Monday, 30 July 2012

Tracking the recovery (2) - Europe

The series of tracking the recovery continues with Europe; in particular looking at the manifestation of the recovery in the Eurozone and the UK. The analysis will constrain itself only on observing the leading indicators from the OECD database and the Conference Board, and compare these to their levels from 6 months ago

We start with the Eurozone leading indicator (LEI) published by the Conference Board. They compare the LEI with a coincident economic index and the quarterly RGDP growth rate. The latest version of the indicator was published last Friday, 27th July 2012 (data for end of June). In the previous post, from 6 months ago I explain why in Europe we only focus on the final product, the LEI index, instead of going through every individual indicator as we did in the US tracking. (Click on image to enlarge)

Source: The Conference Board, Global indicators, Euro Area
After the initial recovery in the first quarter of 2012, shown in the LEI (blue line) as a small “bump”, which certainly offered a much needed increase of confidence after the troublesome November and December, things started to deteriorate again in May and June (Spanish bank bailout, Greek and French elections, etc.). This made the 6-month change in LEI a negligible 0.1%, bringing the Eurozone back at the start, only with more time wasted not undertaking the necessary reforms, making the adjustment even more painful for its citizens. Looking deeper into this can we conclude of a European double-dip, similar to what the UK is experiencing at the moment? Not really, I would rather refer to this situation as 'levitating in a status quo', with dire consequences of inaction. 

Individual LEIs 

Moving further, the OECD offers an opportunity to look at the indicators for individual eurozone countries and compare the recovery for each of them. 

All countries' LEIs were drawn within the same scale for easier
comparison, except for Portugal, whose indicator was already out of
scale. Source: OECD Main economic indicators database
Note that the last available data was for May 2012. I experienced a similar problem last time (in February) when the last available data was for November. The OECD data seems to be available with a certain lag, at least for the leading indicators, which omits to offer the complete manifestation of the business cycle in the individual nations. 

If the data would have been more recent, I'm sure the indicators would be a bit more downward sloping, particularly for the UK, given its recent performance. The UK is an interesting example, having entered three consecutive negative quarters of growth, it has seen a LEI slightly facing upwards in the first 4 months of the year, suggesting a forthcoming improvement of the economy. However, due to the recent developments in the Eurozone, the UK slid back into recession (or never even got out of it). This could mean that the UK has a particularly strong exposure to any bad news coming from Europe, which is tied to the UK's strong links (particularly in trade) to the Eurozone economy as a whole. UK's politicians may be right when they blame Europe for poor domestic performance, but Europe is only one part of the story. The government's incompetence is another (potentially much larger part).


The BRICs haven't been showing reinforcing signs either.  
While Brasil is the only one with positive figures, China
and India seem to be slowing down faster than anticipated.
Russia seems to have took a turn to the worse following
the turmoil behind Putin's re-election. 
The LEIs for France or Germany were on a negative path  6 months ago, but have stabilized since. Even though apparently not enough due to the high dependency of their indicators on the unfolding of the Eurozone crisis. Apparently their LEIs will react ex-post any changes in Europe, which doesn't make it that good of a leading indicator. As for the "periphery", Spain comes as a bit of a surprise, however keep in mind that by the end of April Spanish bond yields were sliding back to their September levels (after the ECBs first big bond buying scheme designed to help Spain and Italy, who were at the time pictured as illiquid rather than insolvent). However in time for the next Recovery Tracking update, we will look back to see the Spanish LEI deteriorating at the present time and very likely in the following few months as well.

Last time I criticised the concept of the leading indicator and it's applicability in the Eurozone under so much uncertainty. The underlying data only re-emphasises that point. From looking at the LEI in April or May one couldn't have concluded that the following three months (next quarter) would bring things back to what they were in December. However, by looking at political decisions and daily market announcements, an investor can make much better predictions than relying on a leading indicator, even in uncertain times like these. Too much unfortunately depends on political action or better yet political inaction. The politicians at the periphery are sticking to the least objectionable option - the status quo of doing nothing. This makes sure they don't breach any of the bailout deals they made with Germany, IMF or the ECB, and it makes them postpone the ever more painful labour market and business environment reforms. They seem to be waiting for the solution to come up by itself, or that somehow borrowing becomes cheap again and so that the unsustainable welfare state model can be financed (at least during their time in power). The outcomes of the business cycle movements are proof of this sort of negligent behaviour. Doing nothing only makes things worse. Spain is the perfect example, unfortunately. 

Friday, 27 July 2012

Tracking the recovery (2) - USA

Business cycle tracking continues with a half-year update but this time under a new title: 'Recovery tracking'. In the first version, published back in February (the latest data for January or December), the recovery didn’t look too good, but there were signs that things could have been better. After seeing confidence being lifted in February and March, things went back to their gloomy reality in May and June. 

Back then, I also presented an overview of business cycle indicators and valuable sources useful to familiarizing oneself with the business cycle theory. I advise the current readers to take a look, simply to get a better idea of the difference between leading, coincident and lagging indicators, and why and where economists use them. The indicators I observe here aren’t necessarily the best ones, but they do have a certain reputation for precision and robustness. 

As was the case last time, I start with the United States (for which there is a wide range of data available) while the next two posts will be concerning Europe and business and consumer confidence.

United States

Recent growth figures for the US (published today) show a slowdown of growth to 1.5% for the Q2 of 2012. The recovery has slowed down globally which is most likely due to the recent news from Europe (Greek and French election, Spanish bank bailout etc.). All this certainly affected the US, which is showing in the recent performance of its leading indicators. 

New housing building permits (a good leading indicator, as it provides insight into upcoming activities in housing construction and economic activity - induced in LEI)

Source: St.Louis Fed, FRED database
Compared to 6 months ago this indicator has been showing some signs of recovery, even though it's still on rather low levels (even when compared to all other busts experienced so far). However, the US housing market has experienced an unprecedented slump so it will take a lot of time for this indicator to recover. 

