Wednesday, 30 January 2013

Huge budget deficits are the result of bailouts

Note: This text was also published as an article for the Adam Smith Institute, on 08th February 2013. For the rest of my ASI writings, click here.

Among Keynesian economists there is a resilient opinion on how the current large budget deficits shouldn't be thought of as a serious problem to the economy, since they are ultimately a result of a depressed economy. Here's the main advocate of such an approach, Paul Krugman
"It’s true that right now we have a large federal budget deficit. But that deficit is mainly the result of a depressed economy — and you’re actually supposed to run deficits in a depressed economy to help support overall demand. The deficit will come down as the economy recovers: Revenue will rise while some categories of spending, such as unemployment benefits, will fall. Indeed, that’s already happening. (And similar things are happening at the state and local levels — for example, California appears to be back in budget surplus.)"
Disregard for a moment the key issue I have with this type of opinion - which is that in a depression a government is supposed to run large deficits in order to jump-start a recovery - let's for now focus only on the argument that a deficit is a result of a depressed economy. What Krugman and the like have in mind when they make this claim is the following; because of the crisis and the credit crunch many businesses fail and consequentially unemployment rises. This creates pressures on the budget deficit, since revenues fall as many businesses are bankrupt and are not paying taxes (on both profits and employee taxes), and on the other hand many new unemployed put pressure on the expenditure side, as the government has to pay out more unemployment benefits. This is all true. All the combined effects of the credit crunch will almost always result in an increased budget deficit. But they will never be so big to make the deficit rise above 10% of GDP as it did in the UK, Ireland or Spain (to mention only a few). Something else was at hand here.

This 'something else' were large government bailouts of fallen banks.

Ireland, Spain, UK and of course the US all had problems with the bursting of the housing bubble, a consequential rapid decline of the construction sector and altogether a huge impact on personal wealth. This however wasn't enough to cause a huge budget deficit. Its persistence is a result of a depressed economy, but the initial cause of the unsustainable public finances in Ireland, Spain, UK and USA were large government bank bailouts. The three European countries are usually the argument Keynesians use to attack the "stupid" euro austerity, since all of these countries had good and stable public finances before the crisis (Greece is a case by itself), while now austerity is hurting their recovery prospects.

However, the enduring pain European countries are experiencing is due to a wrong approach to austerity aimed at closing the deficit only via tax increases and selective cuts, while failing to reform their constraining regulatory environment, their entitlement system, and the rigidities in the labour market.

Claiming that American, British, Spanish or Irish troubles began with austerity is simply misleading. Their troubles began with what was an application of a typical textbook Keynesian solution to a crisis = bailouts and large stimuli. This triggered their public debt to rise and their deficits to widen. Bankruptcies of small businesses and rising unemployment couldn't have single-handedly risen the deficit above 10% of GDP, or the debt-to-GDP close to (or above) 100%. It they did, this would have occurred in a much longer time span. But clear evidence (which Keynesians like to call upon) points out that large budget deficits and booming public debts arose immediately as a result of bailouts and stimuli in 2008 and 2009:  




Source: IMF; World Economic Outlook 2012

As shown in the graphs, all four countries started experiencing troubles as an immediate reaction to government bank bailouts and fiscal stimuli policies. They all had low and sustainable debt-to-GDP levels (Spain and Ireland below 40% and 30% respectively, UK around 45%, and the US around 60%), which in a few years escalated to close to 90% for the UK, over a 100% for the US, 70% for Spain and close to 120% for Ireland (which is a four-fold increase of debt for this country in only three years). As for the budget deficit, Spain and Ireland had a surplus prior to the crisis, while the UK and the US both had relatively small deficits. After 2008/2009 their deficit-spending bailout solution yielded its first results. Have in mind that in neither of these countries austerity didn't kick in until late 2010. After it did however it did little to improve the state of public finances and still hasn't stopped the rise of public debts in neither of the four examples. 

After the evident failure of this approach that caused the unsustainability of their public finances, European countries started to combat the deficit via tax hikes and selective budget cuts, instead of focusing on lowering the tax burden and applying a broad set of institutional reforms aimed at clearing the instabilities of the labour and capital markets. 

They made two big mistakes - application of immediate Keynesian policies thought to work in the short run (reminder, this is 2013, five years after the crisis had started - the short run is over), followed by a selective and wrong application of (let's call them) neoclassical policies. 

Iceland avoided such a scenario and with help of the IMF got its economy back on track. Latvia and Estonia are similar stories, as they all allowed for the initial strong shock to hit the economy, without applying the so-called textbook Keynesian solutions. Sweden and Germany are another good set of examples to follow on how to avoid deficit-spending and focus on long-run structural reforms.

The obvious failure of the stimulus deficit-spending solution (Raghuram Rajan has a good article on Project Syndicate), particularly with its effect on public finances, should be sufficient evidence not to call for these types of solutions for quite some time. 

Sunday, 27 January 2013

Don't lose hope just yet

Just before the beginning of the Davos 2013 World Economic Forum last week, Bloomberg had a good text on the faulty predictions given in the previous Davos Forum, in particular concerning the Greek exit out of the euro, and the euro failure itself:
The parade of economists and investors led by Nouriel Roubini predicting Greece’s ejection by now from the euro zone failed to appreciate the resolve of European policy makers to protect their union and the amount of pain Greeks are willing to stomach.
...
Joining him in questioning whether the 17-nation euro region was built to last and declaring Greece’s departure imminent, inevitable or in its interest were hedge-fund manager John Paulson, Goldman Sachs Group Inc. President Gary Cohn, Nobel laureates Paul Krugman and Joseph Stiglitz, Pacific Investment Management Co. Chief Executive Officer Mohamed El- Erian, Kenneth Rogoff and Martin Feldstein of Harvard University and Citigroup Inc. chief economist Willem Buiter.
Watch the video for their exact predictions:


I have to admit that in the times starting this blog (October 2011) I was in favour of an orderly Greek default, thinking that it would be best for Greece to get out in order to release itself from foreign-enforced austerity and reform the system on their own. However, after seeing what happened in Italy and Spain only a month later (the fact that neither of their governments did anything to apply the reforms and use the time given to them by the ECB's bond buying program in August '11), and after realizing that the same thing will be applicable to Greece, I was more inclined to switch to the "German point of view" and advocate strong structural and institutional reforms for Greece. 

