Thursday, 31 October 2013

Doing business

The newest Doing Business Report 2014 once again sheds light on where in the world opening and owning a business is a welcomed venture, and where you would be better of not being in the private sector at all. 

The report is an annual World Bank publication comparing countries in 10 different areas of business regulations such as starting a business, resolving insolvency, getting licences and permits, and even credit availability. It ranks countries based on the ease of starting and handling a business, thereby painting a picture to investors as to which country is more open for investments, i.e. more business friendly. For lower-income countries specific policies aimed at lowering the regulatory burden on businesses will ensure they rise high on the rankings, while for high-income countries, the relative strength of their institutional environment will still keep them on top, despite some of their policies being less business friendly than expected. 

For example, in my Adam Smith Institute report published last year, there is a series of policies aimed at releasing some of the burdens that still worry a lot of UK business owners, particularly the small and medium sized ones. They were (and still are) concerned about high National Insurance Contributions (NIC), unfair dismissal laws, an increase of business rates, new regulation coming from the EU, and of course credit availability. However, despite these problems (and some others), the UK still offers a favourable business environment where a lot of entrepreneurs would be happy to start and register a company. And they do. London tends to be a very attractive start-up destination for many European entrepreneurs, particularly those from Eastern Europe. And this is all because of the relative strength of UK's institutions, and the fact that London's financial superpower position makes it attractive to search for funding. So despite many UK SME business-owners worried about the scope and size of many regulatory constraints, the UK still manages to attract many new business ventures who will, despite facing the same problems, still rather chose the stability and strength of the UK economy to fulfill their ideas, than having to deal with the relatively inefficient domestic institutions (wherever they come from).

Top of the pops 

So who's topping this year's list (data collected from June 2012 to May 2013)? Singapore and Hong Kong are still holding firmly to the first two positions. Followed by New Zealand, United States, Denmark, Malaysia, Korea (South obviously), Georgia, Norway, United Kingdom, Australia, and the rest of Scandinavians (Finland, Iceland, Sweden). The two unusual inclusions, Malaysia and Georgia, are recognized for the pace and efficiency of their regulatory reforms. Judging by this alone, in the long run these countries are likely to excel very rapidly and thus quickly bridge the gap with the developed economies. Good luck to them, as I can only say they are on the right track. Some other positive examples loom, such as Mauritius (#20), Macedonia (#25), Rwanda (#32) (recall this positive example from Rwanda), Armenia (#37), Montenegro (#44) etc. None of these countries are "paradises", but they are all making the step in the right direction. For example Rwanda (along with Ukraine) implemented the largest amount of reforms in the observed period that reduced costs and complexity for businesses (a total of 8). Along with Rwanda and Ukraine, the positive movers in terms of implemented reforms were Russia, Philippines, Kosovo, Djibouti, Ivory Cost, Burundi, Macedonia and Guatemala. 

In total, 114 economies implemented 238 regulatory reforms aimed to ease the regulatory burden in their domestic economies. A positive trend indeed. This produced the second highest number of reforms since 2009. I guess for many countries it was now or never, even though the pace of reforms in a lot of these countries is still too slow. However, the good news is that low-income countries are narrowing the gap with the high-income ones. Their logic is rather simple; since their institutional environment is still rather weak, and since their stability is questionable, the only way to attract foreign investments is to deregulate the business environment. As more investment is being brought in, it is likely to pull the country out of its poverty trap and create scope for refining the existing institutional environment and hence achieving higher levels of prosperity. Of course the initial push is necessary, and it consist of an initial set of institutional reforms that all these countries are in fact doing. This is the best way to ignite the positive reinforcement mechanism.

Closing the gap

However, the current comparison between rich and poor countries still infers a wide gap (see graph below). The rich OECD countries perform better at every category tested (on average), with the largest gap being in resolving insolvency and trading across borders. In order for the developing economies to truly catch up they need to at least equate the average OECD business freedom levels.
Source: The Economist. Doing Business Report 2014
This means there is still a lot of work to be done, as reformer countries tend to be more successful in some areas but terrible in others. The Economists cites the example of Azerbaijan which ranks in the top 15 easiest to register property, and simultaneously the worst 15 for getting construction permits. Areas like those are still the source of high corruption and vested interests, and this is actually where the reforms should start. 

In conclusion, the report works wonders in at least partially explaining the institutional difference between countries. I would say it suggest of a negative reinforcement mechanism between poor institutions and poor performance, as the worse off the domestic institutional environment, the harder it is to reform it. On the other hand it suggest of a strong positive reinforcement mechanism where countries which were quicker and more successful to reform, managed to create better growth opportunities for the private sector. Policymakers worldwide should take note of this. 

Monday, 28 October 2013

Taleb's antifragility and pseudostability

Nassim Nicholas Taleb, most famous for his bestselling brilliant book "The Black Swan", published a new book last year - "Antifragile: Things That Gain from Disorder", where he presents a rather interesting argument. I haven't read the new book yet (I intend to), but I came across two interviews he did for Financial Times presenting his argument. 