New orders in manufacturing: New orders in durable goods (maybe not so precise as a leading indicator for recessions, but may signal a potential recovery, although the indicator can be biased due to volatility in the transportation sector or defence, which can drive monthly figures unexpectedly) - depicted in the upper left on the figure below: 

Source: St.Louis Fed, FRED database
An increasing number (at least in the trend) of orders in manufacturing in durable goods is a positive sign for the recovery; however, when looking at the index of new orders (upper right), the picture is bleak at most. It seems this indicator has gone down in recent months signalling a potential decrease of confidence among businesses. 6 months ago the situation was a bit better, but even then the verdict was inconclusive. It is obvious that this indicator is highly sensitive to worrying signs of investor confidence that will constrain businesses in their expansion and new orders. Observing hours of production in manufacturing (lower left) can be tricky (the UK is a good example), while the index of supplier deliveries (lower right) is obviously on a decreasing trend, which goes hand in hand with the index of new orders, and paints a worrying picture of the US recovery. 

Fixed domestic investment (a powerful leading indicator that can drive aggregate demand; it falls faster during a recession and grows faster during a recovery than the GDP) - depicted in the upper left corner of the figure:
Source: St.Louis Fed, FRED database
It consists of non-residential (lower right) and residential fixed investment (lower left), where residential is still low (for the same reasons as the new housing permits indicator, which is what residential investment mostly comprises of). Within the category of investment, the best thing to look at is the inventories index (upper right) which is showing volatile movement in the past few years. While this indicator was the main reason behind good US GDP growth data back in January (when it stood at 3%), now it's one of the main drivers of the slowdown in GDP growth. Back then it was hard to tell whether the obviously temporary increase in inventories was due to higher expected future demand, or pilling up stock due to an overestimated demand. It turns out that the later was the case. 

Employment - population ratio: Last time I used a proper leading indicator - unemployment insurance claims - however, the increasing trend of people leaving the labour force made me use a much more precise  and unbiased indicator

Source: St.Louis Fed, FRED database
According to this one, there is still no sign of a recovery in the US labour market. Greg Mankiw likes to pull out this indicator in his regular posts on "Monitoring the So-Called Recovery". 

Finally, here is a joint, weighted-averaged US Leading economic index (LEI).

Source: St.Louis Fed, FRED database
6 months ago, the LEI was averaging higher while showing a slight move towards a negative direction. Now it has clearly gone downwards, implying a negative outlook in the next couple of months. It is possible that negative stock market signals (one of the indicators included in the LEI), worsening of new manufacturing orders, relative stagnation in building permits and residential investments, are all putting downward pressure on the LEI at this point. 

Verdict: Not good, and it's getting worse. And all the forthcoming uncertainty around the Presidential election by the end of this year (and of course around Europe) certainly won't help the economy. However, 2012 was even before it started announced to be a bad year for the global economy. I guess, half way into the year, we're just following that path. Even though the first quarter was looking better than what was being predicted at the time. Let's just hope that going into the summer, the August and September of 2012 don't turn out to be like August and September of 2011. 

Wednesday, 25 July 2012

Britain’s productivity conundrum

Note: This article was written for the Adam Smith Institute blog and was published there earlier today. It came as a timely response to today's press release from the Office for National Statistics (ONS) on UK's third consecutive negative growth (-0.7% this time). They seem to blame it on an extra bank holiday due to the Diamond Jubilee (!?). I already covered that fallacy back in May. For all my other ASI writings see here

Also, I had another article published this week, at the IEA blog, which was a combination of my two previous posts on Germany and Sweden. For all my IEA writings see here.


UK unemployment is falling, employment is rising, hours worked are increasing, while output is still stagnant. What does all this mean? How can the private sector create more jobs, while the total output it produces is still stagnating or even decreasing? Some economists seem puzzled by this saying that one set of data in this case is wrong. Even though this might be true as one of the two parameters is misleading, there are deeper explanations for this prevalent occurrence in the past few months.

It is not surprising that the first reaction on the market is a decrease in productivity (see graph) as more people employed are actually producing less. This can partially be explained by an increase of hiring due to the Olympic Games, since none of these people are creating value or growth for the economy (in terms of increasing output), but nonetheless have paying jobs. 

Source: ONS, Labour Market Statistics, July 2012, pg.8
Lower wage growth would suggest that unit labour costs are decreasing which is making workers cheaper and more likely to find work. However, looking at the graph this doesn’t seem to be the case. But the question still remains: what is driving productivity down?


If we turn to statistics, we can blame the faulty data reporting and faulty measures of economic activity such as the GDP, or the way we define employment. However, we always use this data and if it serves as a sort of a benchmark in good times, there is no reason why not use it in bad times. The efficiency and precision of the indicators is a debate for itself, but I leave this for another time. 

As for employment, personally I would always rather look at the employment-population ratio, an indicator that paints a much more precise picture of economic activity since it takes into account people leaving the workforce, which usually biases the unemployment figures downwards. In that perspective, the labour market isn’t improving, it’s still in distress (see graph below). 

Source: St. Louis Fed, FRED database
The second explanation for a temporary drive in employment compiled with a stagnating output can be seen in the manifestation of the government’s job policies. While the British government is going head over heels to try and bring more people into work, their programs of incentivising employers to hire more workers is an example of a severe labour market distortion. No wonder productivity is rapidly falling. Employers hire people only to get the government benefit. There is no economic incentive for an employer, apart from the government subsidy he receives. The additional worker won’t create new value; his or her marginal product is very likely to be diminishing. So what’s the point of the policy? Simple, it shows good numbers and thus relaxes the pressure off the government. The fact is that this is just another ‘Potemkin village’ designed to skew the public opinion into showing that the government is actually doing something to help the economy. But here’s the catch – whatever it does, it only hurts the chances of recovery. 

