Sunday, 29 January 2012

Apple and the economy: why the West is switching to services?

Last Sunday the New York Times presented a report on "How the US lost out on iPhone work" calling on the phenomenon of the disappearing middle class, claiming that even though Apple is a hugely successful company, its success reaps more benefits abroad than domestically, at least when observing the figures behind job creation.

Apparently, in addition to providing excellent customer value and service, Apple is supposed to rebuild the US manufacturing industry, by shifting its factories back to the US and create more domestic jobs to help kick-start the current sluggish recovery. 

Why are they helping China, when the US is high in unemployment? Why aren’t they creating jobs here in the US, ask the NYT reporters. And yet they list an impressive list of reasons why Apple still shouldn’t be doing so.

The first one is speed and flexibility, the second is scale of production and size of population, the third is cost of both labour and inventory, which are all impossible to match for any Western economy. And Apple isn’t the first or the last company to switch to Asia.
“The entire supply chain is in China now,” said another former high-ranking Apple executive. “You need a thousand rubber gaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need that screw made a little bit different? It will take three hours.” (New York Times, 22/01/2012)

We can discuss why Chinese labour costs are so low, and conclude that this is mainly due to high competition that is the actual driver of this country’s growth, but even that will only partially explain why the West is moving electronics production to Asia. 

The economies of scale are now worldwide. Globalization is to ‘blame’. This is the law of competitive advantage applied to a worldwide level. Some countries specialize in manufacturing and manual labour, and others, where this became too expensive to support, are switching to services. It’s a natural process, and a process that is futile to resist. The best thing to do is to adjust, which the US has been doing. It became the centre of the world in financial services and the IT industry, and for a long time now in higher education and science. The system build in the US, based on science and education gives a boost to these industries and enables them to outsource and export their services. 

If the US is best in providing services and creating unique ideas, this should be the focus of its economy, enabling China to support that in manufacturing. Once (if) China develops enough to become a distributer of knowledge as well, the manufacturing will be able to move to, for example, Africa. But this is unlikely as Chinese population gives a whole new meaning to the principle of economies of scale, and is likely to strive on this advantage for a long time. And the US should accept this. China isn’t disadvantaging the US through its devalued currency; it’s simply using its competitive advantage in providing not only cheaper labour, but also a highly developed supply chain and an altered definition of economies of scale. It takes them much less to complete a job, for much less costs of both inventory and labour. In a global competitive environment, efficiency matters. Those companies that are unable to adjust (like Kodak, which filed for bankruptcy last week) will be forced to close down.

Don Boudreaux made an interesting claim that the report served as an evidence for a high level of prosperity enjoyed in the US:
"As your reporters admit, Apple uses lots of overseas workers precisely because those workers are willing to work in worst conditions and for lower pay than are American workers – strong evidence that the options open to even low-skilled Americans are far superior to those of most workers in developing countries.  Our prosperity enables even the poorest of us to avoid such toil."
Instead of being proud of having such a strong company emerged in the US, along with all other big international conglomerates, the debate is switching to inequality and how these firms should be more ‘patriotic’ and hire domestic workers. But what they fail to realize is that this sort of reasoning would destroy the very foundation on which these successful companies built their wealth. Furthermore, it would increase their costs and lower their revenues and profits, forcing them to offload more and more workers. As always, a temporary policy aimed at creating more jobs would result in a long-run disaster.

It's truly unfortunate that some “would rather have the poor poorer” and working in such conditions “provided that the rich were less rich” (Margaret Thatcher, 1990)


Ultimately, it’s not all about jobs, it’s about creating value, and this is something Apple is good at. In addition its innovations made changes in the music industry and the telephone industry, making our lives easier and more prosperous. To all the people out there using an Apple product, you decided to buy it, not necessarily because it has better performance, but because it’s simple, user friendly and looks good. This is called providing value to the customer, to which the customer will reply with constant and returning business. 

In addition, even if Apple didn’t employ as much people as GM or Chrysler did, it offers a higher income to the workers it does employ. They will then use this higher income to acquire goods and services they wouldn’t have done before. They could borrow more, spend more on a variety of manufacturing goods, engage in service activities they couldn’t afford before, go to fancier restaurants and thereby help other US businesses – help the service businesses in the areas they live in. I’m sure workers in automobile manufacturing do the same, but to a much lesser extent. 

Another thing everyone seems to forget is that Apple’s iPhone gave a boost to a completely new market – the market for iPhone apps. A lot of people with some basic programming skills and a good idea managed to create interesting and useful apps upon which they made a good income. This certainly increased the wealth of that household, which is again money to be used to further help other sectors of the economy. The shipment industry is also experiencing a boost of orders thanks to Apple products, as is the retail industry. 

Apple's value added to the economy is far too great to calculate. Economics operates in a multitude of ways. Nothing is anymore one for one, every action has a multitude of effects that may or may not be beneficial. Having companies such as Apple, Facebook or Google in the US reaps so many unforeseen benefits to the US economy, which cannot be measured through the creation of jobs or tax revenues. There is a reason why they were created in the United States, not elsewhere. Why didn't Europe create anything like this? Or Japan? They all have an equally strong economy and an equally developed IT industry, if not better to some extent. But still, they emerged in the US, due to a specific set of preconditions that encourage innovation and progress. Don’t stop these crucial assumptions of economic growth just because inequality is temporary  high, which is again, an accusation that should be taken with caution. Don’t blame successful companies for the problems created in other sectors of the economies. Don’t be jealous on success – try and achieve it yourself. The founders of these great companies didn't stay home complaining, they went on to change the world and made millions in doing so. Follow their example and create your own future. As President Obama once said, “be the change you believe in”.

