison with their baseline and alternative fiscal scenarios, in the table below (click to get a better view):

Source: Congressional Budget Office 
As can be seen, the main difference between the Ryan budget and CBOs Baseline scenario is that Ryan achieves a balanced budget with a lower size of government in the long run. However, I'm not a big fan of 50 year projections. They can only serve as a type of proxy on today's decision making, but even in that case its prediction power is limited.

Taxation reform 

On the personal income taxes, the Obama budget would introduce a 45% top marginal tax rate, keeping the progressive tax system on all other incomes as it is. Ryan budget would introduce only two rates - 10% for all those families earning less than $100,000, and 25% for all above that threshold. Kind of a double-edged flat tax.

Corporate taxes would also go down in the Ryan budget, to 25% (down from the highest margin of 35% - or as Mankiw puts it from 39.2% including both federal and state taxes), which is still too high and unfavorable for US global competitiveness (note that the UK has just decreased its corporate income taxes to 24% with a pledge for them to drop down to 22% by 2014 - and yet, the UK is still among the highest corporate tax rate countries). To be honest, the current standards of 15% (the lowest corporate tax rate for small businesses) should be applied to all. There is no need to address the inequality among businesses, or is there?

The Ryan budget would also cease taxing overseas earnings of US companies if they invested back in the US. With the current system US firms are greatly discouraged to invest their foreign earnings back in the US, so this reform is absolutely needed.  

On these issues, the proposal is more then welcomed. It aims to decrease the size of government in the economy and provide a boost to businesses and consumers to encourage them to spend more and take on more risks.

Controversy and criticism 

After this, things get tricky. The Ryan budget calls for an immediate repeal of Obamacare and controversial reforms of the Medicare and the social security system. This is a delicate political issue and it takes a lot more than part of a blog post to explain it, so I'll refrain from any deeper analysis for the time being. For now, let me just point out that the current US welfare state is in need of serious reform, not short-term cuts or boosts in spending aimed at achieving political goals. The reform of the welfare state is one of the key issues arising from the current crisis (which has proven its unsustainability) and it needs to be approached carefully. (I plan to write a series of blog posts on welfare state reform). 

But what really bugs me in the Ryan budget is defense spending. Republicans just can't leave it out. I'm supportive of the defense cuts announced by President Obama ($500bn over the next 10 years) and would call for them to go down even further and much more faster. Why can't we be offered a policy that will stop all war funding and all national security spending aimed at making the American people 'safer'? This is a big mistake in the Ryan budget - cutting everywhere else to support a 'military strategy' and prioritizing national security. It is downright hypocritical from Paul Ryan. When he calls for economic freedom, I suggest he starts with individual freedom first.

Esentially, the Ryan budget is a call to cut everything except Social Security, Medicare and defense. Critics of the Ryan budget say that this is out of scope with reality as it disregards all other main functions the government should perform. It has no knowledge of what is needed for a proper functioning of the government. I agree with the critics, but on a different point of view.

The main functions of the government should be to maintain the rule of law, property rights and enforcement of contracts. These institutional prerequisites are the essentials, everything else is optional. They are the guarantee that only the right types of signals are sent to the market, without any distortions. 

I don't mind some basic spending on education or health care, as not everyone can afford schooling or doctors, so keep public schools and keep public hospitals. But the key is to introduce competition among them and enable a high scope of private-based solutions. This is where the process of trial and error will set place and perhaps come up with a better system. It is crucial for this process to develop spontaneously, and not be guided by distorting government subsidies or similar actions. 

In the end, here is the summary of the Ryan budget by the libertarian Republican presidential candidate Ron Paul:
“What is really disappointing is that the GOP budget assumes that the federal government should continue to do everything, or at least almost everything, it is currently doing. We will never have a balanced federal budget, low taxes, economic prosperity, and individual liberty unless Congress stops trying to run the world, run the economy, and run our lives."
Here is Ron Paul's proposal for the US budget if he becomes President - cut a trillion dollars of spending in year 1 along with major regulatory relief, large tax cuts, sound money policies (which include a full audit of the Fed), cuts in defense financing (bringing troops home) and a balance budget by the third year of Presidency. Sounds impossible? Impossible is nothing! 

I would really like to see how that type of rapid and brutal decrease of the government in the economy (down to 15% of the GDP) would react in the system. Even though some initial discrepancies are bound to arise, this budget proposal comes closest to immediately letting market mechanisms instead of government mechanisms send signals of who to hire, in what to specialize in and in what to invest in

Saturday, 24 March 2012

Graph(s) of the week: Budget numbers

Still on the UK 2012 Budget. From the Budget 'Red book' and the OBR report, I have found a few interesting graphs.