The public is bemused into thinking that the government must address the market failures created by reckless bankers or the finance industry. That wasn’t the issue at all; market failures were in that particular case created by a series of government initiated policies. Ranging from the distortions on the housing market, the credit market, the banking risk, the overall systemic risk and even the European contagion – all these areas were cramped by excessive risk taking which was supported by the regulatory environment and policy decisions. The market (i.e. the people engaged in interactions and decision-making) simply reacted to the vastly distorted signals sent to them. So the proper way of fixing this can only lie in the market itself, as long as its recovery signals aren’t being distorted. Having the government subsidize employers to hire more people simply to increase head count, or having the government force banks to reach lending targets to SMEs or pre-determined ‘winners’, are exactly the type of wrong and distorted signals that are preventing the recovery. One is leading to rapidly declining productivity, and the other is making banks lend money to businesses which already have enough of it (see the Bank of Dave), thereby completely excluding the ones that actually need it to expand their productive activities. To paraphrase Arnold Kling and Nick Schultz from their excellent book From Poverty to Prosperity: “markets often fail, that’s why we need markets.” 

There is only one way of resolving the issue of declining productivity and competitiveness, and it’s not an employment subsidy, it’s a labour market reform

Monday, 23 July 2012

The “Bank of Dave” or How one idea can change an industry

Two weeks ago I ran into a story that covers a fascinating and somewhat different approach to mainstream banking.

I really enjoy listening to what the so called “little people” running small businesses have to say on the economy, sometimes even with more enthusiasm than listening to an “expert”. The entrepreneurs and business owners operate in the real economy and notice and tackle the problems first hand (with more or less success). Very often their experience can be much more revealing and truthful than anything one can read in the papers or hear at an academic lecture. This is such a story.

It is a story of a successful businessman from Burnley (a small town in North West England) called David Fishwick with a great ambition to change a fraudulent system with a simple, yet very intriguing solution. To open a bank focused on customers and local development, offering a good deal to both its debtors and its creditors. But it's not the idea itself, it's the way he came to it. 

So far the idea has certainly gained him a lot of media coverage in the UK (see here, here, here or here). In fact he even wrote a book about it and made the whole story into a TV show on Channel 4 that has apparently already caught a million viewers. The first episode is available online, titled “How to open a bank”. It's a really interesting documentary. 

The whole thing started with the beginning of the crisis:
"I never had any desire to be a banker. My company sells minibuses and I have a lot of very good customers who I’ve known for a long time. As soon as the credit crunch happened in 2008, these people couldn’t get a loan from the banks they had been with for years, and so they couldn’t afford to get a new minibus. If nobody could buy minibuses, that would be a very big problem for my business.

I had to do something drastic to keep going through the recession, so I began lending my own money to my customers. Unlike the banks, I knew they were good and honest people who could be trusted. I was proven right, and it made me see just how wrong the banks had gone.

I knew things really weren’t right in the financial system when one of my bank managers came to visit me one day to offer me a loan I hadn’t asked for and didn’t need. He told me that his bank, a big one that I won’t name here, had been given money by the government and they had to lend it out. The problem was that he didn’t want to lend it to anyone who had the slightest chance they wouldn’t pay it back.

Basically, he wasn’t going to lend to anyone that really needed it." (from City A.M., July 10th)
Isn't this the sad truth behind any government guaranteed loan program? Give it to the banks and force them to comply with some randomly selected credit targets based on a static model designed by some group of debunked civil servants, and as a result see the banks hopelessly looking for well-off and low-risk companies to dump the funds on them. The rest of that money will end up in the central banks anyway, either as overnight deposits or any other instrument they can think of. 

Dave’s response was to take matters in his own hands and develop his lending idea even further. He realized there is no need of inventing a “new way of banking”, but simply to restore the ideals from before – a focus on customers, something in which competition is usually the best involuntary solution. Or as JP Morgan Jr. would say: “The banker must at all times conduct himself so as to justify the confidence of his clients in him.”

This is what the bankers have lost the most among the public – confidence and credibility. But it’s still hard to improve this, particularly if the banking oligopoly isn’t broken. The proof of an oligopoly with extremely strong barriers to entry was experienced firsthand when Dave wanted to open up his bank: 
"I quickly discovered that setting up a bank is actually very difficult. I tried to go to the Financial Services Authority (FSA) to get a banking licence, but that didn’t go very well. They wouldn’t even meet with me unless I put millions of pounds in escrow for them. Given the size of what I was trying to do, I thought that was ridiculous. I was beginning to understand why no new bank apart from Metro Bank has got a high street banking licence from the FSA in over a century...

Luckily, I’ve never been someone who takes no for an answer, so I worked with some top-notch lawyers in Manchester and found a way to use various other licences to create something that does all the important bits of what a bank does." 
Even though officially, he cannot call it a bank. So he called it, believe it or not, “Bank on Dave!” (officially, Burnley Savings and Loans). 
“Channel 4 has filmed the whole project, but that doesn’t mean it’s just a publicity stunt. You can take a trip to Burnley and see it for yourself. You might even get a loan – we lend an average of £25,000 every week. That’s money that’s going to small businesses and people in Burnley, where it makes a real difference. 

Many of our customers have been rejected by the high street banks, but among hundreds of them we’ve barely had a missed payment. This is because I meet them face-to-face, and take time to get to know their businesses and, more importantly, whether they’re a person I can trust. In short, I judge them as people, not as credit scores. 
We don’t just offer a better way for borrowers. We help our customers achieve 5 per cent on their savings. And, instead of paying ourselves bonuses, we are donating every penny of operating profit to charity.”
The result? After a tough beginning and many more boundaries he and his team had to face, he ended up with having 62 people depositing £110,000, while making 103 loans worth a total of £365,000. He even made a small profit of £9,500. Not bad at all for an idea based on lending on trust. But even more important than the profit itself was the emphasis of the “bank” to help the local business community of Burnley and thereby fulfil the basic role of every bank – to support the real sector of the economy. In times of lacking confidence, seriously damaged reputation of banks and cash hoarding, this idea comes as a breath of fresh air. 

