Monday, 30 September 2013

Electoral divisions along the Berlin Wall

Last week's elections in Germany ended up more or less as expected. Angela Merkel's conservative CDU has won by a landslide (42%, only 5 seats short of a full Bundestag majority) ensuring her a third consecutive mandate as German Chancellor (an achievement only reached by two previous Chancellors - Konrad Adenauer and Helmut Kohl). Another expected result was the downfall of her main coalition partner, the liberal democrat FDP, which has fallen short of the 5% threshold to enter the Bundestag. This implies some post-electoral complications as a grand coalition between CDU and SPD (the social democrats) is inevitable. This was the governing coalition during Mekrel's first term as Chancellor and it was because of the coalition that the social democrats were punished in their subsequent elections. Just like what happened with the FDP in fact.

Anyway, with the victory Merkel has further strengthened her position as Europe's undisputed leader, which is undoubtedly good news for Europe, despite the one-sided austerity approach which has so far caused nothing but pain. This is hardly Merkel's fault as she is a strong advocate of structural reforms, which are still missing from all peripheral Eurozone countries. The political elites in these countries simply don't want to disrupt the cronies and interest groups keeping them in power. Anyway, at least now the uncertainty is gone and Europe can get back to Merkelism. Or some revised form of it in case of a grand coalition.

The most interesting result that came out of the German elections has occurred in Berlin. FT's Alphaville has the chart of Berlin's constituencies and the majority winners in each of them. What is strikingly obvious is the divide between the two parts of Berlin - East voting for Die Linke (The Left), a successor of the former Socialist Party that ruled East Germany, and the only party no one wants to go into coalition with, while the Western part of Berlin voting for conservative CDU. The SPD and the Greens were strongest on the border. 
Source: Berlin's electoral supervisor (in German). 
Does this imply that the unification process is still not finished? Possibly, as it takes a lot of time for informal institutions (customs, norms, culture, preferences) to adapt to institutional change. But stark regional differences still exists. The gap was decreased in the past 20 years mainly thanks to large fiscal transfers, but the East still lags the West in levels of income, unemployment and the amount of wealth. One could say that East Germany is still coping with its pains of transition, just like the rest of Eastern Europe. Different electoral result confirm this. The Eastern part is more prone to protests and in times of crisis are more likely to invoke the old regime. This also explains why the Alternative for Deutschland (AfD), an anti-Europe party, did much better in Eastern parts of the country. The people like to jump from one extreme to another. This is true for most post-communist countries and it's true for East Germany as well. It will take a generational switch to change such voter preferences in these areas. But in the mean time, stark ideological differences will still be present, and in some countries dominant. 

Saturday, 28 September 2013

Graph of the week: 5 years after the crisis

Last two weeks on the blog, much like in the most of the mainstream media, the focus was on the 5 year "anniversary" of the financial crisis. I opened with a text on Fannie and Freddie's reemergence on the housing market, continued with an overview of some causes and implications of the crisis, and topped it up with the end consequences and cross-country effects

So today, to finish off the "crisis coverage", I call upon a series of graphs to illustrate some of the main consequences on the financial system. 

Source: The Economist
The changes are evident in the world of finance. The first two charts show the emergence of Chinese state-backed banks which have managed to break up the dominance of US, UK and European banks, even as the size of top 5 banks' assets has increased (again mainly thanks to the Chinese banks). However, being fully aware of the reasons behind the rapid growth of Chinese banks, they are in for a roller coaster ride similar to the one Lehman has experienced, so we may after all witness the reemergence of the dominance of Western-owned banks in the years to come. 

New higher capital standards (chart 4) have yielded their first effects, lowering the average return on equity (chart 3), and lowering credit availability to the private sector, particularly the SMEs, as I predicted they would do back in 2011. Compensations have fallen as a result of cross-country anti-banking hysteria, and even though employment in the financial sector has decreased in New York, London and Hong Kong have kept their high numbers. As I've concluded previously, none of this suggests that the world of finance is safer than before, it's just different. Different good or different bad, only time will tell. 

Crisis coverage:

Wednesday, 25 September 2013

Five years after the crisis: the consequences

Having portrayed some of the causes and implications of the financial crisis in my previous blog post, in this one I will focus on the consequences and how the countries struck by the crisis are doing today.

First off, what has really changed since five years ago?

Comparison of US financial and corporate profits, S&P 500 performance
and the employment-population ratio. Source: The Atlantic 
The quick answer is not much. But the devil is in details. The graph above clearly states that corporate and financial profits have recovered quite significantly, while the E-P ratio remains to be dreadful. An obvious conclusion emerges. The real sector of the economy is entering a new equilibrium and the labour market is yet to adjust. The structural shock has altered the patterns of production and labour market specialization, and it's going to take time for the demand for skills to adjust. The IT shock and the outsourcing trend were among the strongest disruptions on the labour market, whose shocks weren't really being felt until the crisis had started. As I've pointed out so many times before, the crisis was the trigger mechanism for the beginning of the restructuring in the labour market, the forces of which were initiated many years before the actual start, but to which many market actors didn't react on time. Add to this various technological improvements like fracking and it's obvious that the pace of technological progress is still not slowing down. As a consequences new markets will emerge, new companies will rise, new occupations will be created, and a new skill-set will be required. This is likely to last for quite some time, even more so as certain government protection activities undermine a quicker restructuring. 