However, what happened in March was that Greece actually did default on its debt (forcing private creditors to accept larger haircuts - €100bn, following the second bailout - €130bn - in February; see graph below), but this was far from over for Greece. As I advocated back then, Greece needed a proper market reform, with a key emphasis on achieving political stability and a firm rejection of a euro exit and currency depreciation. Staying in the euro is a painful but probably most optimal way to restore investor confidence and credibility into this depression-driven country. 

Change in approach? 

In the WEF 2013 new winds are blowing and confidence is increasing among investors: 

“I am confident that the euro zone is broadly on the right track back to financial stability and economic strength,” said Josef Ackermann, a frequent Davos attendee who stepped down last year as chief executive officer of Deutsche Bank AG, Germany’s biggest bank. “The contagion risks of Greece leaving the euro zone were too great for everyone, and European leaders are well aware that a collapse of the euro would be the end of Europe’s status as a leading force in global politics and business.” 
Betting on the euro’s longevity would have made investors money last year. Those who bought junk-rated Greek bonds in January 2012 earned 78 percent, compared with 4.5 percent for German bunds, Bank of America Merrill Lynch indexes show.
One should ask himself what is the reason for this new streak of optimism, and are the policies initiated by the ECB and the European Commission really that good to prevent another November 2011 scenario? Have in mind that in January 2012 the situation was still rather bad (with even the Financial Times predicting a soon end to the euro in December), which continued well into May and June. However, Draghi's speech in July to "do whatever it takes" made all the difference in the bond markets. What was once great uncertainty and volatility in the bond markets turned into a steadily decreasing (improving) path of bond yields for the eurozone periphery: 


Source: Bloomberg
I guess this was the kind of thing all investors were hopelessly waiting for in Europe ever since August 2011 and the first US debt limit fallout and ratings downgrade; investors were waiting for the ECB to signal greater strength in the resolvement of the immediate shocks. It is certain that markets do desire structural reforms in the longer run, but it is also true that short-term investor sentiments will necessarily drive the lending market conditions. 

Even though some are still not convinced that Greece will stay much longer in the euro (Roubini has given them a deadline sometimes in the next 5 years - a much careful prediction this time), nor that the euro itself would survive. Some see austerity, some see lack of real reforms as an eventual end to the euro project. It's hard to argue against this, since austerity is done in a completely wrong fashion, without any emphasis on labour market rigidities (sacking public sector workers just won't do it) or the regulatory and bureaucratic burdens. However, investor sentiment is a delicate creature, and an event such as a euro failure may destroy all hopes for recovery for as much as a few decades. In an ageing continent, with a risingly unsustainable welfare state system, this could be a trigger for a great deal of social unrest and new (old) conflicts. Political stability of the Eurozone, a system that became irreversible, is crucial in sustaining it. This is why it will never perish no matter how faulty were its initial foundations. 

Wednesday, 23 January 2013

Graph of the week: sovereign debt distribution

From the IMF comes a text on what demand for government debt can tell us about future risks of an economy. This basically means that the risk of potential default depends very much on who's holding the government debt, foreigners or domestic investors. Here is the paper, and this is their most interesting finding: 

Source: Arslanalp, Tsuda (2012): "Tracking Global Demand for Advanced
Economy Government Debt"
, IMF working paper
HT: The Economist 

In Quadrant I we have countries with high debt but resilient to a run. In the second quadrant, we have countries with high debt and a high risk of a run (the worse combination). The third quadrant features countries with low debt and resilience to a run (the best combination), while in the fourth are countries with low debt, but prone to a run. The two measures used in designing the investor base index are the demand-side risk indicator (on the horizontal axis), and the supply-side risk indicator (on the vertical axis). And while the supply side indicator is simply a measure of debt-to-GDP, the demand-side indicator looks at ownership of debt (the investor base): 
"By this metric, countries with a high share of domestic investors, such as domestic banks and central banks, as well as foreign central banks in their investor base receive lower scores. In contrast, we assign high scores to countries whose investor base has a high share of foreign private investors as we find they are the most skittish in times of trouble."
The findings are particularly interesting when observing them on a country by country basis, as is done in the graph. It tells us of the high riskiness of peripheral eurozone economies (rightfully including Belgium, but also France and Austria), and a worrying situation in the world's biggest economies of Japan, Germany, US and UK. Even though the later countries don't suffer directly from the risk of default, their high debt-to-GDP ratio makes them potentially risky, at least from the supply perspective. However, have in mind that the methodology of acquiring this data was to give low scores to countries whose debt is own mostly by domestic investors (as is the case with Japan, UK and USA). What this essentially implies is that all countries left of the vertical axis shouldn't worry about the sustainability of their debt since they have a lower risk exposure then their counterparts on the right of the axis. This is a dubious conclusion, as it would imply (from a game theoretical and political economy perspective) that all countries in the third quadrant should converge towards higher debt-to-GDP levels, which are apparently sustainable no matter how high they get, as the majority of debt owners are domestic households or investors. Why did I say political economy perspective? Because the governing politicians will find it more rewarding to run higher public debts to finance their concessions to various supporting interest groups. As long as the domestic entities are the ones barring the burden, there would be no reason for the government to stop this any time soon. Isn't this exactly the case of Japan?