Will it work, will the banks debtors be efficient enough in making their repayments, and will this be enough to attract new creditors, is left to be seen. However, one cannot argue that the idea is very interesting, and I for one am certainly looking forward to the unfolding of the whole story. I hope I don’t write a blog a few years from now that the bank is now broke, and I do hope more vigilant entrepreneurs pick up on the idea so that we can see more and more success stories like these, where new business models support the creation of even more new businesses. All based on the driving forces of creative destruction where the too-big-to-fail banks are the ones that are supposed to exit the market, and be replaced by new, better and more responsive ones. If only the Treasury will allow it.

Friday, 20 July 2012

The LIBOR scandal

London’s financial markets have been disrupted severely in the past few weeks. The LIBOR scandal revealed a striking image of how the financial system worked and how it was interrelated with the political and the regulatory environment. The signals were being disrupted from a whole number of sources. 

The LIBOR is the London Inter-Bank Offered Rate, which basically means the rate at which banks are willing to lend money to each other. It is a benchmark rate used for a number of transactions and financial instruments, ranging from mortgages to derivatives, thereby affecting the prices of loans. Its total breach on the market is an estimated $800 trillion-worth of financial instruments. The whole process of setting up the LIBOR rate is that each bank sends its own estimate of the rate to the British Bankers’ Association (BBA), an independent body which then creates the benchmark weighted rate by cutting off the top and bottom 25% of the individual submissions. It operates on an auction principle meaning that banks submit a rate they would pay to borrow, with respect to current market conditions. 

Financial cartel

The problem with this was a formation of a cartel of traders (so far the blame is on individual traders, not the Chief Executives who claimed to have not known of what low-level traders were doing, but nonetheless resigned as a consequence of the affair). Even though an auction sounds like a perfectly fair and reasonable way of setting the rate, it can well be exploited within a “bidding ring”, a type of a cartel where bidders align with each other to manipulate the final offer rate, biasing it downwards. They were able to do this and correspond with each other since the BBA made individual estimates public, as a call for greater transparency of the process. 

David Henderson points out to why greater transparency in this case might paradoxically lead to formation of a cartel: 
"...[making transactions publicly available] would facilitate collusion and cartels. One of the biggest barriers to collusion is that the members of the cartel can't know if their fellow members are cheating on collusive agreements. The cartel members can agree to share information about prices, but just as they have an incentive to cheat by cutting prices a little, so also they have an incentive to cheat by misreporting prices. And it is that incentive to cheat that protects us consumers... [If the government would] enforce accurate reporting, and back it up with fines, and now the information that the companies report will be more accurate. Result: collusive agreements are easier to enforce." 
The Economist notices the same problem, and proposes a swift solution: 
"In Mr Klemperer’s “product mix” auction, bidders submit detailed bids, which include both the prices they would pay and quantities they would accept for a range of goods. Because bids are simultaneous and are never revealed, bidders cannot learn from one another, making collusion harder. Since the auctions are of the many-winner financial type, a knockout system, as in the stamp bidding ring, is unlikely. 
"Having received a set of bids for different goods, at various prices and quantities, the auctioneer in Mr Klemperer’s set-up then conducts a proxy auction on bidders’ behalf to see who should get what, and what the price should be. Because nothing is revealed to the bidders and they know they cannot influence this process, their best bet is to tell the truth. What is more, since the auctioneer has price information for a range of quantities, it is possible to see how prices change as supply does."
The scandal 

It is natural to assume why banks would want to rig the rate downwards – it lowers their borrowing costs and makes them better off. As a result, Barclays, the only bank so far officially accused of rigging the LIBOR, had to pay a fine of $450m. They were charged of rigging the LIBOR in two periods, from 2005 to 2007, and more recently during the start of the financial crisis in 2008. Top three chief executives in the bank resigned within a week of the scandal going public, including the CEO and celebrity among bankers, Bob DiamondHowever, other banks were included as well and are under further scrutiny. This includes JPMorgan Chase, Citi, UBS, Deutsche Bank and HSBC. The former was even linked to money laundering and dealing with terrorists, criminals and drug cartels. The investigation is currently ongoing in the United States. 

However, in my opinion, the crucial issue weren’t the decreases of the rate in 2008 to which Bob Diamond testified in front of the Treasury Select Committee in the UK (a committee made up of UK Members of Parliament). This can actually be justified as Barclays was being afraid of a government bailout (which is what Diamond said in his testimony) so it needed to prove that it was solvent and liquid enough. Having a high LIBOR submission was a sign of weakness which could have led to deals falling through. Barclays was constantly the highest submitter (see graph), which is why some of the politicians got worried. They had a lot of ongoing deals that would all be under serious threat if the government had to bailout the bank. It would undermine Barclays' credibility. There was evidence that the regulators (the Bank of England) and the government expressed serious concern that the Barclays submitted rate was too high and will it need a bailout. So the main reason to lower their LIBOR submissions was to ease the political pressure on the bank. 

Source: The Economist, July 5th 2012. "As the chart shows, after Lehman Brothers collapsed in 2008, Barclays' numbers were among the highest. Indeed, the bank has admitted to asking traders to keep its numbers in the top four (and so be discarded), but not high enough to draw attention to it. But a complicating factor is whether Barclays thought it had the tacit support of regulators and the Bank of England. Notes taken by Bob Diamond, then head of investment banking, of a phone call from Paul Tucker, a senior official at the central bank, appear to have been interpreted by some at Barclays as a nudge and wink to fudge the numbers. Its submissions fell the following day"

But even if we somehow justify this by adverse conditions the bank found itself in at the time, what is completely unjustifiable is the rigging of the rate from 2005-2007. 

Naturally, all of this once again increased the public anger on the bankers. As if their credibility wasn’t low enough. Once again, the questions of ethics, principles and banking culture are being raised in the public. They want to see heads falling. Three of them had already fallen. All three chief executives of Barclays have resigned as the consequence of the scandal. The question is, why didn’t they know of the rate rigging before the crisis.