When asking the people, they confirm the initial feeling that not much has improved during the recovery, and furthermore that the US financial system isn't as secure as it was before (or at least how it was being perceived before). According to the survey from Pew, a majority of the population still believes that household incomes and the situation on the jobs market haven't changed at all. The majority also believes that real estate values have somewhat improved, while the stock market has significantly improved. Comparing this to the graph above, it seems that the people have an accurate perception of the economy. 

However this is an expected reaction to the aforementioned forces operating on the labour market. And since they're likely to continue for quite some time, the short-term implications are looking to stay gloomy in the years to come.

Cross-country effects 

But even with the troublesome state of recovery and with many open questions on financial system safety in the US, at the moment the country doesn't look like a place ready to burst again. We'll have to wait for another boom to bring the new instabilities back onto the surface. 

The same cannot be said of the Eurozone. Even though things aren't nearly as unstable as they were back in 2011, the structural issues of many peripheral countries still persist, unemployment is running high, growth is anemic and not much is being done in terms of reforms. Europe's debt problems are still increasing despite the austerity pain inferred upon its people. European banks were more infested with bad assets than their american counterparts, however they have written off less debt and are still not out of the gutter. The way European policymakers have decided to handle their austerity policies (tax hikes without real spending cuts - the worst combination for growth) proved to be a terrible solution as they haven't worked in cutting down debt, the deficits are still high, while growth is nowhere in sight. So far Draghi's promise of doing whatever it takes to save the euro is the only thing holding it together. 

Britain is in a similar position where weak private sector investments haven't really helped the country bear the pain of deep budget cuts, while the shy recovery is being driven mainly by a recovery on the housing market, similarly to the US. Britain's main concern is its declining productivity, which is a good explanation of why even though the job market is improving, GDP is still stagnating. In addition, on the business investment market, supply is weak as SME funding is still 20% down since 2008, while on the demand side business owners are still reluctant to take on new risks. 

Japan is still over its head in debt, with Abenomics not looking likely to fix this anytime soon. But Japan is specific due to its lost decades and the responses to the 1990 bubble burst. It's not a typical model of anything so one needs to be careful in evaluating the short-term effect of its standard economic policies. 

By now, we can say the crisis has switched to the emerging markets which are not only worried about their growth slowdown, but also on the next possible Lehman-type catastrophe awaiting to happen in China. Unlike China, the rest of the emerging world is much more vulnerable to global financial flows. The lack of capital investments is driving down currencies and making it hard to finance current account deficits. When the Chinese bubble blows, it's going to be tough times for its main trading partners in the "third world".  

Despite no new financial crisis being on the horizon any time soon in the West, global finance is still a long way from being safe. Or at least it's a long way from the perception of being safe as it was before.

Monday, 23 September 2013

Five years after the crisis: the legacy

Five years have passed since the collapse of Lehman Brothers and the subsequent devastating blow to the financial system in the US, and the consequential spillover of the panic to the rest of the world. Lehman's bankruptcy in September 2008 was one of those events that could have brought down the entire world financial system. Fortunately or unfortunately (for some) it didn't, but the damage was devastating and the consequences are still present. The recovery has been slow and painful, especially with respect to all other post-war recoveries. Some put the blame entirely on the policymakers, where they either didn't do enough, or did too much (where the unit of value is the size of the stimulus). After the massive fiscal stimuli applied in the US and in many European countries during the downturn, in 2010 after the US crisis was officially over according to NBER, austerity kicked in. Austerity came primarily as a reaction to the doubling or tripling of debt to GDP ratios in some countries, in addition to a rising budget deficit, all of which were caused mainly by huge bank bailouts. However, the austerity applied wasn't the austerity based on spending cuts and structural reforms, it was austerity based on tax hikes and little or no real spending cuts. The superficial spending cuts combined with many tax hikes (in order to close the deficit) missed their real targets - interest groups and government cronies whose vast political concessions were among the causes of the crisis in peripheral Eurozone. They were all left untouched. The only ones that really lost out were the taxpayers, either by losing their jobs, losing their incomes, or bailing out banks. 

Today, September 2013, is all about anniversary "celebrations". As I've pointed out in my last week's text, all the major papers, the Economist (Free exchange), Financial TimesWall Street JournalNew York TimesBloomberg and many others have had their take on the lessons and the consequences of the crisis, reminiscing of the shambles during the days of Lehman's bankruptcy. I too will make a contribution, following the prequel from last week on the the housing bubble initiated by Fannie Mae and Freddie Mac.

Understanding the causes 

Going through some of the so-called lessons, I can see that many people still haven't learned what the actual causes of the crisis were. Too many arguments today are still clouded by ideological backlash trying to blame it all on the "banksters" whose greed made them take in more risk in order to achieve higher profits, in addition to years of low inflation and low interest rates. For example, a serious economist simply cannot make a statement like this: "Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities." (this is coming from The Economist, btw). 

I would like to see the research paper making a causal inference between greed and the purchase of dodgy securities. I seriously doubt the consistency and credibility of such a paper. European banks didn't buy into securities that were dodgy. These securities didn't turn out to be dodgy until the crisis had already started. 