Friday, 27 January 2012

Graph of the week: Italian M3

Here’s a graph I picked up from Tyler Cowen last week, which he found on the Telegraph blog. Here’s the original source - the report from Banca d'Italia (the report is in Italian), pg. 7:

Banca d'Italia: Supplements to the Statistical Bulletin, 2012

The graph is entitled 'Italian contribution to monetary aggregates of the euro area' (percentage change over 12 months).

It is showing a significant downturn of Italy's monetary growth. In addition its GDP is predicted to fall for a further 1.5% this year, which is not surprising as the entire scenario reminds me of the Friedman and Schwartz argument on the reasons behind the Great Depression in the US. 

Friedman and Schwartz identified a series of errors made by the Federal Reserve in the late 1920s and early 1930s. Each of these mistakes led to an undesirable tightening of monetary policy and ultimately led to declines in the money supply which could be accounted for the drops in prices and output that occurred subsequently. They speak of several mistakes the Fed made, the most important one being the tightening of monetary policy in 1928 that continued until the stock market crash, what was economically completely unjustified at the time when the economy was just emerging from a recession, commodity prices were declining and there were signs of rising inflation. Such a reaction from the Fed occurred as a response to the instability of stock market prices but such tight monetary policy pushed U.S. into an even bigger recession. “The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October 1929. In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it. Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.” (Friedman, Schwartz, original 1963)

Btw, in the US, the money supply went down by a third from 1929 to 1933 (see first graph), so even though Italy's M3 decrease isn't as severe (at least not yet) it is a clear signal that something could  go terribly wrong in Italy in the next year or two. 

Wednesday, 25 January 2012

How charities and religion (should) solve the problem of social spending

Note: This post was also published at the Adam Smith Institute blog

A few weeks ago I noticed an inequality index I wasn't aware of before. It is a report called the World Giving Index, published annually by the Charities Aid Foundation. The aim of the report is to show which countries are most likely to give donations to charities and therefore, which nations are most open to a privately offered system of fighting poverty. It is done by a set of surveys that ask citizens worldwide whether they have in the last month donated money to charity, volunteered or helped a stranger in any way. One would expect that the outcome would see countries with strong welfare states topping the list, as they have a much better sense of social capital developed than the 'ruthless' US, where self-interest and greed allegedly drive the incentives of individuals. 

Well, surprisingly, or not surprisingly at all, the US tops the list, followed by other Anglo-Saxon countries. Ireland, Australia, New Zealand, UK, Netherlands and Canada are the top 7 in the list. And even though countries like Denmark (17), Sweden (40), Norway (32), Germany (26) are ranked high enough, countries like France (80), Spain (83), Italy (104), Portugal (127) or Greece (151) apparently don't have any sense of social capital at all. 

Source: World Giving Index, CAF


How does one explain these obvious differences between the Anglo-Saxon countries and the welfare state continental European countries? One paper provides a particularly interesting insight. The paper by Scheve and Stasavage from Yale and NYU, uses religiosity to explain the difference in social welfare spending and redistribution between countries. Using a cross-country analysis they conclude that countries with higher levels of religiosity have lower levels of state welfare spending. They use this conclusion to explain the differences in between-country levels of redistribution.

Source: Scheve K., Stasavage D. (2006) “Religion and Preferences for Social Insurance”, 
Quarterly Journal of Political Science: Vol. 1:No. 3, pp 255-286. 
As they show in Figure 1. (pg 259 of the paper) European welfare states (such as Sweden, Denmark, France, Germany, Norway etc.) experience traditionally high levels of social spending (measured as a % of GDP) while simultaneously religious beliefs (measured by the importance of God in a person’s life) are not very high (averaging between 4 and 5 on a 1 to 10 scale). On the other hand, countries in which religious beliefs play an important role (between 7,5 and 8,5 on the same scale) in an individual’s everyday life (such as the US, Ireland, Canada, Portugal) the level of spending tends to be much lower, 5 to 10 percent on average, thus strengthening their initial hypothesis. Therefore religion could act as a substitute for an inadequate level of social insurance.

The next interesting thing to measure here would be by how much do the churches increase the levels of welfare spending, i.e. how much resources that are diverted towards the provision of these services would increase the total relative level of social spending. Perhaps in this case we could obtain a threshold level of social spending needed in one country. If the argument of religion as a substitute for social spending stands, an optimally desired level of social spending in all of these countries could easily be calculated.

But why are then churches and charities so much more involved in countries with lower levels of welfare spending? Does the importance of God influence people to be more cooperative and thus engage in charitable activities? 

Consider the implication of inter-church competition to explain the reasons behind why churches in some countries offer more services to replace government welfare programs. One should look at the difference between countries with one dominant religion and one dominant church and those with many churches (with same or different religious beliefs) and observe that in countries with multiple churches there exists a certain level of competition between them. In these cases offering services such as child day care may be a way to attract more people to their church. Observing this the government has less incentive to invest into the provision of these services. There may exist a reverse causality in this case – it’s not due to the fact that the government decided to lower social spending that the churches have increased the level of services they offer, but quite the opposite – it is due to the competition between churches to lure more and more people in that signals to the government to lower their social spending levels.

If this is indeed true, this should act as a signal to countries such as the UK or Ireland to lower their welfare spending, since private incentives and charitable organizations are likely to take over from the government and provide services such as child day care, private schools, hospital care, retirement homes, homeless shelters, soup kitchens etc. The Salvation Army does just that - a Protestant church well known for its charity work. Perhaps it isn't quite sure how much the private sector can 'offload' the government in its welfare spending, but it should be given a chance to do so, particularly in the Anglo-Saxon countries where social capital is undoubtedly very high.