What must be done? 

First of all, a witch hunt on bankers would be counterproductive. "Rather than focus on the people involved or expect bank executives to morph into Mother Theresa, we should instead direct our attention to fixing the institutional framework" (Joffe: "Libor and transparency", July 3rd). As with the case of a majority of countries and sectors, banking as well is in need of a serious reform. It’s not just the culture of banking – it’s everything. 

The biggest reason why some rogue traders behaved that way was because they were allowed to do so without any consequence. When no one punishes a person for doing a criminal act, he or she is encouraged to continue doing so. No one punished traders that rigged rates (Diamond’s testimony led us to believe that the senior management had no idea what its investment bankers were doing). A clear, strong signal that this sort of behaviour is unacceptable anymore would be to immediately find out who the rogue traders were and imprison them. Firing the Chief Executives just isn't enough. When bankers finally realize they cannot get away with this anymore, the culture might start to change. 

The reason this happened can somewhat be traced to deregulation, i.e. regulators not being fierce enough to punish this behaviour. But more importantly this behaviour is an example of crony capitalism, where bankers could use their money, power, and influence to release any pressure off them. This gave them the confidence that they can get away with anything. Reforming this culture or 'mentality' requires a strong rule of law that appears to be diminishing in the forefronts of capitalism – United States and Britain (at least in the financial industry and politics). The problem starts and ends with institutional failure which sends signals to bankers that they can behave as they wish, while no one will stand against them, primarily because it was in no ones interest to do so. 


As for the LIBOR itself, I agree with the aforementioned point made by the Economist on changing the auction style and on their further points how the rate should be based on actual, not estimated borrowing costs. However, I also find David Henderson's solution quite appealing: 
"So what's my solution? The publicity that has occurred about LIBOR is part of it. To the extent that the word gets out that LIBOR is not an honest or accurate estimate of average interest rates, people will demand honesty or find alternative measures that are more accurate.

When I advocate free markets, I don't do so with the idea that no one in markets will make mistakes or that no one will cheat. Many people will make mistakes and many people will cheat, especially with new financial vehicles. But what the market offers as a solution, which government regulation doesn't do as well at, is that when people find out about it, they can act on the information."
The market failure of imperfect information and adverse selection is best solved by the market itself. 

Tuesday, 17 July 2012

Graph of the week: Innovation Index

This month the collaboration between INSEAD, a well respected business school, and the World Intellectual Property Organisation (WIPO) has released a fifth edition (first co-published, usually it was published solely by the INSEAD) of the GlobalInnovation Index (GII), a measure of innovation and technological progress in an economy. Download the full report here.
"The GII recognizes the key role of innovation as a driver of economic growth and prosperity and acknowledges the need for a broad horizontal vision of innovation that is applicable to both developed and emerging economies, with the inclusion of indicators that go beyond the traditional measures of innovation (such as the level of research and development in a given country). ... [It]relies on two sub-indices, the Innovation Input Sub-Index and the Innovation Output Sub-Index, each built around pillars. Five input pillars capture elements of the national economy that enable innovative activities: (1) Institutions, (2) Human capital and research, (3) Infrastructure, (4) Market sophistication, and (5) Business sophistication. Two output pillars capture actual evidence of innovation outputs: (6) Knowledge and technology outputs and (7) Creative outputs."
What they get from that is a composite index which translates into a graph comparing the GII with the GDP p/c. (click to enlarge) 

The graph can offer a few interesting insights. It’s always a question of methodology and analysis of the data, but let’s assume there are no problems there for now. Looking at the graph we can see why certain countries are falling behind in their competitiveness (observe the positions of Italy, Greece, Spain for example). The fall in competitiveness and the creation and preservation of distorted incentives within a society can all somewhat be explained by the index. An economy which lacks incentive to work due to distorted labour market signals and a distorted business environment, will also lack an incentive to innovate. If the people can be well off without working and without creating value, they will never have the basic incentive to create it. 

The innovation index is also highly correlated with the institutional strength index the same organizations are publishing. Even though such a conclusion requires more analysis of the possible causal relations, it can be inferred (even from the graph alone) that countries with a supportive institutional environment (those with market-augmenting governments, to paraphrase Mancur Olson) tend to be much better in creating and sustaining innovation. The position of China then might be ambiguous to some, but China's innovation is still state-led and all too often based on adoption of technologies. Adoption is far from innovation which makes us think about the methodology used in constructing the index. 

The Economist notes a few design flaws:
"The crux of the issue is two fold. First, the index is misnamed. It is meant to measure the "enabling environment" for innovation, rather than the product itself. To do this, the indicators are adjusted for population or GDP. Scaling makes sense. But it also gives rise to oddities. For instance, it means that Lesotho's spending on public education ranks twice as high as America's even though it is far less per student.

This raises the second crucial issue. The unit of measure, the nation-state, is an artifact of an old way of thinking about places and is long past its expiry date. A regional or even municipal basis seems more appropriate. The nation was a natural way of organizing in the past. And it is used today in part because of the way in which data is collected by national statistical offices, and compiled by intergovernmental organizations. But to understand the world and compare locations, it is meaningless. Why should one treat America's decaying rust-belt and soaring Silicon Valley in the same regard? Doesn't aggregating the two commit gross injustice to understanding?"
A few good points raised there. Innovation is hard to look at from a national border perspective, but I understand the need of doing so. Also, the index does provide a better measure of an institutional environment that enables innovation, rather than innovation itself. So in that perspective it is no different than, say, the Doing Business Report issued by the World Bank. Of course, the people in INSEAD wanted to be 'innovative' and talk of something new, or offer a different view. And they've done it. That makes me conclude that the index itself can offer us good insights on the openness of a certain country to innovation and hence faster development.

Friday, 13 July 2012

Book reviews

Two of my book reviews got published recently. They are both on inspiring books I recommend to my readers, at least as a good summer reading. 