During the time of collapse the media was full of stories about how the banks' balance sheets were filled with risky investments and that this kind of profit-seeking behaviour was unacceptable. Particularly since it's not their money to gamble with. The Marxists were awaken. However, what they failed to realize was that the vast majority of banks' balance sheets were made of previously AAA rated securities which included things like Greek debt on one hand, and MBSs on the other. This varies across different countries however, but the point is that banks did apply a fairly good risk diversification, where only a small share of assets were those of high risk, while in some cases over 90% were AAA-rated MBSs. As the housing bubble burst most of those MBSs made from sub-prime mortgages became junk (toxic). This happened to Lehman for example. Its leverage ratio was 30:1 at the time of bankruptcy. For others it was panic as their loses started growing exponentially. All of a sudden everyone realized that the entire system is inherently unstable. Investors panicked, and the rest is history. 

There is no doubt that the bankers had a big role in risk taking and there is no doubt they take a large share of the blame, but in order to get the big picture we need to understand the underlying factors a bit better. The crucial problem with the system at hand was the idea that risk can be eliminated. This is a huge fallacy and both the regulators and the bankers have succumbed to it. As the regulators were steering banks into "safe" assets like Greek debt or sub-prime mortgages, the bankers were foolish enough to believe that these assets were in fact safe (i.e. risk-free). There is no such thing as a zero-risk investment. Hopefully, we have learned that by now.  

Lessons, implications and open questions

The legacy of the crisis is a multitude of open questions and many opposing views as to what are the correct answers. First of all, there is the issue of justifying the bailouts. Their initiation is the key reason behind the sovereign debt crisis in Europe and debt sustainability in America. However many claim that their existence is justified as they helped prevent the panic of Lehman crash turning into another Great Depression. 

In retrospect, the clear market signal at the time was that the current patterns of production, specialization and trade have reached a point where change was necessary. This is why the recovery is lasting for so long. The market forces simply weren't allowed to restructure and point out to the new equilibrium in pre-crisis times. As things were going well and profits were rising, there was no question of interfering into the structural factors behind the rapid growth. In other words, there was no incentive to respond to the technological shocks and new market trends such as outsourcing. As the crisis started all of these problems suddenly surfaced and became evident to everyone. Except now it was too late for a gradual adjustment on the labour market. The adjustment came immediately, causing many people to lose their jobs. Currently the slow state of the recovery is in some way due to the slow process of adjustment by the firms and the demand for skills to the new equilibrium. This process will last even longer as governments are pushing it back, subject to increasing pressure from all those that are likely to lose out - such as public sector labour unions and workers in declining industries. 

The third issue is the safety of the global financial system. Are new regulations going to make the system safer than before? Isn't this exactly what pre-crisis regulation was aiming to do? Via Basel standards? Isn't it paradoxical that pre-crisis regulators whose sole purpose was to eliminate risk proved out to be the largest culprit in the crisis by encouraging banks to fill up their assets with MBSs or sovereign debt? With the pre-crisis system working perfectly according to many actors at the time, how do we know that new capital standards will do the trick today? Particularly if the regulators again try to steer bank asset into safer investments. I'm not saying regulators willingly do these kinds of things. They actually strive for the opposite. While they were recognizing MBSs as safe assets and encouraging banks to purchase them, they were under the impression this would help the system. But that's exactly the point. By striving to make the system stable, the regulators end up increasing systemic risk and fueling artificial demand that results in asset bubbles. By creating incentives to invest in certain types of assets, the regulators send distorted signals about the demand for these assets and hence distort its prices. They became victims of the asymmetry of information. 

Some countries had it even worse, where in addition to global forces and regulatory omissions, domestic political cronyism got involved. Spain for example had their political elites orchestrating regional banks' investments into politically favored projects, thus fueling the housing bubble. Others like Greece or Italy had political concessions cramp the welfare state. The stage for their collapse was set years before the actual crisis had started. Who can protect them from future failures? The current mechanism of the Eurozone has not only failed to prevent it, the introduction of the euro actually encouraged their instabilities

According to this another thing the crisis has taught us is that investors and banks can never be too careful. Especially when investing into sovereign debt, and when they blindly follow regulations. As for the euro, by now it's obvious to everyone it is irreversible, and that there will always be forces aiming to preserve it. This makes it a safe investment doesn't it? 

Finally, will crises like this one be possible in the future? Absolutely. Perhaps not in the same way and perhaps not that soon, but they are certainly possible. Accumulation of debt and high investments during good times, in combination with an artificial demand for assets causes booms and busts that congest the system. If this happens in the same time as a technological shock that changes the patterns of production and labour market specialization, then the bust becomes larger and the asset boom spreads across the real sector of the economy. The economy slowly and painfully grabs towards a new equilibrium, while during the process many of the ideological battlegrounds of economic theory reinvent themselves all over again. 

Friday, 20 September 2013

Graph of the week: World GDP

A quick overview into how global GDP is doing. From The Economist:

Source: The Economist Graphic Detail 
One obvious pattern on this graph is the overall decline of the pace of recovery, despite the growth rate increasing in the second quarter of 2013. Have in mind that the drivers of this higher growth rate were the rich countries, with the emerging markets experiencing a slowdown. The main "culprit" was the relative growth slowdown in China who alone used to contribute one third to global growth, while around 40% was coming from the rest of the emerging markets. Even the somewhat stronger recovery from the West isn't enough to push back global growth to the pre-crisis 4-5%, and substitute for the lost growth. With further emerging market decline being expected, global output is very likely to continue down this declining path, the same path the West is all too familiar with.

Tuesday, 17 September 2013

Why politicians don't cut spending?