Sunday, 22 January 2012

Percentages and inequality: graph of the week

I will finish the discussion over inequality with the graph I picked up from Greg Mankiw (it’s not intellectual property theft if I cite my sources, right?):




The graph shows that the US clearly has a progressive tax system, accounting for all federal taxes, not just income taxes, meaning that the burden on the rich is much higher than what some are trying to claim. In fact, during last week, there has been an interesting quarrel in the blogosphere that started with Paul Krugman writing a post on low taxes paid by the rich, using a left wing think tank as his source. However, the graph as well as the entire report, failed to include corporate taxes which put a disproportionaly higher burden on the rich, thereby biasing the conclusions. 

The mistake was quickly noticed among economists resulting with Krugman admitting his mistake, but still taking a hit on his critics. There’s a good summary of the whole quarrel by Steve Landsburg.


On a different note (back to inequality), here’s an article by Niall Ferguson from earlier this week. He praises the book “Coming Apart” by Charles Murray from the AEI, and presents with one of its passages the conservative solution to the inequality problem:
"As Murray shows, there is a conservative solution to the problem of inequality. Scrap the failing welfare programs of the ’30s and ’60s before they bankrupt America. Ensure that everyone has a basic income. Then simplify the tax code to restore the incentives that used to exist for everyone to work hard. Finally, end the state monopolies in public education to launch a new era of school choice and competition."
In short, opt for a flat income tax, with a higher tax-free allowance to fight poverty. Then restore the system of meritocracy by reforming education and may I add ending the welfare state and political cronyism. Easier said than done...  

Friday, 20 January 2012

Percentages and inequality: where is the middle class?

In the last post I brought to attention the inequality issue and have presented a different approach on the 1% debate. Today’s post will be a follow up on inequality, the alleged disappearance of the middle class and the forgotten ideas of innovation and progress that drive the economy forward.


Apparently, there is no more middle class in America. What has once been the proud distinction of the nation is now split up between the rich and the super rich on one side (I can’t track the percentages of who’s who anymore) and everyone else, or the poor on the other side. However this data, just as the data on the top 1%, can be misleading.

The middle class hasn't disappeared. One needs to be careful with the data on income measurements. There is a huge possibility of bias as the levels of income are taken from reported income tax data. This means that making inter-country comparisons can be futile as countries (1) don’t have the same statistical standards, and (2) some countries experience a high level of tax evasion from the richest individuals which will bias the Gini coefficient downwards. Looking at the figure presented, the Gini in India, for example, is lower than in the US simply due to a higher level of tax evasion from the rich – the reality is a big income difference between the rich and the poor in India, much higher than in the US or anywhere in Western Europe. The same goes for the bias in China, the Philippines, Thailand, Malaysia, Cambodia and so on. It is much easier for the rich in those countries to misreport their earnings and channel them to offshore accounts in order to avoid paying taxes. This is why the cross-country Gini coefficient data tend to be misleading: they are collected from only one possible source: officially declared income, not the actual income, which tends to be higher than reported. 

However, one can make the same claim the other way around; perhaps the US is also experiencing a high amount of tax evasion from the rich which is biasing the Gini downwards, so that the US inequality is actually even bigger. This seems unlikely for several reasons.

First of all is (again) the data bias argument where the US income data is based on the IRS reported taxable income. Michael Tanner from Cato finds the following: 
"...reports of skyrocketing incomes among the top 1 percent of earners may be distorted by changes in the tax code that have resulted in more wealth being reported as taxable income. These tax changes caused businesses to switch from filing under the corporate tax system to filing as individuals, and executives to switch from accepting stock options taxed as capital gains to nonqualified stock options taxed as salaries. Simultaneously, the reductions in income-tax rates in 1986 caused much previously unreported income to show up on tax returns."
"At the same time, incomes among lower- and middle-income workers have been shifting from cash wages to non-cash benefits such as health insurance and pensions. These non-cash benefits frequently do not show up as taxable income even though they have value to the worker. In fact, a recent study by Mark Warshawsky of the Social Security Advisory Board suggests that nearly all of the recent increase in earnings inequality "can be explained by the rapid increase in the cost of health insurance employee benefits, and that therefore [there] has not been as significant increase, if any, in inequality of compensation." (M. Tanner, "The Income-Inequality Myth", Cato Institute)

Rewarding education, talent and innovation 

Second, there has been an increasing return on education during the last 30-year period, particularly during the last 10 years. People realized that obtaining a higher education degree would make them move to the upper class of income much quicker than it took their parents. Especially today. Young people go to college, invest in themselves thinking they will be able to make a good return on that investment by earning a higher income when they graduate and land a high paying job. This is why there has been a significant increase in demand for (and supply of) finance and business programs. People realized this is where the high returns are. The competition to get there is great; the competition to get a job in the industry is even greater. 

This is, btw, driving the high salaries of such careers – high demand for investment banking jobs and a limited supply. If you succeed and get a job in the finance industry, you are assured to have a high yield on your college investment. On average, young people do this job for 5 to 10 years due to the stress it brings with it, and afterwards invest their acquired wealth and get even higher incomes. In business, the situation is similar. The competition is high, demand is high, the supply is limited, and the returns are big. Eventually when one does end up becoming a CEO, or a member of the Board, he will see a lot of additional income in the form of stock options and all sorts of performance-related bonuses.



This is where the middle class has gone to. And who is to blame them on doing so?

People are not equal in their intelligence, skills or ability. Every person is a unique individual and should be respected for his or her uniqueness. Every individual should be given an equal chance to succeed. Based on their capabilities to rise above the competition, that individual will achieve prosperity. This is the point of capitalism; the more capable and intelligent you are and the more determined you are, the more likely is it for you to succeed.