His main point is on political volatility. If I were to ask you a question: "Which country is going to be better of in the future - the one characterized by more political volatility or the one with more political stability?", what would you answer? The first though that comes to mind is that stability is inherently good. But according to Taleb this need not always be the case. 

If one approaches this question through the democracy vs autocracy debate, where democracies will always carry more political volatility than autocracies, then the argument makes much more sense. A democratic system, with all its flaws, always comes superior to an autocracy particularly because of its volatility and accountability. Due to its economic and political inclusivness it ensures persistent innovation and technological progress and it is a system of everlasting change. On the other hand, an autocracy is an overstabilized system where the rule of one dynasty or party for decades makes the system too fragile. A closed system with limited, state-driven innovation can never hold on for too long (the Soviet Union is a perfect example, but so are many other modern dictatorships, particularly those destabilized by the Arab Spring). 

Taleb's intuitive point is that autocracies (overstabilized systems) in times of systemic collapse have no idea what to do or how to react. Its people cannot anticipate the consequences as they've never experienced such a situation. This in turn leads to a perpetuating crises of consolidation. The most recent example he cites is Syria, but predicts the same thing happening to Saudi Arabia, which tends to keep smoothing out their real problems instead of dealing with them, and is thus only achieving "pseudostability". 

A digression: Chinese pseudostability

Speaking of pseudostability and artificial smoothing, China tends to fit the framework quite similarly to Saudi Arabia. However, I don't think the reaction in China will be a complete regime collapse after the inevitable bubble burst. Why? The mere size of the economy and the composition of savings. If the Chinese start spending money and consuming, they are likely to be pulled out of an AD crisis much faster than the West. The difference is that unlike the Americans and the Europeans, the Chinese save a lot (savings rate of 50% compared to the global average of 20%). They are a traditionalist, savings society, unlike a consumerist society of the West. When an AD shock hits the US, one cannot expect consumption to pull it out on its own, as most of US consumption is based on credit. In China, high savings already imply that consumption is low (investments are the biggest contributor to Chinese GDP growth), so during a strong AD shock all the government needs to do is convince people to start spending. With a one party rule, I assume this wouldn't be too hard. However, there is still reason to be worried, as Japan had almost all the similar characteristics to China at the time of its biggest rise, only to see it all fade away during a 20-year-long stagnation.

Systemic fragility solved by more decentralization 

Going back to Taleb after this brief digression, in the first video he touches upon the legacy of the crisis. He claims that the system is much more fragile today than it was before. Why? A healthy system allows for fluctuations and improves upon the errors made. When the policymakers in the US and Europe decided to bail out the "too big to fail" banks, they failed to punish those who made mistakes. The socialization of investment banking mistakes sent the wrong signals to the market, making the whole system more prone to failure in times to come. The moral hazard implication is huge, as there is nothing to prevent the bankers from making the same mistakes in a few years time. Particularly as many of the big banks became even larger. Their failure will always threaten the stability of the system which is why their collapse will continue to be avoided by pumping in the taxpayer's money. 

The consequence is huge public debt. Taleb rightfully recognizes that the large post-crisis debt came as a result of massive bank bailouts. And according to him high debt makes the system more fragile and unstable than ever.  

His solution to make the system more robust to fat tail (black swan) events is more decentralization. Mistakes should, according to Taleb, be made locally, rather than nationally. Their cross-country distribution makes sure that they stay constrained within the local community and thus never threaten the overall systemic stability. 

Debt should be managed the same way - locally rather than nationally. He cites Switzerland as an example of such a system, claiming that the people tend to be more responsible with local debt and local public finances than national ones. However this operates under the assumption that political variation is higher in local politics than on the national level. I disagree, as many local areas are characterized by a long-lasting one-party rule. Such communities are perfect examples of the aforementioned pseudostability. There is something appealing in Taleb's decentralization argument, but I wouldn't hold on to it as the key to solving the debt problem. 

I guess I have to read the book now.

Thursday, 24 October 2013

"Yes, Economics is a science, but many economists are not scientists!"

This title is actually taken from Paul Krugman. For once I agree with him.

Krugman's blog came as a response to a great text by this year's John Bates Clark medal recipient Raj Chetty from Harvard. Chetty wrote a column for the New York Times this weekend where he defended the field of economics on the basis of its scientific rigor. His text came as a reaction to many non-economists questioning the recent Nobel prize being awarded to two opposing theorists explaining the same phenomenon (Fama and Shiller), but also (I believe) to a series of texts about economics and philosophy started in the NYT back in August, initiated by two philosophers Alex Rosenberg and Tyler Curtain writing a text called "What is Economics Good For?". Their main resentment towards economics is the imprecision in its predictive abilities. Or in other words, economics, with all its new modern analytical tools, not only couldn't predict the crisis, but is also failing to solve it. This caused a series of immediate reactions from many notable names including Krugman, Vernon Smith, Eric Maskin, and a number of others that carried on the debate. The debate actually never stopped since the origination of the financial crisis, when many wondered why economists couldn't have predicted neither the severity nor the length of the crisis. Its ambivalence over what the actual causes were, and consequentially what the best solutions could be are only causing further discomfort to the field.  