On the other hand, any small open economy (which is basically every economy on the right side of the vertical axis except France) with greater exposure to foreign investments will never be able to run too high debt-to-GDP as their biggest constraint will be foreign ownership of government debt, and hence a higher risk of default. These countries will be (should be) converging towards the fourth quadrant. As a result we should end up with two types of countries; (1) those with high debt-to-GDP but with greater domestic ownership, thus making them less riskier (all the countries on the left do actually have lower bond yields than the countries on the right) and (2) those with low debt-to-GDP, where a constraint to higher debt levels will mainly be foreign ownership of debt. 

I don't buy it. Even though their graph very precisely depicts the actual ratings on the sovereign debt market (except for France and Austria), the source of investment is not good enough of a category to differ between high and low risk countries. There is a multitude of other factors at work here. The Economist has a good explanation:
"There is no reason to think that domestic savers in the currency area are inherently less flighty than foreign ones. In previous currency crises, such as in Southeast Asia in 1997 and Argentina in the early 2000s, the first people to pull their money out were well-connected insiders rather than skittish foreigners. Something similar may have occurred in the euro zone. A Spaniard has very little reason to own Spanish government bonds rather than Dutch government bonds since both instruments are denominated in euros and both are ostensibly free of risk. However, if the Spaniard starts to think that a Spanish bond could be redenominated into pesetas, or could be written down as part of a “voluntary” “private sector initiative,” he has every reason in the world to swap his Spanish bonds for German or Dutch bonds—even if the risk seems vanishingly small. (In contrast, savers in countries with their own currency have to buy locally-denominated debt if they want to hedge long-duration fixed-income liabilities.)"

Monday, 21 January 2013

The Sir Humphrey Appleby paradox?

Financial Times has an interesting story on within-government politics, by turning to the example of the 80s British political sitcom, "Yes, Prime Minister". The sitcom revolves around the relationship and conflicts between government ministers and civil servants (bureaucrats), whose main incentive is to preserve the status quo and disable ministers from large and abrupt changes. Much like Niskanen's model of bureaucracy, the bureaucrats are pictured as self-interested utility maximizers, hesitant to change, and maximally engaged into preserving their status and increasing their salaries, perks and office sizes. 
"British civil servants have been described as the envy of the world but to many ministers they are little more than a block on their most coveted policy ambitions. 
Yes, Prime Minister, the sitcom that personified the devious and obstructive mandarin in the character of Sir Humphrey Appleby, returned to British television this week after a 15-year gap. And, for many ministers, the world it depicts, in which officials prevent them from carrying out manifesto promises and protect the status quo at all costs, is as true today as it was in the sitcom’s 1980s heyday."
Their frustrations are summed up by the exasperated Jim Hacker, the series’ fictional prime minister, who has to delve through a foot-high pile of ministerial paperwork to find an important and controversial policy proposal buried at the bottom. 
Nick Herbert, the former policing minister, this week told the BBC: “Yes, Minister was supposed to be a comedy but I soon realised it is an essential training manual.” His criticisms echoed those of Steve Hilton, David Cameron’s former policy chief, who reportedly told students on his Stanford University course: “The bureaucracy masters the politicians. I don’t mean that in a hostile way – it’s just a fact.”
...Michael Gove, education secretary, believed his early days in office were hampered by civil servants. ... 

Mr Gove’s former cabinet colleague, Andrew Mitchell, also ran into resistance when trying to change the way the Department for International Development delivered aid. Civil servants were surprised to see policy briefing notes that failed to meet his standards returned to them with the word “bollocks” stamped on the front."
Referring to the aforementioned Niskanen's model of bureaucracy and the real problems facing government ministers in their decision-making, or more importantly in the implementation of their decisions, is it possible that in democracies political power of those elected to rule is being significantly constrained by a bunch of unelected bureaucrats? If so, we can rightfully call this the Sir Humphrey Appleby paradox (based on the fictional character from "Yes, Prime Minister"), in which politicians with power are holding the bureaucrats who work for them to blame for the lack of proper implementation of reforms and the lack of political will to solve the most important issues in a society. 

Could this be just one out of many justifications for political failure where parties are reluctant into cutting concessions of their support groups? Most probably. Even though I do believe that bureaucrats working in government departments are acting as self-interested agents (in terms of maximizing their salaries and perks), I don't believe their bargaining power is so great that it can stop serious reforms. In today's world we have seen plenty of ground-breaking reforms been pushed through despite their controversies (think of the Health Care Bill, or the Dodd-Frank Act in the US, or the NHS or schooling reforms being undertook in Britain, not to mention several other major changes and decisions). This proves that political will can resolve problems if it's strong enough. The issue at stake is always which types of reforms are necessary and which interest group is about to lose its concessions. This is what is stopping reforms, not bureaucrats. 

The FT text finishes by acknowledging this 
"But even if ministers still feel they are being thwarted by an army of Sir Humphreys, the reality is that Whitehall now works in a different way. .... Ministers are often still too swamped with departmental responsibilities to have time to think politically and strategically. But while in the past this may have allowed mandarins to run rings round them, the politicians now also have influential party-appointed special advisers. 
Ministers will always complain that officials try to stop them doing what they were elected to do. But, as the NHS goes through another dramatic upheaval, with the school system drastically transformed and the benefits system about to be overhauled, it seems they, rather than Sir Humphrey and his ilk, have emerged victorious."
If politicians fail, there is no one to blame but themselves.