People make their money on talent - whether it's singing, acting, sports, innovating, selling, banking - and they are free to do what they want with their money. If the price for their services is high it is because you are willing to pay for it. Just as much you are willing to pay for a game or a concert or a movie, you are willing to pay for the best service from a lawyer, an investment banker or a broker. It has always been this way.

For example, insurance companies are willing to accept the share of risk of adverse events, no matter how likely or unlikely they may be. They make a bet that you’ll never have an illness or an accident, and if they are right they make a profit. The financial services industry enables its customers to increase their purchasing power and buy goods now, instead of having to save for them for a long period of time. The profits these companies earn arise from voluntary trade, the driving force of capitalism, unlike anything earned by political allocation of resources (through bailouts or stimulus projects).

NFL players make more money than any banker on Wall Street. But they don’t get the negative publicity because they entertain us, and we’re willing to pay the price for it. The salaries in the NFL, or the English Premier League are so high due to the willingness of the public to pay the price to watch state of the art sports. Just as the companies are willing to pay celebrities to advertise their products. They are paying for the popularity, i.e. an intrinsic value of an individual.

Companies like Apple weren’t riding on corporate greed and the misery of others. No, they was innovating and creating value for its customers. And through innovation they have made our life better. Apple products are on average more expensive than other similar IT products and are mostly assembled in China, but this doesn’t stop anyone from buying them. Because they offer quality and intelligent design – they are much user friendly than anything so far on the market. They have created their own demand and are fulfilling it and making a huge profit. 

Profits are thus a reward for innovation and creating value for those willing to pay for it. 
Why should we be mad at someone with higher and better skills if he or she can turn those skills and knowledge into creating value and hence profit. 

There is no such thing as an egalitarian society, there never was, and there never will be. For all those claiming that a socialist distribution of income is bringing inequality down, they are right to some extent – the socialist state makes only one redistributive transfer – from everyone to those in power. The result is lower inequality but much more poverty.

Tuesday, 17 January 2012

Percentages and inequality: who is the top 1%?

This week the focus of the blog will be on the rising issue of inequality. Firstly I aim to demystify the rant over the 1% of the rich and their tax burden, after which I will carry on about inequality in general and why is it such an important issue to understand. 

Top 1% (or 0.1%, or 0.01%?)

I didn’t give much attention to the Occupy ‘99%’ movement, but I feel I ought to. I still don’t see the point in trying to explain to them the errors of socialism and how their movement is paradoxically a call for decentralization, not collectivism, but I will touch upon some of the arguments in the whole inequality debate.

What surprises me the most is the hostility created towards the richest 1% of Americans (or Britons) under the populist notion that they made money from everyone else in the crisis, making them more rich than before whilst making everyone else poorer. What needs to be clarified is who are the 1% in America. According to the claims of the Occupy movement they comprise mostly of hedge-fund managers, greedy bankers - the Gordon Gekkos (or Mitt Roomneys) of Wall Street, and those who inherited their wealth (the Paris Hiltons?). They have made money while millions have lost their jobs and hence increased the inequality gap in the US. In addition, these culprits of the crisis don’t even pay their fair share in taxes. Reality may be a bit different. 

Data on rising income

Recent work by economist Emanuel Saez from UC Berkeley adds to the picture of rising income of top earners and the rising inequality between the top 1% and the rest. (On his webpage you can download some of his data and play with it).

A paper by Atkinson, Piketty and Saez (2011) shows that the real annual income growth of the top 1% from 1976 to 2007 was 4.4%, while the average real income growth was only 1.2%. They conclude that the portion of total income growth captured by the top 1% was 58%. The top 10% have doubled their income in the same time span. Here’s a graph showing the substantial increase in income by the top earners:

Source: Atkinson, Piketty, Saez (2011) "Top Incomes in the
 Long Run of History"
 Journal of Economic Literature 49(1)

 And here is the graph from the Congressional Budget Office (CBO) report verifying this fact:

The income growth of the top 1% has fallen since, however, as the financial crisis induced proportionally more losses to those invested in the financial sector. Their growth didn’t fall rapidly, but since 2007 they capture a lesser portion of the total income (not included in the Piketty and Saez database), which is shown on the CBO's estimates.

What the paper omits to mention is that those comprising the 1% aren't the same people now as they were 30 years ago. In fact, every year around 20-30% of those in and out of the 1% changes. There is constant mobility among the top 1% income earners. Advancements in technology and innovation are made by those in the top 1% who used their unique skills and ability to help everyone else – either by making up new products or services or by improving the existing products thus making our lives easier.

What they also fail to realize is that during that time (1979-2007) we have experienced an amazing rise in computer technology and other advancements. In those 30 years we have seen the rapid rise (and creation) of Microsoft, Google, Apple, Oracle, Dell, Amazon, Facebook and many, many more. Beyond the IT sector, it’s the oil companies who are at the very top. The same period saw a substantial rise of Wall Mart, the World’s largest company by size of revenue. Combing the wealth of all 4 inheritors of Sam Walton’s empire (yes, they have inherited their wealth, but are in no sense irresponsible with their company), they would be the richest person in the world. Apart from the oil industry (Exxon, Shell, BP, Chevron, ConocoPhillips etc.) the automobile industry grew rapidly and created enormous wealth, and so did the electronics industry, telecommunications, retailers, chemicals, fashion and finally the finance industry.

Yes, there was a strong growth of the financial sector, but this was in order to support the creation of all these new empires when they were start-ups. What culminated in the current crisis thanks to the regulatory paradox and artificial demand, shouldn’t be blamed on years of created wealth, new products, new energy and the simplification and improvement of our lifestyle (at least in the West).