First one is from the OBR, showing the UK output gap:

Source: Office for Budget Responsibility: Economic and Fiscal Outlook, pp. 39
Is the shock that hit the UK economy in the crisis permanent or temporary? In other words, is the GDP trend line for the UK going to readjust to a lower steady state level, or is the GDP growth expected to bounce back shortly? Perhaps according to this the UK GDP is likely to return to its pre-crisis trend line, however in a much longer time span than anticipated. This only shows the size and effects of the distortion created during the crisis and the fiscal shocks (internal and external) that hit the country and reduced its productive economic capacity. Looking in the long run, any shock is temporary, even though a longer recovery will shift the medium term trend line a bit downwards. A completely different question is whose fault is it that the recovery is so long or whose fault is it that the output gap is still negative, around minus 2%. 

The second graph is from the Budget 'Red book', and is showing a forecast of the government's commitment to reduce the budget deficit by 2016/17 (the actual balance is not shown):

Source: HM Treasury, 2012 Budget, pp. 18

Observe the huge gap as the Brown government decided to bail out the British banks. The result was a completely unsustainable fiscal position that had to be punished on the elections in 2010. The current government is sticking to its commitment to cut spending, which the numbers clearly show and which is the primary source of attacks against British austerity from many of its critics. But even though public sector cuts are obvious and welcomed, other areas of private sector intervention are not. For the British austerity case, I refer the reader to a former post

Finally, here is a short cost-benefit table of the budget, from the Economist:

Source: The Economist, "A big splash with little cash", 24th March
As it can bee seen, the announced policies are likely to produce a net benefit by the end of this year, while resulting in a net cost in the following year (which is still only around 0.1% of the GDP). By far the largest loss of revenues is to come from the increased personal allowance. This will be partially offset by a series of small measures such as the 'granny tax', the increased bank levy or the reduced special spending reserves. The stamp duty on expensive homes (the mansion tax) will bring in a total of only 400m, which makes it hard to justify from any other perspective besides a political one. 

For the end a short note:
I was asked the other day whether I think the Budget was still a Keynesist policy response, a supply side reform (because of decreasing tax rates, reducing red tape in planning, and even announced road privatization), or something in between. My answer was yes, Osborne is still a Keynesian, as he still tends to believe that the government can pick winners (gaming), still wants the government to drive the infrastructural growth and still wants to stimulate the businesses to grow, by trying to influence the prices of credit. Even though corporate and personal income taxes did fall, and the personal allowance was raised so that more people are taken out of taxation, some elementary mistakes of guiding private sector hiring (youth contract) and investments still exist. This budget was, as I said, an improvement, but not the complete policy for growth.

Wednesday, 21 March 2012

UK Budget 2012 - the analysis

The UK budget was announced today.

The OBR also published its economic growth forecasts in which it revised the UK growth upwards, to 0.8% this year, and 2% the next. Available here.

The initial reactions were mixed. Some policies are welcomed, some are long overdue, some are still not good enough, and some are bad. I've split them into three categories: the good ones, the bad ones and the 'limbo' - or those in between. The evaluation of the policies is based on the previous blog post on budget expectations, and whether they have meet the expectations. 


Corporate taxes to go down even faster - to 24% immediately, and to 22% in 2014. A good policy that will benefit the British business. There is strong reason to believe it can be deemed credible. It would be better to reduce it even further all the way down to 20%, but this is a start. At least the business expectations on corporate taxes can be adjusted in the right direction. 

Transparency - Tax statement to be released so that people will be able to see on what their funds are being spent directly. This is a welcomed move as it will keep budgetary spending under more scrutiny. Maybe the people will finally realize on what sort of nonsense the government is spending their money on and do something about it. 

Planning - a call to reduce the complexity of planning is more than welcomed. This is another pro-business policy I called for the other day. They've announced it as a significant effort to reduce the red tape (from more than a 1000 pages of regulation down to 50), and will be welcomed by businesses. 


50p top income tax rate down to 45p. A move in the right direction but should have been more bolder. This way they have made a concession which will still be attacked politically, but haven't made the full economic benefit from it. If they continue on working to cut it down to 40p before the next election that would be encouraging. 