Saturday, 19 January 2013

In honour of James M. Buchanan

The Economist's Free Exchange column has a very good eulogy for the late Nobel-prize winning James Buchanan, entitled the Voice for Public Choice. I suggest you read the whole thing. 

Here's a particularly good excerpt from the follow-up text:

"Public choice suggests that politicians are influenced by the incentives around them and aren't simply members of a priestly class dedicated to advancement of the public interest. That, of course, means that swapping one set of politicians for another without changing the institutional incentives will have a minimal effect on governing behaviour. Not no effect, of course; different parties are in hock to different interest groups. But the op-ed pages of America overflow with demands that politician x behave better or party y pay less attention to interest group z. Ultimately, if you're unhappy with the outcomes of political business as usual you need to reflect on and argue for reform of the underlying institutional, or constitutional, arrangement. That is a lesson from Buchanan."
And it's a great lesson indeed, particularly in today's perspective on solving the euro crisis and fining the cure for a jobless recovery.

As was thought by the Virginia School and as is embedded in the public choice theory, changing politicians in power without reforming institutions and institutional incentives of those who govern, will not change the outcome new incumbents hope to bring. New incumbents adhere to new interest groups and are too often reluctant (or prevented) to change the balances of power within the society. This can clearly be observed with conservative parties reluctant to cut military spending or supporting the interests of big business (pro business is not pro market - Milton Friedman and Margaret Thatcher taught us that), while social-democrat parties are reluctant to cut public sector jobs and wages, or to reform labour market rigidities. This is normal behaviour from politicians who need to satisfy the preferences of their voters. This can very much explain all the major battles in parliaments over budget redistribution or new taxation. And it can very well explain the behaviour and outcomes of the fiscal cliff bargaining game

This type of behaviour of politicians has been a characteristic of democracies for a long time, and this is the central point of interest for the public choice theory. Buchanan and Tullock in particular offered groundbreaking insights on this area of research. What they also noted was that in order to change this type of behaviour new institutional incentives must be designed. Hence the definition of some of Buchanan's work as constitutional economics

My academic training as a political economist and as an institutionalist shapes my opinion on why I think that an institutional reform is crucial to combat the consequences of the crisis and misguided approaches to recovery. Having one or another political option in power doesn't make a difference unless this political option is changing the status quo and basically going against its own base support. Introducing constitutional rules that will govern the incentives of politicians would be the first step to reforming the decision-making system in politics, in democracies. 

If you wanna catch up on prof. Buchanan and his ground-breaking contributions, I suggest the following sources: 

EconLib's portrait of Buchanan and his collected works.

Eulogies at Forbes, Bloomberg (by Amity Shlaes), Cato (by David Boaz), Marginal Revolution (also from Richard McKenzie), New York Times, Wall Street Journal (by Don Boudreaux), etc.

Buchanan's work you should read:

"The Calculus of Consent", with Gordon Tullock, 1965

"Public Principles of Public Debt: A Defense and Restatement", 1962

"The Demand and Supply of Public Goods", 1968

"Cost and Choice: An Inquiry in Economic Theory", 1969

"The Limits of Liberty: Between Anarchy and Leviathan", 1975

"The Reason of Rules: Constitutional Political Economy", with Geoffrey Brennan, 1985

"The constitution of economic policy", by James Buchanan, Nobel Prize lecture, 1986

Public Choice Society 

Let's also not forget that James Buchanan was the co-founder (with Gordon Tullock) and first president of the Public Choice Society. This year will mark the 50th anniversary of the Public Choice Society, to be celebrated by a conference in March, in New Orleans. I am both deeply honored and excited to be presenting my paper on political agency and persistent electoral success (here's an earlier working paper version) on this year's conference, where I will have the chance to meet all the greatest political economists of today. One will be missing though. Rest in piece prof. Buchanan. 

Wednesday, 16 January 2013

Graph of the week: World's highest tax rates

From a report done by KPMG that came out last week, comes the following chart on "the highest effective personal tax rates in the world": (click to enlarge) 

Source: KPMG
HT: Business Insider 

The chart shows only the top 40 countries with high income tax rates. The US is 55th on the list, while the UK made it in the top 40 (it's 37th). Click here to see the rest of the rankings. 

Let's focus only on the international competitiveness side of the story, setting aside the fact that high income tax rates demotivate successful and talented individuals from staying in the country (yes, by talent I also imply acting and the case of Gerard Depardieu). 

When talking about international competitiveness income tax rates also play an important role, sometimes even more important than corporate tax rates. I'm particularly happy with this graph as it included employee social security rates to calculate the overall burden, which are often overlooked but still play an important decision-making factor in determining total labour costs for a business (i.e. for an investor). 

It's justifiable to have high tax rates in highly efficient and institutionally strong countries like Denmark, Germany or Sweden, since they have other factors that attract capital, investments and motivated individuals into these countries. I'm not saying lower taxes wouldn't help them further increase their competitiveness (as they did in Sweden), but their size of government is somewhat justified by its efficiency in providing public goods and not expropriating wealth. These are the two essential functions of the government anyway, so as long as investors and individuals perceive a stable institutional environment where their wealth won't be diminished by bureaucrats, corruption or similar factors, I guess they would be willing to accept higher taxes. 

For countries like Greece or Croatia (or similar countries you may find interesting on the list) this certainly isn't the case. Their states are seriously inefficient in providing public goods or in attracting investors via institutional stability, so their emphasis must be either on changing this serial inefficiency of the government from within (via a public sector reform) or through lowering the overall tax burden thereby making itself more competitive on the international market. This implies a labour market reform, and a reform of the entitlement system, or else the countries could face serious budget deficit problems in the short run. But keeping high income tax rates, and a high overall tax burden in the situation where their economies are undergoing a 6-year long depression, is absurd. No matter what the rating agencies say on how to misuse austerity and how to close the budget deficit with tax hikes, continuing with this policy for too long will not only destroy the country in the short run, it will completely shatter its outlook in the long run by causing a brain drain and resource depletion. 