A simple answer to this question comes from Learn Liberty in this short educational video.

(If the video doesn't work - some browsers could do that - 
 you can access it on You Tube.)

This here is Public Choice 101. (Btw, if you're interested, they also have an excellent explanation of the Median voter theorem, the centerpiece model of political economy). 

Lessons made in this short introductory video are actually the key principles of public choice theory and its economic analysis of politics. Since the voters are generally ignorant about the policies and the politicians they vote into office, and since they are too dispersed to organize as a group, they are unable to scrutinize their representatives more rigorously. On the other hand various interest groups representing a whole range of industries do have a strong incentive to organize and influence the political process via lobbying as their benefits are less dispersed when acting as a small, privileged group.

It pays off for an interest group to be well informed of the policies being implemented. Of course an interest group is only well informed of specific policies affecting them. The video mentions farm subsidies, but you can find a multitude of other examples. Any industry seeking protection from foreign competition is essentially an interest group attempting to lobby the government for favourable legislation to preserve their less efficient business. Of course a strong media campaign must support this to persuade the people that the government "must preserve our jobs". But not all interest groups operate under a public domain. Much more is being done behind the "revolving doors" in D.C.

And then we reach something called the Iron Triangle of the political process. It involves three parties: interest groups, politicians in power (or Congress) and the bureaucrats, where interest groups provide electoral support via their organized members to the politicians, who in return offer them friendly legislation through the bureaucrats (bureaucrats and Congress have a special relationship in itself - I wrote about it briefly). The Iron Triangle will explain to us why some laws get passed even though only a minority will support them and even though they could imply negative welfare (via tariffs, strict immigration laws, etc.). The answer is simple: interest groups are highly organized, while voters are rationally ignorant. The benefit of an interest group member is highly concentrated and it pays off for them to organize, while the same cannot be said for a large group such as the voters.

Olson's theory of collective action 

The cornerstone in the research on interest group formation was done by a brilliant political economist, Mancur Olson (one of my personal favourites, and one who, I think, deserves much more praise for his work). His theory of collective action was one of the seminal contributions of what later turned out to be a new field of public choice theory. Olson's influence on the field was as much as Coase's on new institutional economics - pivotal.

In his first and most popular book "The Logic of Collective Action" Olson stated:
"It does not follow, because all of the individuals in a group would gain if they achieved their group objective, that they would act to achieve that objective, even if they are all rational and self-interested. Indeed, unless the number of individuals in a group is quite small, or unless there is coercion [or some other commitment device], rational, self interested individuals will not act to achieve their common or group interest."
Because individuals do have an incentive to free ride, individually rational outcomes will lead to collectively irrational ones. Olson's theory of groups builds upon this crucial insight. He defines small, privileged groups on one hand, where voluntary provision of public goods occurs by one member or a sub-group of members, as the benefits of provision outweigh the cost to those members. On the other hand latent, dispersed groups are those in which voluntary provision does not occur due to too much free riding. Larger groups will fail to mobilize common interests for three reasons: (i) individual contributions are made irrelevant, (ii) there is the problem of enforcement and no social control (anonymity of members) and (iii) organization costs are too large. Smaller groups don't have these problems, particularly those more homogenous and those with many common interests. This is why small groups are able to solve the public good allocation problem. 

For those who know the work of Elinor Ostrom this will all sound familiar. Elinor's Nobel prize winning work builds upon Olson's theory in which she proves the possibility of cooperation without free riding but only in groups small enough to have social ties which will ensure that gains of cooperation will outmatch those of self-interested behaviour. These are groups which via continuous interactions and networking build a lot of social capital - think of a family unit. 

But it can go well beyond that. For example, consumers are a latent group, while producers are a privileged group. We as consumers cannot do anything if the prices of food, gas, cars or clothes go up. But the industries producing those goods can make sure that their prices stay up. They can keep competitors out (both foreign and domestic), they can lobby the government to provide them subsidies, they can demand favourable legislation etc. And in the end its the customers who lose out as we have to pay a higher price. Another example of a privileged group are labour unions. The unemployed are a dispersed  group. Labour unions can organize themselves into an interest group and lobby the government for more protection of their own jobs. They can basically use their lobbying power to keep non-members out of jobs. This disadvantages the unemployed but they can't do anything about it since they lack the incentive to organize as a group. The story is again very simple: when benefits are highly concentrated it pays off to organize as a group. When it doesn't, when a group is too large, it will lose out. 

Thursday, 12 September 2013

Back from the dead: Here come Fannie and Freddie

In a series of texts on the 5 year "anniversary" of the financial crisis (see among others the Economist, Financial Times, Wall Street Journal, New York TimesBloomberg), many commentators and economists are reminiscing on the panic that surrounded the world of finance at the time following the infamous bankruptcy of Lehman Brothers. More importantly they are all drawing lessons for today, evaluating how far we have gone from the crash and how much we have learned. I was planning on making a few of my own contributions to mark the troublesome events from the fourth quarter of 2008, and I will start by looking at where Fannie Mae and Freddie Mac, those two "evil" Congress-led, HUD goal-obliging, government-sponsored enterprises are today. Financial Times has the numbers stating that 5 years after their $189bn government bailout Fannie and Freddie are actually quite profitable. 

As the US housing market is recovering from its arguably worst slump in history, many cities are experiencing large increases of housing prices which are significantly improving the health of domestic financial institutions, in particular the mortgage giants Fannie Mae and Freddie Mac.