This is why I find such inequality data misleading. Yes, the growth of the 1% did rise substantially, but those who were driving this income growth weren’t creating nothing, they created value added for the economy and were rewarded for it. 

But who is in the 1%...? 

Are rich and powerful today the bankers and the CEOs of financial companies and hedge funds? Let’s have a look at the Forbes list of the 400 wealthiest Americans. 

Only around 60 out of 400 people on that list are in some sort of business regarding the financial sector, including hedge funds, leverage buyouts, investment banking or insurance. And not many of those were big CEOs, rather they were investors like Warren Buffet or George Soros. Do they create value? Yes, indirectly, by building their corporate empires and their own wealth they are able to spend that money on a variety of goods and services (and companies) and therefore create and sustain other jobs. Those who ultimately create jobs are the rich. All those on the top 1% list, or the Forbes 400 list, created the majority of jobs during the last 30 years (not to mention the creation of completely new careers). 

Another paper by Bakija, Cole and Heim (2010) finds who exactly comprised the top earners in the US. In the top 0.1% only 18% are in banking and finance. Around 40% are entrepreneurs and managers of nonfinancial businesses. The rest vary from lawyers (6.2%), medical professionals (4.4%), real estate (4.7%), sports and entertainment (3%), scientists and IT professionals (4%) and so on. Therefore, the bias against the bankers shouldn't be the bias against the rich themselves. This should be clarified to all the supporters of the Occupy movement.

...and why are they paying less taxes?

Regarding the non-payment of taxes here’s what Michael Tanner of the Cato Institute finds:
 “...the nonpartisan Tax Foundation has found that since 2007, there has been a 39 percent decline in the number of American millionaires. Among the "super-rich" the decline has been even sharper: The number of Americans earning more than $10 million a year has fallen by 55 percent. In fact, while in 2008 the top 1 percent earned 20 percent of all income here, that figure has declined to just 16 percent. “
“...the top 1 percent pays 36.7 percent of all federal income taxes. Because, as noted above, they earn just 16 percent of all income, that certainly seems like more than a fair share.”
“Beyond taxes, the rich also pay in terms of private charity. Households with more than $1 million in income donated more than $150 billion to charity last year, roughly half of all US charitable donations.”

And here’s another interesting article on the issue by Alan Reynolds in the WSJ.

In conclusion, the Occupy movement shouldn’t be disregarded, but they should be wary of their accusations. Bank bailouts, government lobby groups, cheep populist political concessions to acquire votes are not a part of a free market capitalism. They are the essential characteristics of crony capitalism. I agree with the occupy movement on one crucial point – things need to be changed. But the road to serfdom must be avoided.  

Saturday, 14 January 2012

Graph of the week

This week I look at the Heritage 2012 Index of Economic Freedom. (click on the graph to get a better view)

Source: 2012 Index of Economic Freedom, Heritage Foundation and The Wall Street Journal
The current index shows an apparent worldwide decrease in business freedom and government spending, for obvious reasons. Ever since the start of the financial crisis, the total World average has decreased from 60.3 to 57.9, mostly due to the growing levels of government spending, rising accumulation of debt, unsustainable fiscal deficits of more and more countries and rising constraints in banking and business regulation. 

The traditionally low average scores are still investment freedom, financial freedom and in particular freedom from corruption. The problem of corruption is what is making all the dark red and orange countries remain in relatively unfree or repressed regimes. The 'heat map' in Europe shows particularly worrying signs where Italy and Greece have ended up in the mostly unfree (orange) category (in both countries the downturn is due to low scores in government spending, property rights, freedom from corruption and labour freedom), Ukraine has turned into a repressed state, and France, Spain, Portugal and Belgium have ended up in the moderately free category (again government spending, labour freedom, fiscal freedom and somewhat corruption seem to be the main culprits). 

What is also interesting to notice is the change in the average freedom score from the US and the UK during the financial crisis and the subsequent recovery. In the figure below, I compare the US and UK yearly scores with the World average and the score of Mauritius, one country that has experienced a significant rise in economic freedom over the past few years. Now it is ranked higher (no.8) than both the US (no.10) and the UK (no.14), with a point above the US, and three points above the UK (77, compared to 76.3 to 74.1, respectfully). They are both still ranked high enough, but the fiscal stimuli and high budget deficits have hurt their positions in fiscal freedom and government spending. 

Source: 2012 Index of Economic Freedom, Heritage Foundation and The Wall Street Journal

You can play with all sort of data between and within each country, region or category of freedom.
Go and check it out at http://www.heritage.org/Index/

Wednesday, 11 January 2012

Crony capitalism and the financial crisis

I will start this post with a video from the Economic Freedom webpage...




...and a definition of the term cronyism taken from the same source:
"Cronyism occurs when an individual or organization colludes with government officials to get forced benefits they could not have otherwise obtained voluntarily. Those benefits come at the expense of consumers, taxpayers, and everyone working hard to compete in the marketplace."

My paper on the financial crisis published last year included a chapter on the rising political power and lobbying of the financial sector to explain their enormous accumulation of power and their interconnection with government officials.  

The summary of the paper is presented on the blog page, where the mentioned chapter has been left out. The causes of the subprime crisis, the housing boom and bust, its contagion on finance and the real sector and consequently onto the welfare states of Europe, are many. The cronyism of the capitalist system in the US and particularly in peripheral Europe contributed to such an enduring crisis and is preventing its swift recovery.

The chapter in the paper recognizes several factors that may provide proof for cronyism: regulatory oversights, increased financialization, lobbying expenditures, rising national support for the finance industry and even the ‘flow’ of individuals between Wall Street and Washington. On that particular point I would recommend an excellent book by Simon Johnson, “13 Bankers” which provided some new insights on the connection of Wall Street and the political establishment. He finds that it became “a tradition for Goldman Sachs employees (Paulson, Rubin) to find jobs in public services after they leave the firm, and vice versa”.