Personal allowance to rise by £1,100 from next year (to £9,205), making 24 million people better off (£220 a year). Even though this was the biggest personal allowance increase ever, it should have gone up to £10,000 this year, with an announcement to rise even further in the years to come. However, I understand why this was unfeasible: the deficit is still too high (5.6% of GDP next year) and every £100 increase of personal allowance means 500m less for the Treasury in revenues.

Tax system in general - a call for simplification is positive (like the removing of the loopholes in the VAT, or the pledge to merge the income tax and national insurance) but more needs to be done to address all of its complexities. The call for transparency is an example of a positive move in that direction. Keep up with that. 

Sunday trading rules suspension only during the Olympics, which is good, but not enough. They should have been made permanent.  

Infrastructure - the privatization of roads is still a suggestion, without any real policy aimed at that direction. Other infrastructural projects are still an example of too much government guidance in the economy (picking winners in the gaming/entertainment industry, funding ultra-fast broadband and building airports). Stick with the private sector solutions.


Business rates scheduled to rise in April - nothing was done to recall this. Too bad since it will increase the costs to businesses. This policy could have been the best confidence booster for businesses.

Credit easing loan guarantee scheme - it won't lower the costs of borrowing to the smallest firms who need it the most. A much wiser policy to help the businesses would have been the stopping of the business rate rise. 

The youth contract - I understand the young are suffering, but it will be much healthier for them and for the economy in general to help the businesses earn and keep more money (via sticking to deregulation and reduction of direct and indirect business costs) instead of giving them money to hire someone. This furthers the dependency mentality and is not good for the business or for the youth. If you really want to encourage more youth hiring, remove the employer's NIC, abolish the minimum wage and encourage temporary, zero-hour and fixed term contracts through business tax incentives. There is a crucial difference between a subsidy and a tax incentive - one encourages you do work more, the other to work less. 

Bank tax to increase to 0.105%, meaning that the banks won't benefit from the corporate tax rate decrease. Not a smart policy to increase bank lending. In addition, the credit easing loan scheme will imply additional costs to banks that engage in it.

Gambling, alcohol and tobaco - a huge increase of tobaco levy will raise ciggarette prices by 37p. Foolish as it will disproportionally burden the poor and middle income groups. Besides, there's not so much revenue coming from these duties. 

Stamp duty for houses over 2m to rise by 7%. So a mansion tax after all. More politically motivated than economically. I'm interested to see how much extra revenue this will raise.

Conclusion: My budget expectations weren't quite met. There's still a lot of political concessions made that will end up hurting the economy. It was aiming to be a pro-growth budget, but more likely a slower pro-growth budget than expected and needed. 
In microeconomic terminology, it is Pareto efficient regarding the current policies, but one can hardly say it was a Pareto improvement.

Monday, 19 March 2012

Budget expectations

This week is Budget Week in the UK, so I'll focus the writings mostly around that. It's scheduled to be announced on Wednesday, but since many of the policies are already anticipated well in advance, I'll give out my own view on some of them. Many claim that this is the Chancellor's last chance to boost growth before the next election. And yet, everything seems to already be known. So let's examine this apparently crucial budget and see whether the UK will continue its Keynesian path, or will it turn to a supply-side pro-growth reform?

First off is the anticipated abolishment of the 50p tax rate. The prediction is it will go down to 45p (cautious) or even 40p (optimistic). This is long overdue. It fails to raise any significant revenue for the Treasury, it discourages high achievers, fails to attract and keep talent, discourages investors, and constrains jobs and growth. It was designed as a simple way to show that the government is determined to fight inequality, but has provided no benefit whatsoever, direct or indirect. The 50p is a good historical proof that policies driven by political motives shouldn't be used when trying to start-up a recovery.
Prediction: It will be announced, however, only to a 45p rate. It should however go down even further to show a clear signal that Britain supports business, hard work and wealth creation. 

Personal allowance is anticipated to be increased, some say to around £10,000 in the next few years. This is a good sign and a proper policy to fight inequality and provide relief to the lower income groups. Political experts claim that this policy is Osborne's concession to the LibDems, making them more likely to accept the 50p rate decrease. Whatever the reason is, the idea is good, it should be implemented with immediate effect with a pledge to raise it further to £12,000, as proposed by Madsen Pirie, so that all those "at or below the minimum wage be taken out of paying income tax". This is a good way to increase the incentives to work, and remove the dependency mentality. 

The PM David Cameron today announced an interesting idea - he called for road privatization. This is a much more welcomed infrastructure policy than what we've seen in the Autumn statement. This doesn't mean there will be tolls on existing roads, but rather a call to find private solutions to build new roads and charge for the traffic being made through them. This is a typical free market idea and I'm frankly surprised the PM announced it. He proposes for the government to encourage the pension funds (NAPF) to invest into a long term project that could bring them a steady stream of income in the future. A good idea I strongly support. 