The pivotal role in the housing bubble

To reminiscent, the role these two government sponsored enterprises had in the crisis was somewhat pivotal. I covered this in my paper on the financial crisis published two years ago. Basically, Fannie and Freddie had a distinguished goal of purchasing mortgage loans from banks on the sub-prime mortgage market. They then either kept these loans as a monthly source of revenue or decided to repackage them into a big, allegedly risk diversified security know as a mortgage-backed security (MBS) and sold it on the market. On the other side of the bargain were banks (both commercial and investment) which filled up their balance sheets with these allegedly zero-risk securities, all in accordance with the so called recourse rule which encouraged private banks to purchase MBSs in order to diversify their risk. A legitimate goal, but the only problem was that MBSs were not a zero-risk asset (no asset is), just like Greek sovereign debt in reality wasn't a zero-risk AAA rated asset. This didn't stop the regulators to encourage the purchases and creation of such assets, nor did it stop the banks from buying them. And why should it? They were all under the impression that they were doing a beneficial thing - the regulators thought they were decreasing risk, while the banks were earning a great profit on such low cost assets. The problem was the artificial demand created on the market for MBSs. Since the banks saw them as a profitable opportunity, and the regulators encouraged this, there was an ongoing pressure for creating more and more of such assets, thus increasing the demand as well as their price. And who created these assets? Our heroes: Fannie and Freddie. They are the ones that used the huge amount of sub-prime loans at their disposal to repackage them into giant MBSs. 

But why, one might ask. Why did Fannie and Freddie have all these sub-prime loans? At the onset of the crisis, Fannie and Freddie have acquired half of all low and moderate income mortgage loans (these are referred to as sub-prime loans), according to the Housing and Urban Department (HUD). However it was the HUD whose target goals Fannie and Freddie were following. A report from the HUD clearly states that F&F had to achieve a joint presence on all of the sub-prime mortgage loan markets at over 50%. And they did this. They have accomplished their goals. The problem was that while doing so they initiated a huge negative spiral of artificial demand for MBSs, which was further fueled by regulator rules such as the aforementioned recourse rule, and faulty risk estimates coming from the rating agencies. 

Finally, the central argument against the very existence of F&F came from none other than Alan Greenspan, Fed Chairman at the time, a few years before the crisis had started. In addition to his warnings on their riskiness, his argument was that GSEs haven't even been able to decrease interest rates for middle-class home buyers, the central justification they always gave for their existence.

The epilogue was a $189bn bailout by the Treasury, entering them in the category of "too big to fail". 

Five years later

Source: FT
Five years later, Fannie and Freddie went from hanging on a thread of bankruptcy and a potentially huge burden on US taxpayers in the years to come, to bouncing back as source of revenues for the Treasury, reporting a profit of $10bn for Fannie and $5bn for Freddie. Fannie was able to return a total of $105.3bn in dividends to the taxpayers, falling only a bit short of the $117bn of bailout funds given to it. In total the GSEs have jointly accumulated $146.2bn that they have returned to the Treasury, being only a few quarters away from repaying the full $189.4bn bailout bill. The reason for their extraordinary good results was primarily an increase in house prices on the recovering US housing market which consequently reduced their loss reserves.

Those investors brave enough to buy into Fannie and Freddie's preferred stocks in 2009 are relishing at this news. Their risk has paid off. They were betting that the housing market will eventually regain strength and thus enable the GSEs to start rolling profits once more. The justification of such a strategy was that Fannie and Freddie were given far more bailout funds than needed to cover their short-term losses. Apparently, they were right. 

Even though by the end of 2008, Fannie and Freddie certainly were in desperate need for liquidity, the total amount of money they needed was based on underestimating the relatively pacey recovery of the housing market. This is easy to say today, but with the overall panic at the time the Treasury apparently didn't want to take any chances.

However the investors aren't all that happy since an decision has been made last year by the Treasury where all new profits are going back to the taxpayers in the form of dividend payments. This wasn't part of the deal in the 2008 bailout, and is hurting the investors. Basically, the Treasury has decided to sweep in all future profits that the GSEs have made. However since the profits are being denoted as dividends, not repayments, this still means that Fannie and Freddie haven't really payed off the debt. In legal terms that is. Which is why the investors are worried, and lawsuits are underway. After all, their argument is that since they are the shareholders of the preferred stocks, they have the rightful claim over the profits of the GSEs. 

This isn't the only thing worrying the investors. There is ample desire for reforming and even abolishing the GSEs. President Obama has given support to replacing the agencies with a new one that has a much more limited role on the market and that will hopefully transfer some of the risk back to the private sector. However with the recent numbers and the recovery on the housing market, the plea for reforms will probably end up with only a few changes, and will hardly be a fully pledged overhaul as many were announcing. 

Life is still uncertain for Fannie and Freddie. After a turbulent period where they went from being accused as the sole culprit for the housing bubble burst, and after being bailed out by the Treasury, they managed to become the net contributors to the budget, having yet to survive attempts of reform. They seem to be riding out the storm pretty well at the moment due to their good numbers and a favorable market, but the question is how long this will last, and even more importantly how much more sub-prime mortgages can they acquire in the mean time. 

Monday, 9 September 2013

Graph of the week: how much for a house in Beijing?