But luckily, many of those who did step in and defend the field handed in some pretty persuasive arguments. Maskin made a good point in saying that prediction isn't everything, comparing economic predictions to those of seismology or meteorology, where neither of the two can be a 100% accurate in predicting when an earthquake is going to occur or whether or not we're in for a sunny day or a rainy day. Economics is more about explanation. Just like any social science, it will never make perfect predictions, but it will provide us with a detailed understanding of many phenomena. How does this differ from every other science? Can medicine be absolutely sure in the effectiveness of one treatment method over another? No. At least not with a 100% certainty. But no one ever questions the scientific methods behind medicine. And rightfully so. 

Chetty draws an interesting parallel with medicine:
"It is true that the answers to many “big picture” macroeconomic questions — like the causes of recessions or the determinants of growth — remain elusive. But in this respect, the challenges faced by economists are no different from those encountered in medicine and public health. Health researchers have worked for more than a century to understand the “big picture” questions of how diet and lifestyle affect health and aging, yet they still do not have a full scientific understanding of these connections. Some studies tell us to consume more coffee, wine and chocolate; others recommend the opposite. But few people would argue that medicine should not be approached as a science or that doctors should not make decisions based on the best available evidence."
The proper usage of models

Economic models used for making predictions also raise many eyebrows from the regular folks. But economic models are just that - models. An approximation or better yet, a simplification of reality, not meant to be perfectly applicable, since all aspects of a complex environment cannot be included in a model (they are determined exogenously, i.e. outside the model - a crisis is a good example of such an unanticipated, exogenous shock).

Models operate under a delicate trade-off between complexity and applicability. If you make them too complex by trying to include too much stuff in there (culture, socio-economic preferences, informal institutions, etc.), you end up getting very little predictability. If on the other hand you make them too simple, you again get low applicability. The key is to reach some satisfactory level of complexity so that you can maximize the predictability and applicability of a model (almost like a Laffer curve). But in neither scenario does it imply a perfect mechanism for making predictions. Their purpose is to design a hypothesis which needs to be tested empirically and/or defended theoretically - so in both cases it requires a scientific method to support it. 

A social science  

Empirical methods in economics are not as robust as those done in say, physics. Take this example; before being sure that the researchers at CERN have actually discovered the Higgs boson, they wanted to be sure up to a 6 sigma standard deviation, i.e. at a margin of error of 0.0001%, while for economists, anything between a 1% to 5% margin is good enough (this is the so called statistical significance used in econometrics). So even though economics is less precise, this has a lot to do with the fact that economic social experiments are much harder to do in the real world. As Chetty says, one cannot perpetuate financial crises over and over just to learn how to solve them. Unlike natural sciences, here we're actually messing with peoples' lives. But one can actually do economic policy related experiments thereby testing the efficiency of a certain policy, as Chetty notices. All one needs to do is make an experiment with one treatment group and one control group in order to examine the effects of a particular policy on the treatment group, and how their behaviour or actions differ from those of the control group. This is how we capture the causal effect (the average treatment effect on the treated). 

Apart from policy experiments, one can also use economics to establish monetary or fiscal policy rules, like the Taylor rule (which was abandoned in the pre-crisis decade, mostly because of a need to respond to the 2001 IT bubble when the Fed created scope for the housing bubble). Or in fiscal policy one can test and establish things like the limited budget deficit - to curb the politicians' incentives to misappropriate budgets. One can also establish debt ceilings to control public debt...oh wait, that one doesn't work that well actually, does it?

Economics is too closely interlinked with politics, so demanding answers only from economics without thinking of the political implications is a faulty approach. For example, many economically sound ideas on which >90% of economists agree upon - like free tradeimmigration, the efficiency of subsidies, a number of empirically proven models and theoretical concepts (stylized facts ranging from public choice theory and institutional economics, to basic micro and macro models), or the basic price mechanism and the simple dynamics behind the laws of supply and demand - will never be implemented by politicians who care only of satisfying and protecting partial interests in order to remain in power. So when you think about the soundness of a certain fiscal policy, tax rate, or budget spending, have in mind that behind that decision, it's not an economist, but a politician.

Detaching science from policy 

Many critics of economics as a science are persistently confusing economics and economic policy. The field of economics does contain scientific method, but economic policy is mostly craft. And in order to "sell" an economic policy to the public, one needs to have good "sales skills". This is where politicians step in. But how often do you see politicians actually calling upon relevant economic research? Only when it supports their ideological viewpoint. 

Which brings us down to Krugman's argument. His reaction on Chetty's text was spot on. He agrees that economics is indeed characterized by scientific method, however he also emphasizes that many economists don't do much science at all:
"The point is that while Chetty is right that economics can be and sometimes is a scientific field in the sense that theories are testable and there are researchers doing the testing, all too many economists treat their field as a form of theology instead."
He cites Chetty's examples of empirical research being done on the health insurance policy in Oregon, where a genuine randomized experiment was conducted with a well defined treatment and control group. Krugman is outraged that many conservative economists don't like to take this evidence supporting Obamacare for a fact. And he has every right to be outraged. But what about other empirical facts that many liberal economists tend to disregard? Such as the inefficiency of state stimulus programs, or the fact that the deficit and debt busts were caused by bailouts not the crisis - something Krugman is actually holding a pretty tautological view of? 