Pro-business policies
There's quite a few of these so I won't go into too much detail, but will just stress out which are essential to help businesses gain more confidence and start growth and hiring. 

Unfair dismissal - the government's proposal to increase the qualifying period for unfair dismissal from one year to two years is most certainly welcomed to help business confidence. Businesses don't hire people to fire them. Maybe someone who never worked in the private sector thinks that it works this way, but it doesn't. Businesses hire to grow. At the very beginning of their development they struggle to find finance and qualified and skilled labour. So having a confidence to fire a worker doesn't mean they will go on and do it all the time - it is a classical principal-agent problem that can only be solved if both the principal and the agent operate with the same bargaining power. 
Reducing the corporation tax down to 20% gradually (25 to 23 to 20 in the next three years). This will create a strong signal to businesses to anticipate a lower tax burden and is the best way to increase business confidence. The pledge however must be seen credible. 
Temporary suspension of Sunday trading rules (during the Olympics) - remove the 'temporary' and the policy is a success. It will yield a small effect but it is a good sign that the government is serious in reducing the red tape. 
Another cost-less policy to help businesses would be relaxing the planning rules (basically sticking to the announced National Planning Policy Framework). It will reduce complexity, bring in consistency and reduce costs to businesses in obtaining permits and going through paperwork. It won't cover the country in concrete, it will simply help businesses anticipate costs better and encourage them to expand. 
The upcoming 5.6% rise in Business Rates (due in April) has to be stopped. If you want businesses to grow, don't levy unnecessary costs on them. Besides what's the point in taking money from them only to return it via some type of credit easing? It creates confusion and is too costly. 

On the youth contract and credit easing I have written before and I still stand against them, feeling that they won't do any good and will distort the possible positive signals sent to the economy. Instead of credit easing just continue with reducing the red tape and disable any direct cost increase for businesses. This is much more likely to see them grow than creating a subsidy that will only increase dependency. 

With all this I would support the reform to end the national pay bargaining for the public sector.  If anything this is distorting the specialization signals in less developed parts of the country, where young people are driven into the public service as the pay is centrally set nationwide on a suitable average level. This is even more increasing the North-South divide. Decentralize this collective bargaining. 

As for the anticipated reforms I would do without, the mansion tax and the tycoon tax are certainly among these. I realize that a politically delicate question of inequality is easiest solved by bashing the rich. It may sound like a phrase, but I would rather have economic growth to pull people out of poverty than having the government punish the rich. Besides, will the poor really be better off seeing the rich pay higher taxes on their houses? 
Increasing the VAT is counterproductive to any increase of the personal allowance and is one of the most unpopular measures so there is little chance this will be done. The same goes for the European FTT. 
Finally, taxing online gambling and alcohol and cigarettes will hurt the lower income classes more than the higher income ones. The same goes for the air passenger duty (APD) - they tend to be too regressive and hit the middle and the poor disproportionally more. 

If it ends up looking somehting like this, then this just might be the pro-growth budget Britain is hoping for. Let's wait and see what Wednesday will bring us.

Friday, 16 March 2012

Private equity - friend or foe?

The topic of private equity firms and their role in the economy became increasingly popular during the past few months, particularly in the US. The subject became the main point of discussion due to its linkage to a certain American presidential candidate and to some extent due to the rising importance of the inequality debate and high unemployment in America. The private equity industry is depicted as one the main 'evils' of capitalism. No matter how absurdly this sounds, the people and the media were concerned that the existence of private equity firms can only harm the productive business environment. They are pictured as corporate raiders who "ride on the backs of businesses, ripping them off and earning a profit on their misfortune". The second main criticism is that their executives receive too much money (and don't pay enough taxes). (FYI, in the movie "Pretty Women", Richard Gere portrayed a typical private equity executive - just so you might get a better idea of who these people are, or at least how the public sees them).

Before digging in deeper into the subject, one should differentiate between two types of private equity firms: leveraged buyout private equity investors, which invest into poorly managed companies, repair them and sell them for a profit (like the character played by Gere); and venture capital firms which invest into start-up companies (like Peter Thiel's angel investment in Facebook in 2004). Unsurprisingly the leveraged buyouts are the ones under heavy public criticism of having an inexhaustible thirst for profits, and burdening the companies they buy out with too much debt. 