But what is even more obvious proof is the correlation between the amount of bailout funds each financial company received and its lobbying expenditures and campaign donations to politicians in committees who made these decisions. I prepared a figure depicting this relationship between lobbying expenditures in 2008 and the share of received bailout funds  in total assets (also in 2008 to avoid any biases):

Source: Vukovic (2011) “Political Economy of the US Financial Crisis 2007 – 2009Financial Theory and Practice, Vol. 35(1) 91-128

Even though correlation doesn’t imply causality, the figure does provide an interesting discussion point on why some companies received more and some received less.

(Note: a complete analysis would have to disclose information on the balance sheets of these institutions and the relative exposure to risks they possessed at the time for the economy as a whole. After knowing that information one can evaluate in more precision the role of lobbying and campaign donations in the total bailouts received. This paper doesn’t cover that, but I’m working on a new paper that will look at this interesting relationship more closely. I also plan to include all recipients of the bailout funds, not just the financial sector)

Here are some excerpts form the text:
"Banks such as Citigroup, JP Morgan Chase or Bank of America spent a lot of money on lobbying activities to avoid bankruptcy and acquire additional benefits for further business activities (such as acquisitions of Bear Sterns and Washington Mutual by JP Morgan Chase or Merrill Lynch by Bank of America). Their lobbying activities did not allow the Lehman Brothers scenario. Although they were also companies full of ‘toxic’ assets they ended up acquiring new banks and expanding their business activity."
 "...one that stands out is AIG which has in the last 10 years, as well as in 2008, spent the most money on lobbying. ... AIG was given two times more funds than any other financial company." "...bailout funds received by AIG ... were approximately 8% of AIG asset values. No other bank received bailout funds of more than 2.5% of its total assets."
 "Lehman Brothers, the only big bank that was left to fail did not invest as much into lobbying and political campaigns as other financial institutions that found themselves in similar problems." Vukovic (2011)
It’s best to see Table 4 in the paper for further clarification.

Another interesting company was Wells Fargo, with clear implications on buying political influence.
"Before the purchase of Wachovia Bank, the size of the Wells Fargo assets was approximately the same as that of Lehman Brothers. Nonetheless, Wells Fargo was given more than or the same amount of bailout money as much larger banks. However Wells Fargo’s clever investments in political campaigns during the crisis left them in an even better position than before" Vukovic (2011)
The data on campaign donations was taken from the Center for Responsive Politics and the individual web pages of congressmen that accepted these donations (including Nanci Pelosi, the House Speaker, and Carolyn Maloney, member of a series of committees regarding the financial sector). Adding to this the amounts, sizes and sources of donations given by Fanny and Freddie (a case made earlier in the paper) further paints the picture of the political-business interconnection and cronyism that happened before and during the financial crisis.

What is making taxpayers angry the most is the use of their money to help out these huge behemoths of power. However, their attacks on the capitalist system are misguided, as they aren’t mad at capitalism, they are mad at crony capitalism. One is based on competition and free enterprise, and the other is based on political favours and protectionism. One leads to growth and prosperity, and the other into depletion of resources, high inequality and misery. The choice is simple - we will unwittingly support cronyism or opt for a change in the system that will bring back the years of prosperity. As voters, we do have that power - that, after all, is the point of political economy. 

Monday, 9 January 2012

The Eastern approach

I stumbled upon a great blog post today from a Hungarian business owner on the prospects of starting a business in Hungary. He entitles it pretty clearly "This is why I don't give you a job". He points out to the devastating effects of the Hungarian system where business start ups are almost impossible, if you don't have political support that is. He describes the anti-capitalist mentality and systemic problems with corruption as the highest obstacles to creating and maintaining a stable business. From the variety of comments the text got I understand that many businessmen in Hungary share his concerns as some of them were forced to simply close down.

I recommend you read the full text to get the clear picture. The text itself contains some rough language, but while reading it I understand why the author decided to use it. There are simply no better words to describe the awful situation in the Hungarian private sector. The administrative, regulatory and tax burdens with which the text starts seem light compared to the system of political corruption, anti-capitalist propaganda and downright cronyism. Hungary is becoming the poster child of crony capitalism. 

To avoid being biased by reading only one text I looked into the situation in Hungary in order to find out whether all these facts are true. They certainly appear to be. Hungary is in some views crossed the Greek scenario and could suffer even worse consequences. Here’s a text form the New York Times right after the new government took office a year ago and here’s what they say now. And here and here is more on the Hungarian economic woes from bloggers. 

Furthermore, the IMF and the EU have pulled out of negotiations over a new line of credit due to the rise of what is believed to be authoritarianism. The talks have been restored however, but there are still issues to be covered. The constitutional reforms have outraged many Hungarians while the international organizations are mostly angry because of Hungary's PM Mr Orban's undermining of central bank independence. Talks have  even been on suspending Hungary's voting rights in the EU Council. Besides that, all three rating agencies downgraded its credit rating to 'junk status'. No wonder the country isn't attracting any foreign investments and is sliding into radicalism. Something is terribly wrong in Hungary. 

The situation is turning to bad to worse and in some cases even paradoxical. The Economist reports in the latest issue (Jan 7th – 13th) on the country’s war against the IMF when they desperately seek international help and even secret services ordered to investigate currency attacks. The country is driving towards dictatorship. All the preconditions are here (shattered private sector, high corruption, authoritative prime minister, banning the media, nationalization, anti-capitalist and anti-business mentality), but the people still won’t let go. They’ve beaten communism once before, but this is another tough fight they will have to endure. 