The no.1 on the list, Belgium, is a case study by itself. Have in mind that this country didn't even have a government for a year and half. It's economic and tax policies should be observed through the lens of a possible separation and the consequential variety of interest groups who need to be satisfied. 

Friday, 11 January 2013

It's tough being an academic economist these days

A new working paper on NBER is entitled "Nine facts about top journals in economics", by David Card and Stefano DellaVigna.

It's a descriptive paper presenting the trends around submissions and publications of journal articles in the top five economic journals (as picked by the authors): American Economic Review (AEA), Econometrica (Econometric Society), Journal of Political Economy (Chicago), Quarterly Journal of Economics (Oxford/Harvard), and Review of Economic Studies (Oxford). 

Here are some of the most interesting findings: 
"First, the number of yearly submissions nearly doubled from 1990 to 2012..."

Source: Card, DellaVigna (2013) "Nine facts about top journals in economics"
 NBER Working Paper 18665
"Second, the total number of articles published in the top journals declined from about 400 per year in the late 1970s to around 300 per year in 2010‐12. The combination of rising submissions and falling publications led to a sharp fall in the aggregate acceptance rate, from around 15% in 1980 to 6% today. The increasing difficulty in publishing in the top‐5 journals may have important implications for the setting of hiring and promotion benchmarks in the field." 
The quantity has increased so it's only natural to focus on keeping quality of the papers received on the same level as before. The upsurge of higher education has opened the scientific fields to a variety of new potential entrants. Stiffer competition in the field can only bring about more quality of the published material.

Source: Card, DellaVigna (2013) "Nine facts about top journals in economics"
 NBER Working Paper 18665
"Third, the American Economic Review is the only top‐5 journal that has substantially increased the number of articles it publishes per year, and as a result now accounts for 40% of top journal publications in the field, up from 25% in 1970. Assuming that promotion, hiring, and pay decisions continue to value the top‐5 journals more or less equally, the AER now exerts a substantially larger influence over the field than it used to."
This "monopoly" of the AER isn't good news for the filed. It will be a problem if the AER becomes more focused on quantity rather than quality of its papers. I doubt it however, since the papers published there are still state of the art work.
"Fourth, published papers in the top‐5 journals are nearly 3 times longer today than they were in the 1970s. Though the journals as a group have increased their total pages, they have not fully adjusted, leading to the decline in the number of published papers. "
"Fifth, the number of authors per paper has increased monotonically from 1.3 in 1970 to 2.3 in 2012, partly offsetting the decrease in the number of articles published per year. Indeed, weighting each paper by the number of co‐authors, the number of authors with a top‐5 journal article in a given year is somewhat higher today than in the 1970s or 1980s." 
"Sixth, papers published in the top‐5 economics journals are highly cited: among those published in the late 1990s, for example, the median article has about 200 Google Scholar citations. Citations for more recently published articles are lower, reflecting the fact that it takes time to accumulate citations. Interestingly, papers published in the 1970s and 1980s also have total citation counts below those of papers published in the 1990s, reflecting the nature of the sources used by Google Scholar, citation practices of current authors, and other potential factors."
Source: Card, DellaVigna (2013) "Nine facts about top journals in economics"
 NBER Working Paper 18665
This is a very interesting finding. If I understood it correctly, the 1990s presented the biggest boom in the development of economic sciences. Perhaps this can be related to technological improvements in writing software and/or improvements in generating and measuring data.
"Seventh, citation‐based rankings of the top‐5 journals are fairly stable over time, with the notable exception of the Quarterly Journal of Economics which climbed from second‐to‐last to first place among the top‐5." 
"Eighth, citations are strongly increasing in both the length of a paper and the number of coauthors, suggesting that trends in both dimensions may be driven in part by quality competition. The effects hold both when predicting the number of citations (in logs) and when predicting the probability of an article in the top 5% of citations in a given year." 
"Ninth, despite the relative stability of the distribution of published articles across fields, there are interesting differences in the relative citation rates of newer and older papers in different fields. In particular, papers in Development and International Economics published since 1990 are more highly cited than older (pre‐1990) papers in these fields, whereas recent papers in Econometrics and Theory are less cited than older papers in these fields." 
I account this to the newer and more precise findings in these two fields. 

Since we're on the topic of academic journal articles, some readers might find this paper particularly interesting:
"The Nonsense Math Effect"

"Mathematics is a fundamental tool of research. Although potentially applicable in every discipline, the amount of training in mathematics that students typically receive varies greatly between different disciplines. In those disciplines where most researchers do not master mathematics, the use of mathematics may be held in too much awe. To demonstrate this I conducted an online experiment with 200 participants, all of which had experience of reading research reports and a postgraduate degree (in any subject). Participants were presented with the abstracts from two published papers (one in evolutionary anthropology and one in sociology). Based on these abstracts, participants were asked to judge the quality of the research. Either one or the other of the two abstracts was manipulated through the inclusion of an extra sentence taken from a completely unrelated paper and presenting an equation that made no sense in the context. The abstract that included the meaningless mathematics tended to be judged of higher quality. However, this “nonsense math effect” was not found among participants with degrees in mathematics, science, technology or medicine."

Wednesday, 9 January 2013

CPS: "Thatcher’s lessons forgotten"

I wrote another text for the Centre for Policy Studies, on Margaret Thatcher's legacy in the UK:
Vuk Vukovic, lecturer of Political Economy and Principles of Economics at the Department of Economics, Zagreb School of Economics and Management (ZSEM), writes on Margaret Thatcher's role in the specialisation of the UK workforce and its benefits, and points out her successors failed to understand the lessons she provided. 
Click here to see the rest of my CPS writings.