Let’s take a closer look at this criticism. Private equity firms take over poorly managed companies in order to make them more efficient and more productive before they sell them off for a profit. It invests into a company non publicly traded and with a limited access to capital (compared to bigger publicly traded companies) and it does so by raising capital (usually through debt) to buy equity (ownership) of a particular company. The company gets better access to capital and it gets help from its new owners in managing the company. The firm has a goal to maximize the value of the acquired equity (maximize the return to investment). It can do this by driving a company towards an IPO, sell or merge it with another company or it recapitalize it in order to make it more efficient. In each case the investor is looking to make a profit, which is a perfectly normal incentive for someone willing to take the risk of managing a falling company. 

The whole process often involves cutting jobs, but this needs to be looked at from a different perspective: they invest into weaker companies in the first place. A private equity firm replaces the old inefficient management and ensures a reallocation of labour and capital. This creates anger with those who lost jobs and were put in a worse-off situation but it is very likely the firm would have gone under anyway due to poor former management. The entry of a private equity firm isn’t a guarantee of success, but it does try to offer help to those firms who have the potential to succeed in a global economic environment but just happened to be poorly managed at one point in time. On the other hand it also speeds up the process of failure of those companies which were never really going to make it in the market, and were unable to adapt to market conditions and consumer demand. One can say that, essentially, private equity firms make the creative destruction process a bit quicker and less painful.

A recent NBER working paper by Davis et al (2011) tracked 3200 leveraged buyouts to compare the performances of acquired firms before and after the buyout. They found that private equity resulted in a rapid job destruction but also in a faster job creation. The net job losses were found to be less than 1% of initial employment:
"private equity buyouts catalyze the creative destruction process in the labor market, with only a modest net impact on employment. The creative destruction response mainly involves a more rapid reallocation of jobs across establishments within target firms." Davis et al (2011)
After all, the whole point of private equity firms isn't creating jobs (even though in the long run it indirectly does create more jobs by enabling the firms to expand and hire more people, create more value and create business for other sectors of the economy) – its main emphasis is improving efficiency, productivity and producing high returns. They bring in new ideas based on successful examples of previous restructuring which very often results in a successful venture, for both the company and themselves. 

Improving productivity is not always an easy process. This often involves cutting off the weakest performers and enabling the remaining ones to use the tools at their disposal more efficiently. One way to ensure this are performance incentives to the CEOs of the newly acquired companies. The performance-based compensation means that the CEOs had an extra incentive to make their businesses as efficient as possible. This is also tied up with the burden of high leverage and the fact that they needed to pay off the debt out of existing cash flows. Even though this is a big expense for a company it provides a good incentive for CEOs to keep up with rising productivity and efficiency.  

Finally, if their role is to speed up the process of creative destruction which always ensures that the net job and value creation in the economy are positive, then private equity firms should be striped of their negative connotations. People often fail to see the long term effects of things like leveraged buyouts; they only focus on the short term job loss figures. But the system of dynamism in an economy is bound to create and destroy jobs at the same time, and these forces are not to be tampered with. Both job creation and job destruction are important in a dynamic economy since sometimes the market send signals of resource misallocation, so a dynamic response should be an adjustment in terms of more busts and job losses, only to channel those resources into more productive activities and eventually more jobs.

Sunday, 11 March 2012

The stimulus debate revisited

The debate on stimulus vs. austerity keeps covering new grounds. The former debate originated (mostly) between Krugman, DeLong, Thoma on one side, and Cochrane, Fama, Barro on the other. There was also the Alesina case for contractionary expansion and a rebuttal from the IMF with new evidence against expansionary austerity. Even though the discussion of the appropriate policy is a constant question among economists, lately the Harvard debate between John Taylor and Larry Summers and numerous blog posts of Professors Krugman and DeLong on how the austerity is ruining the European and the American recoveries, made it the key talking point once again. The focus of the debate this time is mostly around empirical research on the effects of the stimulus. While some (Talyor, Cochrane) fail to find any data to support the stimulus argument saying it didn’t do anything to help the economy, others (Romer & Romer) claim that without the stimulus, things would have been much worse for the US, with an even higher unemployment rate and a much more painful adjustment.

I see formidable arguments on both sides. The stimulus certainly did have an effect on the US economy. By helping save the automotive industry and by bailing out some banks it prevented the possibly necessary restructuring of the private sector. A good recent empirical paper by Valerie Ramey suggests that the government stimulus cannot stimulate private sector activity. It can only do so much to help the public sector. She finds strong evidence of the well known 'crowding out' phenomenon where the government spending multiplier is less than one when trying to stimulate private sector activity. As for employment, government spending helps to hire more public sector workers but it doesn't stimulate the private sector to hire more. It does however tend to have a net effect of increasing employment. 