Did you know that the prices of housing units in Beijing are higher than those in Manhattan? Could the reason for this be the lack of supply of land (as it is in Manhattan)? Or is it due to speculation that's even further fueling the Chinese housing boom

The last scenario might be more suitable to explain the situation. The Chinese are, like the Americans 10 years ago, and the Japanese 30 years ago, "flipping houses", to use the popular term. 

And here is the result:

Source: Quartz
The graph represents growth rates of housing prices in 4 major Chinese cities. Land parcels are being sold for record prices. In Beijing $1100 was paid for a square foot of a residential parcel (compared to Manhattan's average of $323, with the highest bid being $800). Other cities have also experienced a rapid recent growth in real estate prices and land for commercial use. The logical explanation would be that supply is scarce so land prices must go up. This could be true since some cities have applied tougher restrictions on the housing market to discourage speculators. But it is the speculation on the market that is more likely to be driving the rapid price increases:
"...Especially in big cities, apartments are often seen as investment vehicles more than as homesteads. For instance, even though swanky high-rises are getting more expensive in Beijing, their sales in smaller cities are flagging, suggesting that genuine demand is weak. As Bank of America-Merrill Lynch’s China strategy team noted in March, “China is building too many housing units too fast.” Per capita housing stock, they note, hit 35 sq m in 2011, and is rising by 1.2 sq m a year, putting China in the same league as many wealthy countries..."  
"... oversupply is already hitting smaller cities, and as demand flags, prices have started to fall. If that fall becomes severe enough to make developers run short of cash, they may discount their inventories in larger cities and cause prices to suffer there too.

If house values fall that could be bad news for China’s financial system, because people frequently use property as collateral. But the greatest impact will be on local governments, many of which now have colossal debt burdens as a result of stimulus spending. Largely unable to issue their own debt because of central government restrictions, local governments depend on selling land ... for revenue. In 2011, those sales accounted for more than 60% of local government revenue."
A few closing points on inequality 

Btw, with such high numbers being pushed around I can't shake of the fact that inequality is much worse in China than in the US for example. The people on the bottom, working in Western owned factories are working for 4$ a day (these aren't actually people on the income bottom, but let's assume for the sake of the argument that they are), while on the other hand those who can afford to buy real estate in Beijing or Shanghai simply to turn a profit by filliping them are surely much, much more better off. It is actually true that China's inequality problem is getting bigger. Funny for a country claiming to be socialist, isn't it? If you still believe that story, that is.

Bottom line, "state capitalism", to borrow the term the Economist used last year to describe the system of the new emerging markets, isn't really too helpful in lowering inequality. Just look at other examples of state capitalism such as India, Brazil or Russia. And these are the good ones. State capitalism's primary purpose isn't wealth creation - it's making sure that all these new wealth creating activities don't threaten the power of the ruling elites. 

Finally, it's not state redistribution that can solve the issue of inequality in emerging nations, especially if the very state is trapped by cronyism. Only inclusive institutions combined with high levels of social mobility can do that. 

Wednesday, 4 September 2013

In memoriam: Ronald Coase

Yesterday, at the incredible age of 103, one of the greatest minds of our time, Nobel prize winner and emeritus professor at University of Chicago Law School Ronald Coase has passed away. 

His contributions as well as his influence to the economic science are monumental. His groundbreaking research has set the stage for a joint field of law and economics, and has also influenced the new institutional revolution in addition to a number of other fields and areas of research in economic theory. It would be unfair to say he only made two major contributions since both of these (written 23 years apart from one another) not only won him the Nobel prize, but have continued to influence the economic science ever since. The first was his 1937 paper "The Nature of the Firm" (downloadable) where he introduced the concept of transaction costs in microeconomic analysis. He believed that firms exists because they economize on transaction costs - costs like market entry, acquiring information, managing a company, bargaining, etc. If these individual transactions can be reduced into fewer transactions by organizing a hierarchical body then entrepreneurs will form firms. With microeconomic theory at the time focusing only on production and transportation costs, Coase's inclusion of transaction costs was a breath of fresh air into the science. However, in 2009 Coase said he was surprised how much The Nature of the Firm was being cited since it was "little more than an undergraduate essay".

The second was his 1960 paper "The Problem of Social Cost" (downloadable), widely considered to be the seminal contribution to the joint field of law and economics. It is from this paper that the Coase theorem was later developed (it was Stigler who actually coined the phrase "Coase theorem"). In the Problem of Social Cost Coase examines how a cost imposed on society by an individual firm (an externality such as pollution) can be solved by mutual negotiation and consent if transaction costs are zero and if property rights are well-defined. This idea was subject to vast misinterpretation, which Coase tried to make more clear in his subsequent interviews and texts. He later stated about the theorem: “All it says is that the people will use resources in the way that produces the most value, that’s all ... I still think it’s an obvious point. You wouldn't think there was a need for a Coase Theorem, really.”