The most recent was on Acemoglu and Robinson's newest and most formidable book yet, "Why Nations Fail: The Origins of Power, Prosperity, and Poverty" published by the Adam Smith Institute (I mentioned some interesting findings of the book in a few previous blog posts, see here and here, or see the lecture). 

Here's an excerpt from the review to get the general idea:
"Acemoglu and Robinson formulate their central hypothesis around the fact that a strong set of economic institutions which will guide incentives towards creating wealth can only be achieved through more political freedom. Political inclusiveness and the distribution of political power within a society are the key elements that will determine the success or the failure of nations." 

"...The problem isn’t that poor nations remain poor because of outside (or inside) exploitation, economic ignorance or laziness of the population. It lies in the role of politics, and how the ruling elite will organize the country’s political and economic institutions. If political institutions are organized as extractive and concentrated in the hands of a narrow elite, then economic institutions will only serve the purpose of the ruling elites extracting the maximum wealth for themselves. If they are organized as inclusive, with power being dispersed among the many rather than concentrated among the few, then this institutional environment will create incentives of inclusive economic institutions, where innovation and creative destruction will ensure the creation of sustainable economic growth and development. Becoming a rich nation necessitates the overthrow of the ruling elites and the distribution of power and political rights evenly within a society. The government has to become accountable and responsive to its people, who can then use this security and stability to advance on the economic opportunities available to them."
I encourage you to read the whole thing 

I should note that this version is also forthcoming to be published in Financial Theory and Practice, a peer-reviewed journal published by the Institute of Public Finance in Croatia.

The earlier review was Mark Pennignton's great book "Robust Political Economy. Classical Liberalism and the Future of Public Policy":

"In the lasting battle of ideas between collectivist intervention and individual liberty, the book serves its purpose as a defence of classical liberalism. It provides a framework to challenge the currently dominant intellectual climate focused on the failure of markets in the domains of inequality, injustice and economic reasoning. The attacks against classical liberalism are often wrongly centred on the efficient market hypothesis of neo-classical economics, the informational market failure argument, the asocial conception of individualism and the problems of social injustice and an unequal distribution of income. The book shows how all these arguments fail, in principle, to explain how a coercive alternative can provide a better policy outcome. The author rightly recognizes that in an uncertain environment with limited and imperfect knowledge a centralised authority may only increase the systemic risk in a society. On the other hand individual interactions are more likely to be able to respond to organizational and collectivistic problems of coordination." 
The review was published in the June issue of Financial Theory and Practice, Vol. 36(2) pp 221-227.

Wednesday, 11 July 2012

Voting with feet (part 2)

or Could the Tiebout model be used to solve problems in health insurance?

After the first part introduced the ‘voting with feet’ concept and touched upon migration patterns in the US to see whether this story actually holds, the second part will ask whether the voting with feet concept can be applied to the problem of US health care provision. 

The individual mandate and the health insurance debate was one of the key points that will characterize Obama’s presidency. While arguments in favour suggest the individual mandate is necessary to address the adverse selection problem in the health insurance market (a classical paternalist approach), arguments against usually touch upon individual liberty issues of forcing upon the people to purchase insurance when they choose not to. There is also an interesting argument from Cochrane that the supposed market failure in the health insurance market exists due to over-regulation of that market (or in other words due to government failure).

Introduce voting with feet

Many suggestions have been made that the health care reform (the individual mandate in particular) should be legislated on a state level rather than a federal level, so that people can “vote with their feet” in terms of health services provided. Limiting ones choices via a federally imposed punishment for non-cooperation is a dangerous interplay with personal freedom. That’s why the law has a negative connotation for more than half of Americans. 

How would this look like? Let’s assume that the individual mandate is legislated in the Northern part of the country while the Southern states have opposed it. Or even better, let’s randomize (in order to avoid any geographical and semi-cultural bias) and assume that accepting and opposing states vary based on territorial location across the country. 

Would this cause rapid inter-state migration from the accepting into the opposing states for all those who feel that the individual mandate is unconstitutional? Yes and no. It basically depends on whether the individual mandate will make their utility lower than the alternative of moving to an opposing neighbouring state (taking into account the transaction costs of finding a new job and place to live). I doubt that the price of the health insurance (or the ‘tax’ imposed for non-payers) is so high that people will decide to move for that reason alone. 

For example, how many Massachusetts citizens emigrated to another state because of Romney’s individual mandate? I’m assuming not much. 

Having said that, I still think it’s better to allow individual states to leave it up to their citizens to vote pro or against the insurance particularly since this is unlikely to lead to a mass inter-migration within the United States. Every individual state will act on the democratic principles where the majority of its people will decide whether or not they are willing to accept the reform. This seems much more fair and much more durable than a rule imposed on a federal level that can simply be repealed if Republicans win the House, the Senate and the Presidency in the forthcoming elections. Legislating an important and widespread law such as this only to repeal it in a few months time (even in a few years time) is a dangerous thing to do to the fragile state of the US health system. 

The durability of the reform is much more likely to be preserved if some states adopt it and others don’t. This would be a perfect social experiment (as expensive as it gets, but that’s the problem with economics – no matter what kind of social experiments the economic science does, it will always be more expensive than CERN’s LHC for example, and therefore unattainable). Have in mind that broad based social experiments in economics are rare, but when they do occur – like in the cases of East and West Germany, or North and South Korea, they offer amazing insights and conclusions.

The social experiment would observe the accepting states as the treatment group, while the rejecting states would be the control group. Observing the change in the quality of health care of the citizens in opposing states would be the main research question. 

From the current point of view one could assume that accepting states would be the ones which would experience better results in the quality of care, in particular by those who were mandated to buy health insurance (the researcher should probably exclude all those who still rejected the mandate and decided to pay the fine tax). But what if it doesn’t turn out that way. Perhaps there will be no significant change in relative health of the population and no difference across states. In that case the health reform will prove to be too expensive and would probably be suggested to be scraped in those states where it went through. 