Even though I'm not an expert on the situation in Hungary I do know a thing or two about the issues in other South Eastern European countries, where a similar situation is arising. They suffer from the same misbalances, and the same hostile environment towards capitalism and businesses. The only difference between Hungary and some of the Balkan countries is that at least Hungary didn't undergo a devastating war 15 year ago. The relative underdevelopment of the banking and financial system in the Balkans prevented them from experiencing the same financial blow during the 2009 credit squeeze as Greece and Hungary did. Crony capitalism has been a dominant system in the Balkans for over two decades. It’s only a matter of time before it starts producing the same malign consequences as it did in Hungary and Greece. The only problem is, Balkan radicalism is far more dangerous.

From the Eastern point of view, the situation in Western Europe isn’t half that bad. Just a reminder that it can always get worse if we’re not careful. 

Friday, 6 January 2012

Understanding unemployment

Today's reports on the decrease of US unemployment to 8.5% and an increase in nonfarm payrolls by 200,000 in December 2011, resulted in an expected increase of optimism among economists and investors. Every job creation is most welcomed, particularly since increasing job creation is a sign of a positive direction of the economy. It is expected as the recovery paces up, uncertainty will decrease and confidence will increase, making the firms invest more and eventually hire more. More jobs being created will further stimulate the positive feedback loop as more people will have stable incomes, anticipate a more certain future stream of income and will spend more thereby increasing the aggregate demand. So if we see positive signs of job creation one could conclude that we are half way there to achieving a complete recovery? Not quite.

I don't mean to be too pessimistic, but I would like to draw attention to the article by Dan Mitchell of the Cato Institute:
If the unemployment rate drops because hundreds of thousands of jobs are being created each month, that’s obviously good news.
But if the jobless rate falls because the government estimates that lots of people have become discouraged and dropped out of the labor force, then that’s not good news.
In other words, sometimes the unemployment rate, by itself, doesn’t tell the full story.
That’s why one of the best statistics to look at is the employment-population ratio, which measures the number of people who have jobs and compares it to the number of people who could have jobs.
I have checked the FRED for the data on this unique and interesting indicator, the employment-population ratio, and have found that unlike the unemployment rate, it still isn't showing any positive signs of recovery. 

Source: St. Louis Fed, FRED Database
Here's a closer look at the last 20 years, also available from the US Bureau of Labor statistics:

Source: St. Louis Fed, FRED Database

As can be inferred from the graph, unemployment is still at low levels and the employment-population ratio is locked down to the levels of 30 years ago. One conclusion of why this could be so is the fact that many people simply dropped out of the labour force. They became discouraged workers and have ceased looking for work. This movement would artificially lower the unemployment rate (calculated as the ratio of unemployed over the total labour force) as people who drop out are simply not accounted for.   

The employment-population ratio does capture this change as the people who are out of the work force are still accounted for in total population. It tells us that the recession is far from over. Uncertainty is still too high, confidence too low, businesses still constrained with regulations, high costs and a lack of funding, banks still unwilling to lend to take risks, and unemployment is still to high. Once the preconditions have been made, job growth will follow and the scenario from the beginning of the text will be achievable. 

Thursday, 5 January 2012

Graph of the week

The graph of the week section continues with comparing the current recovery with the fastest, the average and the slowest recovery so far. 


Source: Wall Street Journal, Real Time Economics Blog

So far the current recovery is not doing so well. In comparison over 9 categories, the current recovery appears to be slower than the average (in some categories significantly slower than the average). In general it isn't the slowest recovery so far, but it is dangerously close to being one (especially since the comparison is drawn over a set of recoveries - this means that some inconsistencies may arise in comparing each of the previous ones with the current one). 
The rate of new jobs being created (total jobs and manufacturing) is particularly low (0.4% and -0.3%), just as the housing prices (which are still falling, -8.8%), but they're both just above the slowest recovery levels. 

The worst points of the current recovery are disposable personal income, which is alarmingly low (1.8% growth over the last 2 years) and bank lending, which is negative and with a gap of 24% from the average recovery, and 4% from the worst recovery so far. Both parameters (together with the jobless rate) accurately depict the current rising levels of uncertainty and lack of confidence. Less money left to individuals and low levels of bank lending constrain businesses from investing and consumers from consuming, resulting in low levels of aggregate demand. No jobs are being created, and hence disposable income can't be growing. People are reluctant (or unable) to spend their earnings not being able to anticipate the certain future stream of income. Or perhaps this is the case of high income taxes that discourage consumption and result in low disposable incomes? Personal spending growth is a bit higher but is in general a lot lower than the average. This is particularly interesting since this is the first recovery in which personal spending growth was higher than the growth of disposable income. Does that mean that people are still taking on debt to finance their consumption?

One thing is certain though, the small businesses (the drivers of growth) are struggling because of a lack of bank lending. Corporate profits are high, bank lending is low and no new jobs are being created. The lack of bank lending hence isn't damaging to the big corporations, but to small businesses and potential start-ups. They are the ones not creating new jobs, and the economy desperately needs them to do so. 

All in all, it doesn't look so good so far for the current recovery. With worrying, double-dip signs of 2012, it might turn to be even worse in effect. Let's wait and see..