The path to greatness 

Born in a London suburb, he received his BA from the London School of Economics in 1932 and was a member of staff at LSE from 1935 until 1951 (the same time Hayek was there). During his student times he spent a year in the US as a travelling scholar where he observed the American automobile industry. It was from this experience that he got the ideas for "The Nature of the Firm". His becoming of an economist was pure luck, as he himself admitted, since he wasn't interested in economics until he met Sir Arnold Plant on his final year who introduced him to Adam Smith's invisible hand and explained to him the coordination mechanism of the price system. It is also interesting that at the time Coase was more of a socialist, as he wondered why do people think Lenin is wrong to say a government can be centrally run like a big firm such as Ford or General Motors (Lenin used the Deutsche Post to make his point). In answering this question he developed the crucial insight about why firms are formed. Even though firms are like centrally planned economies they are, unlike the governments, formed by people's voluntary choices, and are governed by the price mechanism. The cost of using the market induces people to make the choice of forming a firm to lower this cost, which leads to the most efficient production processes taking place within a firm, not a government.  
During WWII he worked for the Central Statistical Office of the War Cabinet in London, an experience he cherished as he saw how large organizations tend to operate. He left LSE in 1951 first to join the University of Buffalo, and then the University of Virginia in 1958 (Buchanan and Tullock were there at the time). While working in Virginia he studied the Federal Communication Commission's allocation of radio frequencies. In his 1959 article (jstor) he suggested the Commission should sell the frequencies to the highest bidders in order to solve the externality problem. It is here where he first suggested that with well-defined property rights radio spectrum could be allocated in the market just like any other good. It wasn't until 1994 that his suggestions were actually implemented. What is interesting about this article is that he presented it to a group of economists from the University of Chicago including Nobel prize winners George Stigler and Milton Friedman, trying to persuade them that if property rights were properly defined market actors would yield an efficient solution. George Stigler recollects on that night: 
“We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument, the vote went from 21 against and one for Coase to 21 for Coase. What an exhilarating event! I lamented afterward that we had not had the clairvoyance to tape it.”
It was from this anecdote that "The Problem of Social Cost" was written. Coase was hired by the University of Chicago in 1964. In 1965 he became the editor of the Journal of Law and Economics, a position he occupied until 1982. It is believed that under his leadership the journal achieved its influential status. Coase himself said that he used the journal to create a new subject, which he was successful at. Not to mention that in this process he has influenced the creation of many others. Oliver Williamson and Douglas North (both Nobel prize winners) on several occasions pinpoint Coase as their major influence behind the new institutional revolution. In 1991 Coase received a Nobel prize in economics "for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy." 

As all great economists Coase was active and fully engaged in his work until the very last day. Just like Elinor Ostrom who graded PhD papers on her deathbed, or Paul Samuelson who wrote op-eds just a few weeks before he passed away. In his last years he shifted his attention to China, which culminated in a co-authored book in 2011 (at the age of 101) entitled "How China Became Capitalist" (with Nina Wang). In the book the authors claim that the Chinese transition wasn't because of deliberate actions of the communist party, but small, marginal changes in society. They dubbed China the product of human action, but not human design, as "China became capitalist while it was trying to modernize socialism". Not since Milton Friedman was there a more respected Western economist in China. 

Perhaps the best description of Coase as a person as well as the essence of his work was summarized by Gary Becker: "Coase didn't say a lot, but I began to realize that every time he did say something, it was really profound."

Misinterpreting the Coase theorem

The simplest interpretation of the Coase theorem is that individuals can resolve their disputes in their best interest without the need for government intervention, assuming no transaction or bargaining costs. However since transaction costs do indeed exist, there is a need for government to lower these costs via an efficient institutional design and properly defined property rights. In other words, courts and efficient institutions are necessary to solve disputes. But not laws that for example prevent smoking, or Pigouvian taxation of externalities like pollution. The right to create social cost like pollution or smoking would simply end up in the hands of those who value it the most. Consider the following example that Coase himself has noted. A confectioner has machines that when operating shake the office of a nearby doctor thus disabling him from performing delicate examinations. The answer is not to enforce a government regulation to render the confectioner out of business. If the value of the machines to the confectioner is higher than the harm imposed on the doctor then there is scope for a mutually beneficial agreement of a payment (compensation) from the confectioner to the doctor for using the machine. It works the other way around as well - if the doctor's work is valued more than the confectioner's, he can make payments to the confectioner to stop production during his work. Another example is a factory whose pollution imposes costs on a dry cleaning business. If the factory owner values his production more than what the dry cleaner values his, he can simply pay him the cost he's imposing onto him.

Coase wasn't trying to describe a perfect world without transaction costs (he actually resented such inapplicable economic analysis), but rather make it clear what the role of transaction costs is in designing the institutions of an economic system. The theorem is actually a great showcase of the real world - a world full of transactions, bargaining and choices not only constrained by budgets but by the design of an institutional system within which these choices are made. It is the real world where the Coase theorem has found many of its applications. An example I always think of is the hunting of elephants in Kenya and Botswana. While in Kenya poaching was banned in order to save elephants from extinction, in Botswana local farmers were given property rights to elephant herds. The ownership of elephant herds would incentivise the farmers to preserve their long term value. As a result in Kenya, which applied the ban on hunting, since the 1970s the amount of elephants has dropped from 140,000 to only 16,000 today, while in Botswana their number has grown from 20,000 to 68,000. 

Apart from the externalities problem Coase also had a few things to say about public goods. In his 1974 paper "The Lighthouse in Economics" he challenged the classical a priori view that a lighthouse is a typical example of a public good that cannot be provided by the private sector at a profit. He showed that in 19th century Britain all lighthouses were privately provided and charged ships for their use as they entered the port. 