This is a good example of conflicting opinions among economists, where the issue at hand is either highly controversial or on which economists are still unsure about. But with upcoming decades of vigorous research, relevant policy solutions to these issues will surely be given. The question is how likely are they to be implemented by those in power?  

The problem with quacks

Conflicting theories in science will always exist, and are in fact welcomed as out of opposing views usually arise the best ideas (avoiding the confirmation bias). But economics tends to be attacked more than any other science on the soundness of one approach over another. The reason is simple: during bad economic times (as we have now) many forgotten fallacies of the past suddenly get rediscovered. Why is this? A partial culprit is believe it or not - the media. In search of explaining a certain phenomenon the press likes to match opposing economic ideas; one being the so-called "mainstream", and the other "the alternative". Even though sometimes the alternative proposals can indeed be quite sound (it all depends on how we define mainstream), in most cases they are not. Too often a lot of space is given to obscure economists (quacks) offering their own quick fixes without any scientific method whatsoever standing to confirm their findings, and without ever considering even the basic effect their misplaced ideas might cause on systemic stability. But since debates on economic topics are much more popular and widespread than debates on topics in physics or chemistry, these quacks tend to get a lot of media space to push forward their ridiculous and washed up ideas.

You can surely find the same thing in every science (how many times have you seen people claiming to be scientists talking mostly nonsense? And it wasn't because they weren't "mainstream", it's just that their conclusions are often completely senseless). However, in economics these quacks tend to be much more widespread, particularly when non-economists start thinking they have a magic idea of how to fix the system. Most of these people are luckily never taken seriously, but some tend to attract quite large crowds of followers. It is because of this that a lot of people seem to think economics is mostly hokum, and it is precisely because of this why economists must react and explain to the public the crucial difference between economic policymaking and economic science. Economic science must always stand to support economic policymaking. When it doesn't, markets start to crash. 

Monday, 21 October 2013

Video of the week: Costs of the US government shutdown

Bloomberg has an informative video on the costs of the US government shutdown. Their main point comes down to how much has the uncertainty over political decisions cost the US economy so far since 2009. They come up with with some striking numbers: 900,000 jobs, 0.3% growth p/year, and an 18 basis point increase in the corporate borrowing costs. 

The crucial issue everyone is worried about is uncertainty, just as I've predicted in my shutdown coverage. I'm proud to say I got this one right - game theory helped me understand that in the case of the debt ceiling negotiations the commitment device was simply too strong for the parties not to strike a deal. And even though the US default has been avoided, all of this will cost the country dearly (although not as much as it did in August 2011), while uncertainty is looming. The Policy Uncertainty Index has once again escalated, while many analysts are still counting the total losses

The total cost of the shutdown is estimated to be $26bn, which is nothing compared to a $16 trillion US GDP, but this is likely to downgrade the growth figures (S&P downgraded the growth predictions by 0.6 percentage points). But when we put it in another perspective, here's some of the things we could have bought with this money:
El Salvador's economy looks tempting..Or two Icelands! Come to think of it, just one Buckingham Palace would suffice. 

Anyway, with the debt ceiling once more being raised (it will again be reached by February 2014), a frequent question on everyone's minds was "What's the point of having a debt ceiling if all we do is raise it every now and then?" And to this I have no concrete answer. What kind of a signal are the politicians sending to the market about its debt sustainability if every time the debt ceiling is close to being breached, it's raised once again? To make one thing straight, it is expected for the ceiling to be raised as the economy is expanding (GDP is increasing), as long as the debt-to-GDP ratio is sustainable enough (this being a broad definition). But debt-to-GDP is also rising at an unprecedented level, now over 100%. Recall that the main culprits for this over the past decades were (1) the wars in Afghanistan and Iraq during the Bush administration, and (2) massive bank bailouts during the current administration.

So with debt ceilings being raised more frequently in the past few years than ever before, one thing at least is certain - the US will never default on its debt. In a conventional way at least. Meaning investors can relax. On the other hand, if the debt-to-GDP ratio keeps on rising, with political responsibility (and accountability) being dispersed, and no political will to solve the entitlement problem, in the near future things don't look that bright at all. 

Tuesday, 15 October 2013

Fama, Hansen, and Shiller winners of the 2013 Nobel prize in economics

The 2013 Sveriges Riksbanks Prize in Economic Sciences in Memory of Alfred Nobel has been awarded to three recipients for their empirical analysis of asset prices: Eugene Fama, University of Chicago; Lars Peter Hansen, University of Chicago; and Robert Shiller, Yale University. 

"There is no way to predict whether the price of stocks and bonds will go up or down over the next few days or weeks. But it is quite possible to foresee the broad course of the prices of these assets over longer time periods, such as, the next three to five years. These findings, which may seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller."
You can find a more detailed explanation in the official press release, in addition to an excellent technical note explaining asset price movements, provided by the Nobel committee. 