If it does however turn out that the health reform was beneficial to improving people’s health compared to the people in rejecting states, then the message to the policy-makers of rejected states would be to implement it. The people will see the difference and vote accordingly (not with their feet, but in ballots). If the results after 10 years offer positive reinforcement to the reform, this could be the thing that makes the reform go nationwide. 

But at the moment this is a dangerous political game. It is hard to talk the people into it on the count of touching into their personal liberties. However, after a while if the voters get persuaded that it does work, they may change their votes and urge their state representatives to adopt the law. Having the decision based on the state level is the best possible way of solving this central issue in US politics that may prove to be the turning point in the forthcoming presidential elections. 

If proponents of the health reform really have no fear that this reform will benefit the public in the long run by fixing the health system and improving the quality of health care in America, then they shouldn’t try to enforce it on a federal level, but introduce it gradually on a state by state basis and watch its effects in the real world. This is essentially how any major reform should be constituted – not via federal bureaucrats imposing their will, but via decentralized decisions made by the people based on evaluating the actual costs and benefits of the reform.

Monday, 9 July 2012

‘Voting with feet’ (part 1)

Tiebout model

Charles Tiebout first proposed the idea of "voting with feet" in his 1956 seminal paper “A Pure Theory of Local Expenditures” published in The Journal of Political Economy, as a non-political, market way to solve the free rider problem in local governance. 

The idea is simple. The model basically implies that people will choose where they want to live based on local public goods and services offered in different municipalities. People differ in their individual preferences towards different services and their willingness to pay for these services. They will choose where to live accordingly. A local provision of public goods will hence depend mostly on the taste of its residents – a logical proposition. 

The idea was even embraced by two of my favourite Nobel Prize laureates Friedman and Hayek
Friedman: "...The second broad principle is that government power must be dispersed. If government is to exercise power, better in the county than in the state, better in the state than in Washington. If I do not like what my local community does, be it in sewage disposal, or zoning, or schools, I can move to another local community, and though few may take this step, the mere possibility acts as a check. If I do not like what Washington imposes, I have few alternatives in this world of jealous nations."  
Hayek: "I'm inclined to give local authorities power which I would deny to the central government, because people can vote with their feet against what the local governments can do." 
However, the model Tiebout proposes is not without flaws. As with any economics model two assumptions exist which pretty much defy reality: complete information and no transaction costs. Economists do this for simplicity; it helps them avoid unnecessary analytical complexity and gives them an opportunity to reach a unique solution to the problem they observe, and presumably offer policy advice based on it. In the real world, however, even if the conclusions are perfectly sound, many assumptions aren’t. This doesn’t make models uninteresting or inapplicable nor does it prevent policy-makers in trying to overcome the problems in implementing the theoretical findings.

As for Tiebout model's assumptions, people often don’t posses complete information on which part of the country could be the most beneficial to them, even though thanks to the wonders of the internet, this information is becoming more and more accessible and less and less costly. However, transaction costs are likely to be significant in any case. Other assumptions include the rationality of communities, non-spillover of public good benefits across communities, an optimal city size and no issues with commuting. Even if we were somehow to accept these assumptions it would still be very farfetched. 

Nevertheless, the model appears to work. At least in the US. Here is an interesting paper that empirically assesses the Tiebout model and finds it applicable to the US local government (though it does so only on the basis of environmental quality). There is a vast majority of other research available that tend to support the voting with feet story. The graphs below emphasize this to a certain extent. While New York has mainly net positive migration (black lines are inward, red lines are outward migration), L.A. has the reverse trend - people are moving across California and all around the South-East. Forbes is running a detailed map of inner-US migration where one can find out very interesting information about these patters for each specific county. One of these interesting patterns is the migration to Florida, particularly from New York (I assume old people make up most of this data). As for the patterns after the crisis (shown in the two graphs on the right), their frequency seems to have dropped, which was expected as the transaction costs of moving suddenly increased (actual costs could have even decreased due to lower housing prices, but relative to total wealth which decreased, the costs of moving increased). 

Source: Forbes Map: Where Americans are moving; and
WSJ: "Recession alters migration patterns in US"
But these patterns don't tell us what makes people move - is it really the disatisfaction with local goods and services offered, or is it usually due to accepting better jobs, or changing careers which seems to be much easier to do in the US than Europe, for example. I guess it’s really the choice of whether the utility gain from the new location will be bigger than the transaction costs of moving locations. 

So basically as long as U(Δm) > f(c; m)

Where f(c; m) is an increasing linear function determined by the location of the move (the further away it is, the higher the costs – it could also be a convex function). We can also add a stochastic shock in the equation where an event like the crisis or the housing bubble burst increase the relative transaction costs even if location is unaffected. But this is where things get a bit complicated, which emphasizes my earlier point. 

What can migration patterns explain?

However, even if Americans on average care more on the utility they receive from local communities, in Europe people are much less inclined to move even within the EU (at least across borders). People are much less mobile in Europe, mainly due to two things: language barriers (within the EU) and immigration constraints (outside it). 

Reflecting upon this, can competition in local, national and international levels explain the trails of world migration, both now and historically? When people aren’t happy with their lifestyle in the local environment they will aim to switch it; whether due to ambition, a chance to earn more money, or simply to survive. 

This is the point of foreign direct investments if you look at the World globally and countries as local units. FDIs will flow to where the returns are highest and where the tax rates are the lowest. The perfect combination is security of the investment, a relatively high return compared to the alternatives and a low tax rate. This is why emerging markets succeed – their reforms offer more security to foreign investors and a high return due to an unexplored market. The best way to attract foreign investors is to incentivise them with low enough tax rates. Similar things attract people as well. 

This mobility can also be used to explain the growth trails of some nations. For example, a large amount of mobility between sectors can lead to a rapid industrialization and development. Human capital transferred to places where it can make the most of its value will very often delivers that value. This is why many students go to study in the US or the UK, hoping they could stay and ensure a better life and fulfill their ambitions. 