Here's the whole text

"Many leftists in the UK tend to search for a deeper cause of the current recession. For them, it wasn’t the irresponsible spending and a large welfare state creating a dependent economy during New Labour (and particularly their response to the crisis in 2008), but rather it was the “Big Bang” of 1986 and the abolition of exchange controls in 1979 made by Margaret Thatcher that led to a rapid accumulation of risk and power to the banking industry. Little do they know that these two policy decisions, among others, were the cause of a rapid political and financial rise of London, re-establishing it as a global centre of power, and making the UK more open and more attractive to foreign capital and investment.

Modernizing Britain

With the Big Bang in particular, Thatcher broke the class-based cartels in the City of London and made way for a new virtuous cycle of young individuals from around the world, enabling London to position itself as a global financial leader. Finance, Forex trading, and insurance replaced old inefficient industries like shipbuilding or mining. The process that Thatcher initiated was the beginning of a necessary restructuring and re-specialisation of the UK labour market, where a lot of old inefficient jobs were abolished and a lot of new jobs were created.

The effect of such a change was extremely beneficial for the UK in the long run. There was a generational shift from mining and shipbuilding (combined with a rapid increase in university engagement) towards financial services or anything that developed as support. Different signals were sent from the market and different patterns of specialisation were created.

The transition on the labour market was initially painful as a lot of workers got redundant and lost their jobs. But after a while they changed occupations and careers, even though they probably never got over the fact that their industries were destroyed. Think of how this affected their children in the long run. Instead of working in a shipyard, the children had an opportunity to get a good education and move to new buoyant industries. Think of the significant increase of personal wealth this brought to the average family. And think of the significant impact on newly created wealth for the UK as a whole. Closing inefficient industries (or more correctly, stopping support provided to them), opened up room for a range of other better, higher-paying industries. No one can predict where the patterns of new specialisation will end up, but provided that they are left without external interference they are very likely to produce a much more efficient and sustainable outcome. 

It is also interesting to note how a restructuring of the UK's and London's industrial advantage didn't come without significant resistance from those affected. Unions went on strikes to oppose these changes but they were irreversible. Even though the unions and their members will never admit that the change initiated by Margaret Thatcher was good for the UK economy, they too have been affected in positive ways and have achieved better lifestyles and more wealth than before. Thatcher has restarted the virtuous cycle of institutional and industrial development in the UK.

The rise of cronyism

The enormous opportunities for wealth creation brought by globalization in some instances did lead to a creation of new powerful elites (banking, political and media) which threatened the sustainability of the system. But it is here where the UK’s post-Thatcher leadership forgot her lessons.

Thatcher strongly opposed the accumulation of power by the elites and the consequential rise of cronyism. She advocated wealth creation and the principle of property ownership. But as much as she supported wealth creation, she was against wealth expropriation. She knew of the distinction of being pro-business and being pro-market. One does not imply the other. Being pro-market meant supporting competition and equal opportunity, not creating monopolies or picking industry winners.

Administrations that followed seemed to have forgotten this distinction. The accumulation of power and risk in the British banking system did not arise as an effect of Thatcher’s reforms, but as a consequence of what Charles Moore describes as a “devil’s bargain” between New Labour and the banking industry which has allowed “a huge amount of regulatory leeway in return for conferring commercial respectability (not to mention donations) upon the party”.

Margaret Thatcher for one would have stood firmly against the oligopoly position of banks which have undermined the interest of the customer. She would have also rejected the “too-big-to-fail” doctrine. Her insisting that there is no such thing as government money, but that it’s the people’s money strongly depicts how she would have felt and reacted to large nationalisations of Northern Rock or RBS.

When CPS Chairman Lord Saatchi recently told Lady Thatcher that the five leading banks had a combined market share of over 80%, Thatcher retorted ‘that’s impossible!’ What she meant by that was not that it wasn’t true, but that it was intolerable. She recognised that strong competition, particularly in industries with vast amounts of power, were necessary.

It was the creation of a crony capitalist mentality where politics aligned close with banking and media power (hint: Leveson inquiry, LIBOR scandal, etc.) that threw Britain into a state of unsustainable welfare dependency, irresponsible decision-making, and low probability of achieving substantial growth any time soon (unless the system is changed). Luckily this still hasn’t undermined Britain’s accumulated wealth, but it has certainly limited its growth.

Had her lessons not been forgotten, the UK would have ‘dodged the bullet’ and wouldn’t have been trapped in the downward cycle of a rising unsustainable welfare state and anaemic growth. The development of the finance industry and all the consequences it bared wasn’t Thatcher’s curse, it was her legacy. The problem was the interpretation of this legacy."

Monday, 7 January 2013

Why Krugman should NOT be the US Treasury Secretary

There was an article in the Guardian over the weekend endorsing Paul Krugman to become the next US Treasury Secretary. Apparently the initiative came from actor Danny Glover who started a petition online. 

Here are a few central points in favour of prof. Krugman's candidacy: 
"Krugman would be tough to oppose on any substantive grounds. He has a Nobel Prize in economics (also the John Bates Clark award for best economist under 40). The New York Times columnist is probably the best-known living economist in the United States, and perhaps the world."
What credentials! If only the author has explained which are these substantive grounds? Liquidity-trap economics I presume? 