Unlike many of those who recognize this as a positive effect, I see it as an unnecessary distortion of market signals. If the finance industry grew too big, riding on consumer optimism, low interest rates, price appreciation or rising household and corporate debt than the consequences were unavoidable. Add to this the regulatory artificial demand creation that increased systemic risk by guiding banks to invest into sovereign debt and MBSs, the conclusion is that the overheated system became unsustainable. So it needs to be restructured, not by the government's allocation policies, but via market allocation policies. The market forces operate more slowly and have stronger effects, but as a result they provide more robust solutions. 

The broken window fallacy

When the government creates a fiscal stimulus in order to restore confidence in the economy, it does so by creating an artificial demand for workers in alternative careers. Just like the broken window fallacy teaches us, it artificially restructures labour and capital from one industry to another.  

According to the broken window fallacy, periods of war (or more precisely after-war rebuilding) can paradoxically be favourable for an economy as they drive many resources in post-war development towards high infrastructural projects focused on rebuilding the economy, which lead to high and sustainable levels of economic growth. Since there is a lot that needs to be repaired, many capital and human resources will now be reallocated from the war industry into other activities of production and use resources in this fashion. But the crucial point is that these resources could have been used in a much more efficient manner than rebuilding the economy if it hadn't been for the war. My favourite answer to all those who succumb to the broken window fallacy is: why don’t you let me smash all the windows on your house? This will create the job for the local glazier and you will redistribute your income to him. But perhaps you had different plans with your money. Now that you have to pay for your windows to be fixed, you won’t be able to, for example, take your family to a restaurant this weekend, meaning that you deprived the restaurant owner of his income. 

By creating a job for one part of the economy you unwillingly deprive the other, perhaps more successful part of the economy of their income. You are sending a signal that the restaurant owner should go out of business as he won’t have any clients since they will all be spending their money on fixing their windows. 

This is a vast simplification but the point is clear. When the government does the same during a crisis it sends a signal that some industries and careers should be preserved, no matter how inefficient they are. The reason is that upon these decisions rests the electoral success of a politician. So, they must be short-sighted, or they won’t be in a position to make the decision anymore. 

By artificially reallocating resources this way, a fiscal stimulus slows down the creative and innovative processes of the market economy. A fiscal stimulus can only help an economy retain its pre-crisis status quo. It will not help it nor guide it towards establishing a new equilibrium. Any growth it creates will most likely be 'jobless growth' in which the private sector didn't respond properly to the distorted allocation signals. 

"Patterns of sustainable specialization and trade"

In an excellent paper for the Adam Smith Institute, Arnold Kling devises a theory on how signals in the market send information on the efficiency of each industry. Since new production technologies are unknown, one must take time and effort to discover them and develop new production technologies and processes. Patterns of sustainable specialization and trade will create new market signals that will give headway for new industries to arise and restructure the job market. New skills will be required and new occupations will be created. For example, think of the occupations such as typewriter repairman or telephone operator. These employed a lot of people, but were they bailed out by the government when a new industry came along? I'm not saying the US automotive industry (for example) was going to be replaced anytime soon with a transport device faster and more efficient than a car, but it was a clear signal that US car manufacturers were apparently doing something wrong. Just look at this graph that compares the US and the Japanese car industry:

Source: Weil (2009) Economic growth. Pearson International Edition
That's essentially the point: if something is not efficient enough, something more efficient will replace it. And the decision of how this should be done shouldn't come from the government but from entrepreneurs. 

The finance industry on the other hand was caught up in a bubble. The exit strategy was an immediate bailout, but for whom? Only for those companies that invested enough in political campaigns. The result of the bailout was another huge distortion sent to the market. The end effect of stimuli and bailouts can only set a trigger for another business cycle bust. Forget about the short run - the best 'short run' policy for the future generations is a policy focused on long-run stability and clear signals sent to the market on who to hire, in what to invest, in what to specialize in and so on. Otherwise we simply create more problems in the future. When you're thinking about sustainability and stability, think about the long run. To conclude, as Kling puts it:
“...government spending is not likely to solve the problem. Government jobs are not self-sustaining. Instead, they require subsidies from present taxpayers or, if the spending is deficit-financed, from savers (and, ultimately, future taxpayers) ... The restoration of patterns of sustainable specialization and trade will have to come from the private sector. Short-term so-called stimulus programs may impede the necessary adjustment, rather than hasten it.” (Kling, 2012)

Friday, 9 March 2012

I love civil servants

Here’s an interesting anecdote I would like to share with you. It’s on the efficiency of UK public servants, namely the staff working at the local council, administrating the council tax. For those who don’t know, the UK has a system of a local property tax called council tax that is levied on each person occupying a property, and it’s supposed to be used to finance local government services. It’s a lump sum paid by the occupier(s) disregarding one’s income or current work situation (e.g. retirement), although exemptions always exist. 