Also, around the blogosphere many notable economists and newspapers have weighted in and provided quick comments and congratulations. Mark Thoma lists them all in one place, but individually you can look at the New York TimesWSJThe EconomistFinancial TimesFT AlphavillePaul Krugman, Tyler Cowen and Alex Tabarrok each wrote a text on all three laureates (Eugene Fama, CowenFama, TabarrokRobert Shiller, CowenShiller, TabarrokLars Peter Hansen, CowenHansen, Tabarrok), John TaylorBrad DeLongJohn CochraneArnold Kling, a technical note on Hansen from Not Quite Noahpinion, and many, many more. 

So what makes the contribution of the three laureates so important? Predicting asset prices in the short run based on the price movements of the past few days or weeks is extremely difficult. This was first discovered by Eugene Fama back in the 60-ies, as he has shown that new information tends to be instantly incorporated into prices. But after the initial reaction to, say an announcement of dividends, the movement of a price is very hard to predict. Fama's crucial contribution is the so-called efficient market hypothesis (EMH) which claims that financial markets are always efficient information-wise and that one cannot constantly achieve returns above the average risk-adjusted market returns ("beat the index") if all information is available. Prices of assets are said to reflect all past available information and instantly adapt to it. To some controversial, the EMH became the focal point of empirical work in financial economics for more than 30 years. Whether one supports it or opposes it, the EMH undoubtedly had a crucial impact on research of asset prices. This is why many have argued that Fama's Nobel prize was long time coming.

The main criticism of this model came from behaviorists such as the second laureate Robert Shiller (among others like Daniel Kahneman, Amos Tversky or Richard Thaler), who tested the EMH by comparing the variance (volatility) of stock prices to the variance (volatility) of discounted dividends, and found that stock prices are much more volatile leading him to conclude that stock markets are inefficient (irrational), as financial markets tend to suffer from overconfidence, information bias, and various other human errors (behavioural economics). In his excellent book "Irrational Exuberance" Shiller compared the 20-year annualized returns with the 10 year price-earnings (P/E) ratio using almost a 100 years of data and concluded that long term investors did well when prices were low relative to earnings. When P/E is high, risks are high, so one should lower his or her exposure in the market, but get into it when P/E is low. Keep also in mind that Shiller was on of the economists often cited to have predicted the crisis, by predicting the housing bubble burst back in 2006. He co-created the S&P Case-Shiller index, a widely used tool to measure US housing market prices.

The link between the two opposing theorists is the following - in the short run one can only anticipate movements before the dividends get announced, while everything else is a random walk movement of prices. In the long run, prices can be predicted by looking at the ratio of volatile prices to smooth dividends (see graph below); if the ratio is high it tends to fall, so you should sell, but if the ratio is low, it tends to rise, so you should buy:

Lars Peter Hansen fits into this story by developing an econometric method called the Generalized Method of Moments (GMM) estimator, which is particularly useful in testing rational theories of asset pricing, or in other words, when one needs to test both the mean and the variance of stock market returns. Using the GMM he found it to be much more applicable to the unusual properties of asset price data than the most well-known Capital Asset Pricing Model (CAPM) model. His contribution is very technical and thus difficult to explain to a layman. However, Tabarrok at MarRev and Yang at Not Quite Noahopinion offer fairly easy explanations. In addition, here and here are some lecture notes for those more interested in the subject.

In conclusion, the Nobel committee states that the laureates have "laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."

As far as the predictions, the Wall Street Journal was once again correct on declaring Hansen a shoo-in for this year (last year their favourite was the eventual winner Alvin Roth) and giving a big chance to Shiller in case behavioural economics becomes the focus, whereas Thomson Reuters, who usually base their predictions on research citations, was way off. Their main favourites were split between Angrist, Card and Krueger for empirical microeconomics, Henry, Pesaran, and Phillips for economic time-series and forecasting, and Peltzman and Posner for regulation. 

In the end, some suggested readings from each of the laureates:

Eugene Fama
Lars Peter Hansen
  • Hansen, Lars Peter (1982) "Large Sample Properties of Generalized Method of Moments Estimators" Econometrica Vol 50(4): 1029-1054. 
  • Lars Peter Hansen (2008), “Generalized method of moments estimation”, in S.N.Durlauf and L.E. Blume (eds.), The New Palgrave Dictionary of Economics, Second Edition.
Robert Shiller
  • Shiller, Robert J. (1981) "Do stock prices move too much to be justified by subsequent changes in dividends?" American Economic Review, Vol 71(3): 421-436. 
  • Shiller, Robert J. (2000), Irrational Exuberance, Princeton University Press.
  • Campbell, J.Y. and R.J. Shiller (2007), “Robert Shiller interviewed by John Campbell”, ch. 11 in P.A. Samuelson and W.A. Barnett, Inside the Economist’s Mind: Conversations with Eminent Economists, Blackwell/Wiley.
Congratulations to the winners! 

Monday, 14 October 2013

Two years of blogging

This day marks the second birthday of the "Don't worry, I'm an economist" blog. Last year's celebration was marked by stressing out some of the best and most popular posts. Back then I reminded the readers on why I started the blog, and how I was happy to see the entire idea unfolding into a platform which I hope was clarifying the argument in favour of structural reforms and a strong institutional environment. I claimed that the crisis wasn't an aggregate demand shock but a structural shock building up on declining productivity and an inability to adapt to technological changes in the past few decades.