He continues:
"Krugman has been right about the major problems facing our economy, where many other economists and much of the business press have been wrong. A few examples: he wrote about the housing bubble before it collapsed and caused the Great Recession..." (continued below) 
So have Shiller, Roubini, Schiff and many others, and much earlier and more precise than Krugman. Most of these are respectful economists (not Nobel Prize winning but still very good at their fields), while Schiff is an investment broker. Does this mean we should consider them for the position as well? No. 

As for Krugman's prediction on the housing bubble, here's what he actually said back then (2002):
"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."
I can hear similar arguments now, except that today the government needs to create some sort of a spending boom to offset the lack of private sector investments. Let’s hope this doesn't cause the same effect as the previous recovery did.

Of course he doesn't admit he was wrong but claims the sentence was taken out of context; "I was talking about the limits to the Fed’s powers, saying that the only way Greenspan could achieve recovery would be if he were able to create a new bubble, which is NOT the same thing as saying that this was a good idea."

Read the text and judge for yourself. He was right btw; a housing bubble did, after all, lead to a recovery. Up until 2007 that is. 

Going back to the endorsement: 
"...he has forecast and explained that large budget deficits and trillions of dollars of "quantitative easing" (money creation) would not cause inflation or long-term interest rates to rise; and that the "confidence fairies" would not reward governments that pursued austerity in the face of recession."
Not yet they didn't. Primarily because the economy hasn't fully recovered. Of course inflation and long-term interest rates would stay low in an uncertain environment and stagnant growth in the West, where investors are looking for safe havens like US, UK or German bonds, but this doesn't mean the same situation will persist after the World starts recovering more strongly. As for inflation expectations, sure they are low now and for the next couple of years primarily thanks to the signals sent by the Fed, but we are still waiting to see how the Fed-induced monetary "bomb" will affect us in the next boom years (there's still a lot of time before it happens, so we're safe for now). 

As for the confidence fairies not rewarding tax increases and postponement of structural reforms which only further increased uncertainty (think of European and UK austerity or the US fiscal cliff), gee I wonder why?
"Most importantly, Krugman is on the side of the majority of Americans. He has written extensively in favor of policies that favor job creation, explained the folly of budget cutting in the face of a weak economy, and opposes cuts to social security and Medicare benefits."
Majority? I doubt it that the majority of Americans have any idea whether or not budget cutting is good or bad in a weak economy. As for the cuts to entitlements the country is split in half in a debate over should the US create a European-style welfare state. I would be very careful in claiming that the majority of Americans are in favour of this. If the author of the text in the Guardian and his group of friends support this, it doesn't mean that the majority of Americans does.
"Krugman has written extensively about the stupidity of the last few years of economic policy in Europe, which has been a major drag on the whole world economy. The treasury secretary would have only limited influence on Europe through the IMF, but in developing countries the US treasury department pretty much is the IMF."
Wow! I was not aware of such an important role of the US Treasury in international economics and politics. Does this mean that countries like Hungary for example now have an alternative to a stand-by arrangement with the IMF?

It's true that Krugman was opposing the "stupidity" of Europe's economic policies, but from the wrong ground I'm afraid. He opposed welfare state and entitlement reforms but was strongly in favour of large stimulus spending to "end this depression, now". This type of reasoning closely resembles the policies of Gordon Brown from 2008 to 2010, which were the crucial reason behind the UK's enormous budget deficit, unsustainable public finances, and kick-the-can-down-the-road policies aimed to close that deficit. 

However, I'm sure that Krugman would support taxing of the rich as one favourable way to close the budget deficit (if we have to do it, even though he thinks the US doesn't have a structural deficit problem at all *-see end of text). As a matter of fact, isn't this exactly the deal reached in the fiscal cliff negotiations? Higher marginal tax rates for the richest Americans, no tax reform, no entitlement reform. Krugman's only objection was that Obama has left the Republicans some leverage to repeat the same scenario in a month from now when they start the talks on the entitlement reform and the debt ceiling. He would have had none of it. 

Aside his academic brilliance that has earned him a Nobel Prize, having strong biased positions like these and the fact that some people think he makes a few good points every now and then on his blog, aren’t the credentials necessary for a US Treasury Secretary, who has to take responsibility for his actions. If Krugman was the Treasury Secretary in 2002, would he have supported Greenspan in initiating the housing bubble or would he have opposed it? These are the decisions a Treasury Secretary has to cope with every single day. 

Finally, can I make a suggestion for the US Treasury Secretary, since we're apparently allowing anyone to make important nominations? I nominate Ron Paul. He served his last day in Congress the other day so he's available. There Danny Glover, organize another petition for that. Or, instead, you should stick to what you do best. If "best" really is the most formidable word...


* He blames it all on a depressed economy - there is some truth here if you look at the short-run slump of the deficit caused by the crisis (see his graph below), but the long-run sustainability of the public finances implies that the US has to choose between dropping the welfare state idea, or supporting it by introducing a VAT, thus increasing substantially the size of its government. All this depends basically on the preferences of the population. It will be interesting to see the development of these preferences over the next few decades.

Source: Krugman blog: On the Economics and Politics of Deficits, Dec 29th 2012
UPDATE: Krugman is flattered by the candidacy but he respectfully refuses. He wishes to remain "the outside man" and criticize government policies from a safe distance that we all enjoy. Cheers Paul! 

Friday, 4 January 2013

Graph of the week: inter-bank transactions

Transactions between Eurozone banks shows an interesting pattern (click to enlarge):

Source: The Economist

It looks like the banks are taking cash away from the PIIGS, Belgium and France, and are moving them mostly to Finland (!?), Germany and the Netherlands. The Finland issue is particularly interesting. Perhaps this has something to do with it: Moody ranked Finland's banking system the strongest in the EU. 