I’m not to rant about its efficiency in the fact that it raises less than a quarter of the funds for the local council, or its unfairness on making it a lump-sum payment regardless of income, or how it’s sometimes used to fund lustrous projects (such as the one on the picture – courtesy of Dan Mitchell), or anything like that. No, I am more concerned on the issue of simple logic in the daily operations of public service. 

In order to see and track your council tax online you need to register for an account (much like a lot of web pages). You can do the same thing for your internet, electricity or water bills; just register and order a paperless bill – it saves the environment, saves money on posting, and reduces the amount of paper I pile up at home. 

So I made the payment the other day via an online system and naturally the payment couldn’t be processed even though the money was taken from my account. In order to see my account online to check the status of the payment I needed to register on the council’s web page, so I registered. But, I didn’t get access to the account immediately. The registration process meant that they would send me my password by email, but my username via post in the next couple of days. This bemused me. Instead of sending both the username and the password in an email, they would send the username separately – via regular mail, three days later. 

First of all, why the username, why not the password? Isn’t the password the thing that’s supposed to be more secret? Second of all, why send them separately at all? So that I should more easily lose one of them, presumably the paper one? Third, wouldn’t it be much simpler, easier and cheaper just to send them both by email immediately? I couldn’t access the account for three days cause I was waiting for the mail to drop by. And finally, how cost efficient do you think this is? I can picture a conversation of the two office clerks designing this ingenious system:

- Hey, so when someone asks for the username and password, how should we do this, just send them both by email?
- No, we should send them separate, and by using regular mail.
- Why?
- Cause, it’s more professional that way, besides, people love getting mail every day, especially if it’s from their city council.
- Sounds good. So...send the username first?
- No, the password will go first, this way a customer will have time to memorize it before the username gets to him.
- Oh, ok, so we send them both by mail.
- Now that’s just silly – we need to mind the costs you know. There’s a crisis going on. Send only one by regular mail, and the other by email. That way we save up some money.
- Ah, of course...I assume the password will go by email, right? So it can get there first?
- Now you’re learning. Feel free to take your three hour lunch break now.

Think about it, just from the money saved on sending one of these two pieces of information via email, they saved enough to put up another ‘keep off the grass’ sign. That’s what I call efficient. 

Wednesday, 7 March 2012

Graph(s) of the week: Debt

This week I'll take a look at the cross country comparison of household, corporate and financial sector debt levels.

Figure 1. Household debt, % of GDP. Source: The Economist

Figure 2. Financial sector debt, % of GDP. Source: The Economist

Figure 3. Corporate (non-financial) private sector debt, as % of GDP.
Source: The Economist 

It is interesting to notice how the UK ranks top in household debt (almost a 100% of GDP) and financial sector debt (a staggering 220% of GDP), while coming (only) third in corporate debt (still over a 100% of GDP). The pre-crisis growth decade was obviously driven by debt accumulation in Britain painting an highly unsustainable picture of their economy. According to this, the UK could be in much worse shape than imagined. Its financial sector debt can partially be explained by the fact that a lot of financial institutions with London headquarters have global operations (as explained previously) so when they spread out the debt isn't that worrying. However, domestic companies and households were accumulating wealth on debt creation rather than value creation. The US paints a similar picture, with a lot of their household debt being tied up into mortgages. Easy obtainable credit and low interest rates sent distorted signals onto the market that encouraged private sector debt accumulation. This debt bubble had to burst eventually. 

Note: for Italy and Greece (not pictured), unsustainable government debt was the culprit. With government debt the story is a bit different since it cannot be so well hidden as household or corporate debt. It is much more sensitive to international investor sentiments and it is a signal that public finances need to be brought under control. This can be much harder to establish for other types of debt. 

Saturday, 3 March 2012

Bashing of the bankers

Bonuses and performance 

It’s not very popular to be a banker these days.