The essential message hasn't changed. However, the second year was marked by a wider variety of topics. 

The largest focus was again on the recovery (both in Europe and beyond), but this time I've put more emphasis on technology, institutions and political economy, all in the same goal of trying to emphasize the structural, institutional and political issues undermining the state of the world economy. Some of my own personal favourites (top 15) from last year include:
In addition to these there were many other interesting topics, inspiration for which was driven mostly by current events but also by a number of issues I found to be important.

By the end of the year the most popular topic were the US presidential elections (which I even made a few predictions on, most of them correct), followed by the unfolding of the fiscal cliff crisis (where my game theory predictions somewhat failed). This year I also decided to offer my new years predictions which I will go through by the end of this calender year to see how good I was as a forecaster (so far I was right about Merkel's victory, Britain's inability to achieve a robust recovery; I was partially right about Italy's elections, but too careful on Hollande in France; was spot on about Egypt, but couldn't foresee the turmoil in Turkey; and so far right about Japan and the slowdown of the emerging markets).

Furthermore, in addition to the usual budget analyses and the tracking of the recovery, I covered a range of issues from immigrationminimum wagesgrowth convergenceinternational tradethe optimal size of government, Croatia's EU entrylocal government stimulus, bureaucracyinequality (and the often underestimated issue of social mobility), and even had an interesting discussion on market monetarism

Then I switched to institutional topics by the end of the year (most of which I've already mentioned above), and technology, in particular the long term effect of disruptive technologies,  

Last month was the 5 year anniversary of the Lehman bankruptcy marking the official start of the financial crisis. I opened the coverage 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, topped it up with the end consequences and cross-country effects, and summed it all up with a graphical presentation of the effects on the financial markets. 

Some sad news also struck us during the past twelve months, including the deaths of Nobel Prize winning economists James Buchanan (in January) and Ronald Coase (in September), and former British Prime Minister Margaret Thatcher (in April), all of which I paid respect with an in memoriam. 

Last year I also attended the famous Public Choice Society conference (50th annual), and have written a couple of posts as reflections upon the conference. More importantly it was here where I had the opportunity to present my paper on political agency which received quite good reviews. It is still a work in progress (hopefully to be done by the end of the year!).

All together, it was a fruitful year, with slightly less articles published, but much more audience gained (by now the blog gets a modest visit rate of roughly 300 clicks p/day, or a bit over 9000 p/month). I'm happy with these numbers and will continue the writings on mutual satisfaction of both myself and the readers.  

Thursday, 10 October 2013

Graph(s) of the week: European values

A few months ago I was sent a link to this interesting interactive webpage called the Atlas of European Values. Breezing through it I found quite a few interesting facts about cross-country differences in Europe. The page presents a series of maps which include a range of survey data across the globe (but most detailed in Europe) on a number of issues in politics, religion, work, society, well-being and the like. Some of the issues I found were quite striking. 

Democracy and authoritarianism 

Let's start with this one - the number of people who think democracy is the best political system:
Source: Atlas of European Values
The variation is cross-regional in all the maps, which is good as it gives us a deeper insight into inter-country differences. Even though the majority of the population in each country feels that democracy is the best system of governance, the number of people convinced in this idea is far greater in Western Europe (always around or above 90%, except in some parts of Britain - I guess some people there still fancy the monarchy?), than it is in Eastern Europe (the former socialist countries). Take Russia or Ukraine for example, where the majority supporting democracy is the lowest. On the other hand 88% of Belorussians-  Belarus being the only remaining dictatorship in Europe - feel that democracy is the best political system. 

In another map, when asked whether or not the people have confidence in their governments, a majority of Russians (above 60%) said that they do, as opposed to all other Western (and Eastern) countries exhibiting a very low level of confidence in their government (between 10 and 30%). This goes a long way in understanding why Putin still receives strong support in this country, despite his authoritative reign. Or maybe precisely because of it!

The next graph shows why. It maps the percentage of people that think having a strong leader who does not have to bother with parliament and elections is a good idea (so basically the definition of Putin). Here's how it maps out (the higher the number - the more red an area is - the more people favor an authoritative leader): 
Source: Atlas of European Values
The East-West divide on this issue is huge. While in Western Europe (including the new EU member states except for Romania and Bulgaria) the number of people who feel this way is quite low (average around 20%), in certain former members of the Soviet Bloc the effect is almost completely the opposite, with the aforementioned exceptions of Romania and Bulgaria leading the way by having almost 90% of the people feeling the need for strong leadership. There are several possible explanations of such behavior. Perhaps the people simply got accustomed to strong authority leading the country during socialist times, so in current times of misery and a failed consolidation of capitalism, they invoke upon the older system characterized by more stability and different informal institutions - or to be more precise, where the level of social trust was higher

But look at Poland for example. Out of all former socialist countries it has the least desire for strong authority. History plays an important role here. Poland was historically always torn between two superpowers - Prussia (Germans) and the Russian empire, so their final episode of socialism only made them even more resilient never again to have an autocratic system. 