Tuesday, 3 January 2012

Lack of money, lack of confidence, lack of growth

Problems facing small and medium sized businesses


The highest burden for businesses recently has been the lack of money, to put it simply. Illiquidity is rising worldwide and more and more private sector businesses are unable to service their liabilities. Late payments are forcing many small businesses to invest less and lay off more. The inability to anticipate future income or payment for a good or service is rendering the businesses with apathy and a severe loss of confidence. No firm is comfortable enough to make credible plans of new investments and business growth in a complex array of uncertainty. And who could blame them? Consumers feel the same way. With the uncertainty of whether they will find or hold on to a job they postpone major spending decisions. Even in Christmas time, shopping sprees are lighter than before (although still big enough to satisfy the compulsory gift-giving demand). People are reluctant to put on more debt and take on more loans and often discouraged to do so by the banks and their existing debt burdens. The aggregate demand is crippled as the dynamics and the complexity of the economic system is constraining all of its actors the same way. More money thrown into the economy won’t do any good for anyone. It won’t make the people or businesses spend more as they rightfully fear the uncertain future. It won’t make the government better off either as they are increasing public sector growth and accumulating more debt and a higher deficit.



What is essentially needed is to make firms want to grow, expand and hire more. The consumer confidence will only return once the business confidence is restored, meaning that businesses will start hiring more people who will anticipate stable jobs and salaries which they can use to increase their consumption. Therefore it all begins from the business side. And since the businesses see lack of credit, low consumer confidence and cash flow problems (see the figure and table above) as substantial constraints to their business (notwithstanding regulatory compliments) the answer could be in cutting the cost to businesses and making them more flexible in their operations and more focused on maximizing the efficiency of their resources. Introducing subsidies and stimuli will only shift the resources from making profits on their regular market onto making favours on the political market in order to attract the subsidies. Cutting costs creates a completely different incentive – it gives the business an incentive to use its resources more efficiently and to transfer them into more production or more hiring.  

Cutting costs for business must come from lighter regulatory requirements, at least for small and medium sized businesses. They are the ‘drivers’ of economic growth and in a crisis they are likely to suffer the hardest burden since banks are holding back lending to risky borrowers. Small businesses fall in the risky category since they cannot claim the same prudence and creditworthiness as big corporations. They don’t have as nearly the same access to funding, especially in Europe. This only deepens their wows and further undermines their confidence and their ability to expand. Without money (in the form of higher sales or bank loans) these firms cannot expand. Giving them money via subsidy will increase their dependence on the government and will make them completely inefficient on the market. Once the funding stops, these companies will fail – the ultimate effect that happened in most poorly governed transitional economies.

The only possible solution is to open their horizons by reducing all unnecessary regulatory compliance and lower the employment taxes they need to pay. This will more than anything create an incentive to use their money more efficiently and divert it towards productive means. It will substantially reduce the burden of the crisis to the businesses and make them more flexible in coping with its adverse effects. It will give them an ability to plan their future with more certainty. It will strengthen their fiscal position and enable them to obtain more loans from banks whose demands they will be able to meet. The expected effect from the businesses is the same as what the Keynesists would expect to see from a fiscal stimulus, only this solution is much more realistic in an environment lacking in confidence and filled with uncertainty.

Perhaps the sovereign debt crisis will change the corporate culture in Europe and make its companies seek funding outside of traditional sources such as banks. Perhaps this will encourage them to develop a private bond market where they will be able to reach more funds. Just as long as the government doesn't try to guide them, the change in corporate culture might be an inevitable and necessary solution. 

Sunday, 1 January 2012

New Year’s Resolutions

Happy New 2012 to all! I’ll start us off with the New Year’s resolutions to be expected from the blog and some suggestions that should be followed by the policymakers. It’s mostly a recap of the ideas presented in the blog so far. If it reaches at least one civil servant, I’ll call it a success.

Let’s begin with the new ideas for the blog itself:
  • All new blog posts will be accompanied by a figure or a picture in order to approach the reader from a more amusing perspective. It is aimed to make the blog more ‘user friendly’ in a sense that it will provide visual stimulus and witty or intriguing links and immediate conceptual understanding of what the post is about. I won’t change the design of the blog though, I like it this way. Perhaps in time when I get bored with the current outlay.
  • Apart from that I plan to introduce a new page presenting business cycle tracking. I will track the data that recognizes business cycle movements which I feel could be particularly useful in the following year. This may help the readers to see and possibly anticipate where the economy is going. I will refrain from making any forecasts for now, as I feel you need more time and devotion to do so. Besides, forecasting models tend to have many biases and cannot anticipate events such as the earthquake in Japan or the American Congressional quarrel in August this year, for example. The predictions of a bounce back in 2013 will suffer from the same shortcoming, similar to the prediction of a supposed bounce back in 2012 made back in 2010. Expect the page to be made by the end of January. By the end of each month I will devote a blog post to show the temporary movement of the eurozone and US business cycle situation. 

For the policymakers, I will call upon some of the previous writings on the blog. This doesn’t mean I think my blog posts hold the unique wisdom necessary to repair the current malign system or that I think of myself as the guru to provide the necessary answers. It is simply a set of ideas I feel are good enough to be considered as a part of an academic debate on what is supposed to be done.

1. In Europe, end further bailouts and dependency. Opt for controlled defaults and reform the unsustainable European welfare state
2. Remove regulatory requirements from small and medium-sized businesses to start up economic growth
3. Don’t steer bank investments into new 'safe' assets 
4. Relax regulatory requirements on banks as they tend to only create adverse effects
5. Leave investments to the private sector, government infrastructural spending only reshuffles wealth, it doesn't create new wealth 
6. Avoid senseless cuts, instead cut where it’s really necessary – regulation and taxes – in order to restore confidence and clear the path to private sector growth
7. Don’t subsidize youth employment, rather focus on growth enhancing strategies (such as the ones mentioned above) and the market forces will quickly create jobs for the young
8. Give technocrats a chance, maybe they will find the strength to reform with avoiding the political pressure
9. And finally, learn from the financial crisis that originated in the US four years ago