No wonder these countries are having trouble kick-starting their economies; their banks are shrinking assets and are thus lowering the possibility for further credit and deposit creation. As an effect of high risk and uncertainty money is leaving the countries (recall the Spanish situation from June last year) and is further strangling the system. The ECB's help is also pretty useless in this case since the banks are not losing money; they are transferring it to a lower risky environment. Does "doing whatever it takes" by shoveling them with more money (which they end up moving abroad) make any sense then? Not really because none of these attempts will substitute for a proper structural reform in the selected economies.

What's even more worrying with the graph are across the continent reductions in inter-bank loans (except for Italy). This further emphasizes the decline in possible credit creation as banks are finding it less and less reliable to loan to each other - at least across the continent. In Greece both types of asset shrinkage are reaching terrible proportions. It makes me wonder if any recovery will ever be possible in this country. Perhaps after they reform and start growing on the newly acquired strength of their domestic economy will they experience a boom in foreign investment and "bring all this money back". It's a possibility. If they ever make it out (i.e., if they don't end up in radicalism), they are in for a rapid recovery. 

Tuesday, 1 January 2013

The day after

The fiscal cliff has been averted, for now. It appears that the commitment device I was referring to in the previous text was strong enough after all. My argument was that the Nash equilibrium of the bargaining game will prevent an outcome and force the US down the cliff. I modeled it as a weak commitment device, without time discounting, and without having written down any of the parties' utility functions. Having included these parameters, the game would have given a scope for a cooperative equilibrium, however with a lower probability than a non-cooperative equilibrium. This can be extended in a lot of ways. 

Anyway, I wasn't all that wrong, since the budget cuts deal was put off for two months (so no deal was reached here - the model didn't account for extending the deadline), there were no reforms to entitlement spending and there were no reforms of the complex tax code. The tax rate deal was reached, taxing only individuals earning more than $400,000 p/y (at 39.6%, from the previous 35%). This was all approved in the Senate (89-8), and waits to be approved in the House*. I guess this is a clear win for the Democrats ("taxing the rich"), even though their part of the bargain is left to be agreed upon in the next two months. I expect another situation similar to last night's. 

Here are some of the reactions on last night's deal: 

From President Obama (video: Financial Times): 


From the New York Times:
"Despite repeated, intense and personal efforts by President Obama and Speaker John A. Boehner as well as bipartisan coalitions, gangs of senators, supercommittees, special commissions and wonky outsiders, the grand bargain remains the elusive holy grail of fiscal policy and seems destined to stay that way for now.
... While Congress appeared on Monday to be lurching to a deal to avoid significant tax increases for millions of Americans, the emerging patchwork tax deal would push a series of fights into the next Congress, most of them very likely to be marked by the same 11th-hour, rancorous dynamics that have been the signature of every other fiscal deal. 
Most pressing, Congress will have to come together as early as next month to lift the debt ceiling, which Republicans are already hoping to leverage to eke more spending cuts from Democrats. A similar fight almost led to default in 2011, and damaged the nation’s credit rating. ... 
...“That’s the nature of the dysfunction,” said Julian E. Zelizer, a professor of history and public affairs at Princeton. “For the parties, it gives them temporary cover and to fight again on the issues in the next few months. The parties please their base, but the country does not get a solution.” 
But that seems to be the nature of what constitutes progress in such a sharply divided political world."
From the Wall Street Journal:
"By waiting until the last minute, and by cutting a deal on a much smaller scale than either side once envisioned, Washington also deferred many of its thorniest questions, though perhaps for only a few weeks. In late February or early March, the Treasury Department will run out of extraordinary measures to avoid exceeding the government's borrowing limit—which it otherwise would have reached on Monday—and Congress will need to approve an increase. 
The delay in the spending cuts will run out about the same time. In effect, Congress has delayed the fiscal cliff by erecting a new and potentially more dangerous one."
From the Economist: (entitled "Short-term relief, and little else") 
"By avoiding that hit and finally nailing down numerous features of the tax code, the deal lifts a cloud that had hung over the economy and investor confidence. But on almost every other point, the deal falls short of already low expectations. ...
... While Republicans will try to use the sequester and debt-ceiling negotiations to secure the spending cuts that this week’s agreement omitted, Mr Obama signaled today he was equally determined that taxes have to rise further, too. “If Republicans think that I will finish the job of deficit reduction through spending cuts alone…they’ve got another thing coming,” he said in a brief public appearance Monday that riled Republicans with its partisan, combative tone. It may be that Mr Obama was mostly trying to reassure his own liberal base that it was the opposition, not him, who caved in this time. But it may also be a sign of the tone likely to prevail in coming months."
And my favorite reaction comes from Greg Mankiw:
"The fiscal deal struck last night makes one thing clear: President Obama must have really hated the recommendations of the bipartisan Bowles-Simpson commission that he appointed. The commission said that we needed to reform entitlement programs to rein in spending and that increased tax revenue should come in the form of base broadening and lower marginal tax rates. The deal appears to offer no entitlement reforms, no tax reform, and higher marginal tax rates. After all the public discussion over the past couple years of what a good fiscal reform would like like, it is hard to imagine a deal that would be less responsive to the ideas of bipartisan policy wonks."
This is particularly sad, since this is what "bad" austerity implies; higher taxes, no spending cuts, no reforms (see previous texts, here, here, here and here). Mankiw is right; after all the public discussion over how the reforms should be initiated, how to rein in the tax code, what are the good and bad examples of an austerity policy and how is it supposed to be implemented in the US to help it grow, it is surprising that the deal includes none of the "good" sides, and focuses exclusively on raising taxes and failing to address any long term issues (for now).

*Update (02.01.2013): The deal passed the House (257 to 167), with 85 Republicans joining 172 Democrats and voting for a rise in taxes first time in the past two decades.