Technocratic governments 

Moving on, the next graph is on whether or not experts should run the government. The darker the area, the more people believe that a government of technocrats is a good idea. 
Source: Atlas of European Values
A very interesting finding where former socialist countries like ex-Yugoslavia, Hungary, Bulgaria, Romania, Czech Republic, Slovakia and Poland all seem to feel strongly in favour of an expert-led government (on average more than 80%). This correlates well with the lack of trust in government and especially with the lack of trust in domestic political elites. The people are simply faced with lack of supply of high-quality individuals on the political market, and are running out of options. Interestingly enough, Spain joins this group of countries, probably due to the disastrous effect its political elites had on the country

Mind you, the survey was taken in 2008, so some of these factors might have changed due to the influence of the crisis. For example Greece and Italy, two countries that actually did have technocratic governments (neither of which lasted for too long), had it even worse in terms of political cronyism before the crisis but the people there didn't think that resorting to experts is the best alternative. Perhaps that explains why the reign of technocratic governments was short-lived. 

Government intervention 

Finally, the issue of whether the state should control firms more effectively.
Source: Atlas of European Values
It is no wonder why West Germany (notice the German divide), Britain, Scandinavia, and Poland are doing relatively better than the rest of Europe. In the end it all comes down to preferences and informal institutions. 

Monday, 7 October 2013

Betting against the US default

CNN Money reports that investors are betting on a US default. This isn't unusual as bets like these were already in place during August 2011, when the chances of default by reaching the debt ceiling were even higher. Today, the total payout in case of a default could run up to $3.4bn, while back then they could have paid out around $5.6bn. How does this scheme work? How does one "bet" against or on a debt default? CNN Money explains: 
"Financial institutions can buy what essentially amount to insurance contracts that protect against a government default. These securities, called credit default swaps or CDS, cost a 0.34% premium to insure against the government defaulting in the next year. That means an investor pays about 34 cents for every $100 of potential payout they would receive in the event of default."
But as always in the world of finance, it's not as simple as it seems:
"First, these contracts are only available to institutional investors. Second, credit default swaps on U.S. debt are usually priced in euros, because if the United States defaults, who wants to be paid back in dollars? Third, there are far less lucrative payouts if other scenarios occur. For example, the government could elect to partially pay its debt. Even the definition of "default" is murky. ...
In the CDS market, a true "default" happens only if the U.S. were to stop paying principal and interest to Treasury bondholders, or if it refuses to acknowledge its bond contracts or restructure its debt." 
How realistic is it for the US to default? One would say almost impossible, as the US government bonds were widely considered to be essentially a zero-risk asset for a long period of time. This has a lot to do with the fact that the US is printing the world's reserve currency, and when your domestic debt is denominated in dollars over which you have control of, there is nothing to be worried about, right? Wrong. The moral hazard implication is huge here. Such a comfortable position around accumulating debt is what got the US on the brink of a fiscal cliff in the first place. 

The debt sustainability problem is huge according to CBO's latest debt outlook report. It predicts that public debt is likely to reach 100% by 2038, and go over 200% around 2076, while interest on debt repayment (which are currently around 8% of budget revenues) are predicted to take in huge portions of future budgets if things carry on the way they have so far:
"The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. . . . 
At some point, investors would begin to doubt the government's willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money. Moreover, even before that point was reached, the high and rising amount of debt that CBO projects under the extended baseline would have significant negative consequences for both the economy and the federal budget."
CBO's range of scenarios are also quite pessimistic. Only two scenarios assume deep spending cuts and tax hikes that would shrink the debt, while most others see the debt increasing between 77% and 190% by 2038. The 190% figure isn't that unrealistic at all since it implies that politicians simply carry on doing what they have before, raising expenditures more than revenues. 

So once again, how likely is it for the debt ceiling to be breached and the US thrown down a downward spiral of loss of confidence, investor panic and reemergence of a worldwide recession? 

The US public debt is suppose to reach it's debt ceiling by mid October this year (see graph below). It has been close several times before, but every time the politicians raised the bar, amid some controversies, and stabilized the markets for a short period. This is a typical short-termist solution that offers only temporary relief, whilst pilling up risks only to make it even worse the next time around. Such a strategy of dealing with debt simply cannot carry on infinitely.  
Source: The Economist
The situation is very tricky. If on one hand the debt ceiling doesn't get raised, and the US actually does reach the unlikely scenario of debt default, we are in for another long and painful recession (has the current one already ended?). On the other hand, if the debt ceiling does get raised as it has many times before, then we're just allowing the long-term debt unsustainability to continue, which will eventually burst and cause a deep recession. One can say that current budget quarrels and debt ceiling issues are the seeds of a future financial meltdown. The solution needs to be reached immediately via a reform of the entitlements system (read some of my previous proposals and ideas here, here, here, here and here) and pro-growth policies removing the restrictions on businesses to invest and hire. A welcomed change would be to overtake the entire crony political establishment in order to reinstate the proper US values and high levels of social mobility in order to return the country back on its path to prosperity (and avoid things like these happening in the future). But that's an institutional issue and a topic of another post. 