There have been a lot of attacks against the bankers worldwide. The responsibility for the financial crisis and the recession rests solely on their shoulders (and the rest of the finance industry, but it is less convenient for the general public to call out hedge fund managers) The bankers (mostly investment bankers) took on too much risks, almost ruined their banks, only to be bailed out by the taxpayers, and now, as a result they are stifling lending and thus crippling the recovery. No wonder everyone is mad at them. 

But the story goes a bit different than that. First of all, the bankers only took risks they were allowed or even encouraged to take. It is silly to blame European banks for holding Greek, Italian, Portuguese or Spanish debt since they were instructed to do so by the Europe’s banking regulatory authorities. All these debts were perceived as risk-free assets. The MBSs in the US were given only the finest investment grades. It was a regulatory rule to have these in the bank balance sheets. As a result this created an artificial demand for such assets which paradoxically increased instead of decreasing the systemic risk of every bank holding such assets. 

So, banks weren’t greedy and risk-loving – they were, as always, risk-averse and careful. But even by knowing this piece of information, one still cannot shake the fact that the bankers received huge bonuses for their focus on achieving short-term profits. Even though bonuses and remunerations of managers in all private sector companies were rising very high (with the average wage of the economy mostly stagnating – see the figure below), this was more due to globalisation and the fact that all these companies, banks and the financial industry in particular, became global players. They have surpassed the national market and their managers are operating in a global environment, which is reflected on their wages. Company employees still remained in their national environments so this, naturally, didn’t reflect on their wages.

Figure 1. United States CEO earnings versus the average wage.
Source of data: Piketty and Saez database, table B4, availlable here.
Another reason for high wages was higher competition for top managers and CEO. In a global competitive environment you must ensure to attract a unique talent of a certain manager with a proper severance package. Otherwise you risk losing him or her to a company that is willing to meet their demands. It is the similar story with wages in sports, particularly team sports such as football (European and American) or NBA. If you have a wage cap on football player’s salary or cannot afford to pay him with respect to his talent, you will lose him to a bigger, richer club. The individual player has a goal to earn enough money now for the rest of his life, so between club loyalty and a higher wage he will almost always choose the later. Even with highly loyal players, the owner of the club needs to raise their salaries to meet a certain standard to keep the player in a club. And yet, no one finds this insulting. As long as they entertain us, who cares what their salaries are. 

But there is a crucial difference; sport clubs, if they go under won’t be rescued by the taxpayers – maybe the club fans, but this is also very unlikely. However, banks need to be in order to prevent systemic chaos. So the taxpayers have every right to be angry for having to do this – and they tend to think of system injustice and how the bankers are living off other people’s hard work, and how it isn’t fair that they can get paid so much, while everyone else gets so little, particularly since they drove their companies to the edge of collapse.

But the answer isn’t to control their bonuses or control their wages. Governments and the public sector in general don’t have a goal of acquiring profit. Private sector companies strive on this ability. If they lack it, they will go under, but if the government lacks this motive, they will just be reimbursed with more taxpayers’ money if things start looking badly. This is why it is wrong for a government to control a bank or to set its long-term or short-term goals.

Don’t let the financial sector flee the country. Don’t over-regulate it and destroy its innovative skills. Both in the US and the UK, the financial sector is a big net exporter (yes, services too can be exported). The financial industry and services are the industries of the future. This doesn’t mean we should all end up in this sector and have no one working in manufacturing. Besides, even if this does happen, there will be an increased demand for qualified labour in manufacturing which would be filled up – maybe not immediately though. Just look at London. Once the bearer of a proud and strong shipping industry (many former London docks still stand as proof), now has completely restructured into a world financial giant. What was once shipping and mining is now finance, forex trading and insurance. And why should anyone stop this buoyant industry with constraining regulation and high taxes? The effect will be that it will leave London. The same can be applied for New York. The younger talented generations of financers will go to Hong Kong or Singapore. They won’t put up with constrains on their lifestyles. 

The finance industry is not the enemy. It is the crucial line of support for the real sector, and the more diverse and developed it is, the better it is for the economic growth of a country. However, competition must be restored in the finance industry. My worries aren’t based on big performance bonuses, short-term or long-term; rather I’m more worried about the problem of oligopoly in banking which is currently keeping high prices on lending for small businesses. In addition, a lack of competition will do what every monopoly or oligopoly tends to do – lead to a big distortion of prices in the market. This was the problem in the first place, along with misguiding regulation that led to the downturn in the market. Big bonuses just exacerbated the public anger.