The legacy

Finally, from the Institute bearing his name, a closing point: 
"Coase was critical of economics for being static and preoccupied with formalizing concepts that date back to Adam Smith. He believed that the goal of economists should be to change fundamentally the way we look at a problem. This goal was part of the inspiration behind the Ronald Coase Institute, which a group of scholars formed with Ronald Coase in 2000 to assist young scholars whose research has the potential to help transform their economies. Coase’s support for these young scholars was an act of generosity illustrative of a lifetime of scholarly generosity and confidence in the power of ideas. Ronald Coase himself was an outstanding example of an economist who changed fundamentally the way we think about problems, and the impact of his ideas continues strong today."
Here is a list of some of his most notable writings (a full list of publications can be found here):

1937. "The Nature of the Firm." Economica 4 (November): 386–405.
1938. "Business Organization and the Accountant." Reprinted in James M. Buchanan and G. F. Thirlby, eds., L.S.E. Essays on Cost. London: Weidenfeld and Nicolson, 1973.
1959. "The Federal Communications Commission." Journal of Law and Economics 2 (October): 1–40.
1960. "The Problem of Social Cost." Journal of Law and Economics 3 (October): 1–44.
1972. "Durability and Monopoly."  Journal of Law and Economics 15 (1) : 143-149.
1974. "The Lighthouse in Economics." Journal of Law and Economics 17 (2): 357–376.
1992. "The Institutional Structure of Production." American Economic Review 82(4): 713-719. (Nobel Prize lecture)

And these two books that reprint some of his most important work:

1988. The Firm, the Market, and the Law. University of Chicago Press, Chicago.
1994. Essays on Economics and Economists. University of Chicago Press, Chicago.

Monday, 2 September 2013

India's new central banker

Raghuram Rajan, a notable economist from the University of Chicago and author of the famous "Faulty Lines" book on the financial crisis, is to be appointed as the new governor of the Bank of India. Certainly a role he's more than capable of. He joins a whole line of notable academic economists that ended up in policy - such as Stanley Fisher in the Bank of Izrael, Ben Bernanke in the Fed, Joe Stiglitz in the World Bank, Christina Romer, Larry Summers (also a potential Fed governor), Timothy Geithner, Greg Mankiw and a whole number of others at the Council of Economic Advisers (which isn't really that surprising). Some of these were more successful at their policy roles, some less, but they all proved the importance of having a renowned academic expert (say, a technocrat) to give advice or directly control some of the nations main economic institutions. I have no doubt that prof. Rajan will be successful in his position. After all, the pressure in India will probably be much less than at any US policy institution, despite the troublesome economic climate. On that line, here is a list of countries who should take note - countries which have a lot of world renowned scientists working abroad who would be more than successful in improving the efficiency of their domestic economies. Italy and Greece already tried it, but their electorates have failed them. 

Anyway, the current state of India's economy is troublesome. Despite a decade of strong economic growth, it accumulated a record current account deficit, is facing a high inflation, a plunging currency (the rupee is off 20 percent against the dollar making imported food and oil more expensive), with economic growth slowing down threatening to downgrade the government's bond rating. The Central bank earlier this year cut rates which further weakened the rupee, only to raise them back in July. A tricky situation indeed, where more aggressive Central bank stance on inflation and the currency will further cripple domestic economic growth.

Source: Bloomberg
Will Rajan be able to cope with all this? A few months ago he wrote an article for Project Syndicate, precisely identifying the problems India is facing right now. The first problem, he claims, are India's poor institutions and poorly defined property rights:
" factories and mines require land. But land is often held by small farmers or inhabited by tribal groups, who have neither clear and clean title nor the information and capability to deal on equal terms with a developer or corporate acquirer. Not surprisingly, farmers and tribal groups often felt exploited as savvy buyers purchased their land for a pittance and resold it for a fortune. And the compensation that poor farmers did receive did not go very far; having sold their primary means of earning income, they then faced a steep rise in the local cost of living, owing to development. 
...strong growth tests economic institutions’ capacity to cope, and India’s were found lacking. Its land titling was fragmented, the laws governing land acquisition were archaic, and the process of rezoning land for industrial use was non-transparent. 
...because India’s existing economic institutions could not cope with strong growth, its political checks and balances started kicking in to prevent further damage, and growth slowed."
The second problem was the financial crisis and a slow recovery in the developed world that triggered problems for emerging markets and their 2009 short term stimuli: 
" industrial countries, beset by fiscal, sovereign-debt, and banking problems, slowed once again, the fix for emerging markets turned out to be only temporary. To offset the collapse in demand from industrial countries, they had stimulated domestic demand. But domestic demand did not call for the same goods, and the goods that were locally demanded were already in short supply before the crisis. The net result was overheating – asset-price booms and inflation across the emerging world.
In India, matters were aggravated by the investment slowdown that began as political opposition to unbridled development emerged. The resulting supply constraints exacerbated inflation. So, even as growth slowed, the central bank raised interest rates in order to rebalance demand and the available supply, causing the economy to slow further."
Rajan also offers his own idea of a "quick fix":
"To revive growth in the short run, India must improve supply, which means shifting from consumption to investment. And it must do so by creating new, transparent institutions and processes, which would limit adverse political reaction. Over the medium term, it must take an axe to the thicket of unwieldy regulations that make businesses so dependent on an agile and cooperative bureaucracy."
So, he suggests an institutional and political reform coupled with supply-side policies aiming to shift the focus towards savings and investments. Great stuff. However none of these factors will be his to influence. His role is to get a grip on inflation and the declining rupee, and hope he won't hurt growth too much. Good luck!