And finally, to end on a somewhat positive note, the investors betting against the US are a minority, as far more still have confidence in the US claiming that a default is not likely at all. In other words they do believe that Congress and the President won't send the country into another recession and will raise the debt ceiling once again. So they expect more of the same - short-termist policies and lack of long term vision. They all need to be reminded on the most important lesson of economics

Thursday, 3 October 2013

US government shutdown: another bargaining game with incomplete information

At the end of last year the main preoccupation in United States politics was anticipating the consequences of the infamous fiscal cliff. A quick reminder for the readers; back then the two main political parties had to reach a consensus over necessary budget cuts and tax increases in order to avoid automatic large spending cuts and tax hikes that would immediately lower the budget deficit but would also push the country into another recession (hence the term "push off the fiscal cliff"). The very threat of a fiscal cliff necessitated a consensus from the two parties. Its December 31st deadline was the status quo restriction on the policymakers to avoid another recession and "do the right thing" by agreeing on which taxes should rise and where in the budget should they cut. By the end of December things were getting really unstable while signals sent by the media were implying that no solution will be reached. However in the very last minute President Obama and John Boehner (House speaker - the House has a Republican majority) did reach a decision temporarily saving America from a double dip and postponing the debt ceiling decision for another month or so.

Back then I analyzed this situation using a game theory framework, implying that a Nash equilibrium outcome would be No deal, i.e. both sides are likely to stick to their agenda and push the country off the fiscal cliff.

Why the shutdown?

Ten months later, a similar situation is arising, but this time with different consequences. After having failed to agree on the budget for this fiscal year which would inevitably raise the debt ceiling, President Obama declared a government shutdown. This is nothing strange as it happened before, and is actually allowed by the US Constitution which requires Congress to regularly pass laws funding the government. If it doesn't the government shuts down some of its operations. The idea is something I essentially agree with - the Constitution implies that elections alone are insufficient to protect the citizens against potential government usurpation of their rights. If you think this through the concept of interest group state capture, or the current crony political system, you tend to understand the power in Madison's words.

The consequences of the shutdown aren't nearly as severe as they would be in case of a fiscal cliff (I mean if the government can operate fine with a third of their employees not coming to work, then the conclusion is self-evident, isn't it?), but they are inconvenient, and they do put the US in a difficult position regarding its credit rating. The markets are sending signals of concern over how the dispute will be settled, while international politicians (IMF) are urging the US to find a consensus and not put the entire world recovery at risk. 

However, despite the warnings, both sides remain stubbornly confident in their position, not showing any signs of backing down. President Obama declared he won't consider any bipartisan efforts to curb the long term deficit and the unsustainable costs of Medicare and Medicaid, until the current budget is approved and the debt ceiling is raised. On the other hand the Republicans are given an opportunity to show to the public that the US doesn't need such a large government after all. Even though this might be true, the actual shutdown is likely to be more costly than the regular operations of government*. The last time this happened (1996) it cost the government around $1.4bn, which was effectively even higher as when people got back to work there were backlogs which made everyone less efficient. It may also cause temporary economic activity to slow down as public sector employees aren't getting their paychecks on time. Moody's have estimated that a three week shutdown will cost 1.4 percentage points in terms of growth in the fourth quarter. This is indeed a significant cost. 

The bargaining game

And now the game starts (table below). Once again, the situation is very similar to that of 10 months ago. Whoever caves in and allows the other party to claim victory loses significantly (payoff of -6). If the debt ceiling isn't increased, both parties lose as the electorate will blame them both for causing a mess. However, both parties could resort to ideology and persuade their partisan voters that the blame is on the other party. Even as the country as a whole loses out the loss to one party is arguably less than if they back out and admit defeat. This is why in the game table (the same one we had before but with lower payoffs) a No deal is a better solution for a party than admitting defeat and letting the other party retain its position. The standard noncooperative game ends up in a No deal, No deal equilibrium with a payoff of (-3,-3).  

If they do reach a consensus and cooperate, they benefit by "saving the country" and can go to their electorates (and radical party members) announcing they've made a good deal, but had to cave in to some of the suggestions the other party made. With political discourse as it currently is, that outcome is getting increasingly unlikely. 

Strike deal
No deal
Strike deal
No deal
-3, -3 *

Last time I introduced a dynamic component to the game solving if for a subgame perfect Nash equilibrium and getting the same outcome of No deal. This applies today as well if we assume that the shutdown (a status quo) is a more preferred option than succumbing to the other party's optimal position. The problem then, as it was now, was in the perception of the strength of the commitment device (the punishment). If the politicians of either parties don't perceive the threat of shutdown or the debt ceiling severe enough, they aren't likely to cooperate. But if the commitment device (the threat of default) is strong enough, eventually it will yield a cooperative solution, just as Axelrod (1984) has predicted for many real-life scenarios. And just as it eventually did happen during the fiscal cliff negotiations. 

The outcome for the economy? More uncertainty. High costs.  

* If one wants to lower to size of government, shutting down some of its services this way isn't the way to do it. For example if we want private provision for certain government services (like parks, monuments, etc.), one needs to allow time for market actors to react upon this signal and provide such a service.