Perhaps this mobility can be one parameter in explaining the differences between Europe and the United States - in terms of ‘mentality’, the welfare state model, the realm of social justice, and value of work. I’ve written before on how religiosity can explain different levels of social spending. The willingness to inner-migrate and 'vote with feet' can be another good explanation of these differences. 

If this is indeed true, perhaps this finding can be used to solve the problem of health insurance provision in the US? Part 2 will deal with this issue. 

Friday, 6 July 2012

Dr Arthur Laffer at the IEA

Last week I had a chance to see the Arthur Laffer lecture at the Institute of Economic Affairs in London, and I have to admit it was one of the best lectures I've been to while in London (these include Nobel prize laureates Christopher Pissarides and Elinor Ostrom, Olivier Blanchard, Niall Ferguson, Jesús Huerta de Soto, John Allison, Tom PalmerDetlev SchlichterDaniel Klein, Adair Turner, Martin Wolf, John Cochrane, Madsen Pirie, Tim Evans and many other great professors, economists, philosophers and politicians).  

So in a great competition this lecture strikes me as one of the very best. Dr Laffer underlined his theory of the conveniently called Laffer curve while going through the history of US taxation from 1917, judging all the administrations and all the effects their decisions had on tax revenues. His biggest praise went to the Reagan and Clinton administrations (not surprisingly, the ones where he served as an adviser to). He also coupled the lecture with a few vivid and amusing examples from his personal correspondence with Margaret Thatcher and Ronald Reagan. 

Enjoy the lecture!


Britain on the Laffer Curve by Dr Arthur Laffer. from Institute of Economic Affairs on Vimeo.

Thursday, 5 July 2012

More 'good hunches'

In previous texts, I've pointed out to some more and some less precise predictions on future economic events. While Samuelson was way off on the Soviet Union's economic expansion (as are so many economists today on China), Mankiw was pretty accurate regarding the problems of the US debts and budget deficits along with the unsustainability of the US social security model and subsidized mortgages (this was the topic of the original 'Good hunches' post). Other good hunches include Rajan, Roubini (aka Dr. Doom), Shiller (Mr. Bubble) and a few others on the upcoming financial turmoil.

However, good predictions are usually very hard to find. In fact the economic science is faced with much more bad predictions. Not to go too deep in history and examine the predictions on the demise of the Soviet Union and communism in general, just remember how many pundits claimed in November 2011 that the Eurozone will break up by the new year? And yet it still stands, not out of the gutter quite yet, but still determined to remain and reform. 

And not even the most notable forecasters out there can always be correct. How many of "Dr. Doom's" predictions went wrong? No one know as he won't brag about them, obviously. Here's one though. Look up his Financial Times article from September 2011 where he claims that in order to avoid turmoil Greece should default and exit the euro immediately, having currency depreciation leading its further recovery. He even claimed that a Greek exit might have "secondary benefits to other Eurozone economies who could then decided by themselves whether they want to follow suit, or remain in the euro, with all the costs that come with that choice". In his latest article for the FT (June 2012) co-written with Niall Ferguson, they claim that an exit out of the euro would initiate a potentially explosive event and that more needs to be done to reduce the probability of exits. In retrospect they imply it was good Greece didn't exit and devalue (or in other words it was good Greece didn't listen to Roubini back in September). Mankiw also made a few blunders of his own, where there is even a web page set up offering prizes to those who recognize the "worse predictive and policy follies in his textbook". I won't even touch upon Krugman who had as many bad predictions as he had good ones. 

The legacy of Adam Smith 

However, EconLog's David Henderson points out yesterday (with reference to the 4th of July) how Adam Smith goes a long way in making strikingly precise predictions. In his essential 1776 "The Wealth of Nations" he had this to say on the outcomes of the 13 colonies' Independence war, Britain's possible and likely reactions and, most impressively, further development path of the newly found nation: 
"To propose that Great Britain should voluntarily give up all authority over her colonies, and leave them to elect their own magistrates, to enact their own laws, and to make peace and war as they might think proper, would be to propose such a measure as never was, and never will be adopted, by any nation in the world. No nation ever voluntarily gave up the dominion of any province, how troublesome soever it might be to govern it, and how small soever the revenue which it afforded might be in proportion to the expence which it occasioned. Such sacrifices, though they might frequently be agreeable to the interest, are always mortifying to the pride of every nation, and what is perhaps of still greater consequence, they are always contrary to the private interest of the governing part of it, who would thereby be deprived of the disposal of many places of trust and profit, of many opportunities of acquiring wealth and distinction, which the possession of the most turbulent, and, to the great body of the people, the most unprofitable province seldom fails to afford. The most visionary enthusiast would scarce be capable of proposing such a measure with any serious hopes at least of its ever being adopted. If it was adopted, however, Great Britain would not only be immediately freed from the whole annual expence of the peace establishment of the colonies, but might settle with them such a treaty of commerce as would effectually secure to her a free trade, more advantageous to the great body of the people, though less so to the merchants, than the monopoly which she at present enjoys. By thus parting good friends, the natural affection of the colonies to the mother country which, perhaps, our late dissensions have well nigh extinguished, would quickly revive. It might dispose them not only to respect, for whole centuries together, that treaty of commerce which they had concluded with us at parting, but to favour us in war as well as in trade, and, instead of turbulent and factious subjects, to become our most faithful, affectionate, and generous allies..." 
"...They are very weak who flatter themselves that, in the state to which things have come, our colonies will be easily conquered by force alone. The persons who now govern the resolutions of what they call their continental congress, feel in themselves at this moment a degree of importance which, perhaps, the greatest subjects in Europe scarce feel. From shopkeepers, tradesmen, and attornies, they are become statesmen and legislators, and are employed in contriving a new form of government for an extensive empire, which, they flatter themselves, will become, and which, indeed, seems very likely to become, one of the greatest and most formidable that ever was in the world."
How's that for a good prediction!