Thursday, 27 November 2014

Two faces of modern entrepreneurship

The Atlantic had a very interesting recent text on the "Mysterious Death of Entrepreneurship in America" where they tell the tale two breads of entrepreneurs, one thriving and the other one hopelessly failing. At the same time when Silicon Valley entrepreneurs are soaring, the smartphone app market is booming, pages like Kickstarter are redefining the the very supply and demand for funding (providing a very interesting alternative to all sorts of traditional lending schemes), but on the other hand business dynamism overall is declining. Mom and Pop stores are dying out. BLS has the data: 

Brookings has produced a study describing the very same process of entrepreneurial decline, where the declining business dynamism is obvious across all sectors of the economy. As I've written before, the process of creative destruction in the US has halted in the past years. And why is this worrisome? Because of the effect on job creation. No longer are US SMEs the key driving force of new employment. 

This could be down to several reasons. One is surely the effect of the recession, even though the trends of declining business dynamism go all the way back to the 1990s (see further data here). Another could be the fact that the big companies are expanding more and more and are thus simply taking up more space in the corporate game, successfully running the small stores out of business. These big companies are usually not the source of major job creation (see the final graph), since they tend to expand abroad after reaching a certain size, where they focus much of their new job creation. This is why historically the domestic job growth in countries like the US has always originated from SMEs. Which is also why Americans like start-ups and small businesses. This is the famous US entrepreneurial spirit: 
"One paradox of globalization is that it's localized employment. Since big companies off-shore much of their job growth (or replace what's left of it with software or smart hardware), the future of work in the U.S. will come from work that absolutely has to be here, like health care, education, and food services. Start-ups can be special for many reasons—they can challenge lumbering incumbents, they can create new demand for stuff, they can introduce more ideas—but from a big-picture macroeconomic standpoint, they're also special because they're here, and when they expand they tend to expand here. It's easy to make fun of Silicon Valley these days. But at least its companies have a California address."
All in all, the declining trend of entrepreneurship is something to be worried about. It explains well why the US employment population ratio is still low, meaning that the US labor market hasn't really recovered (despite a low unemployment rate - I've mentioned this distinction several times on the blog). Furthermore all this could simply be pointing out to a new equilibrium for the US (Europe as well), where creative destruction has slowed down. The question is why? If it's a short-term consequence of the crisis, then a decade or so later we might see a reverse in trend. However, if it has slowed down due to structural instabilities and what Fukuyama refers to as political decay (I recommend his new book; read an excerpt from the book at Foreign Affairs), then the problem is extremely deep and it will take unprecedented effort to fix it. 

Tuesday, 11 November 2014

Graph of the week: A country divided

This weekend Germans celebrated the 25th anniversary of the fall of the Berlin Wall. A symbolic event that represented the end of an era (both the Cold War and communism in Eastern Europe were finally over); followed by a stream of euphoria and triumphalism from all sides. Looking back, 25 years later, some might say that the euphoria was misplaced: the world yet again resembles a Cold War status quo, where old foes are once again flexing their muscles in foreign territories. On the economic side, some Eastern European countries are arguably better off than before, while others remain in shambles of a failed transition. 

In Germany, at first sight the convergence wasn't as successful as initially hoped. 25 years later the western Germans are still living better than their eastern compatriots. GDP p/c in east Germany is still 2/3 of that in the west, unemployment is higher, its demographics is worse, and net migration is still positive from east to west, leaving many eastern rural areas scarcely populated. Looking at the images below, the eastern part of Germany suffers from the same 'illnesses' as all former communist countries (particularly those of a failed transition). This once again shows, more clearly than anything else, a natural experiment of history where one nation with the same history, culture and climate, divided by two different institutional system, generated two very different outcomes: one is prosperous and happy, the other (in relative terms) poor and miserable. 

Source: Washington Post
But let's not be too harsh. This divide in Germany isn't all that different than the north-south divide in Italy, Britain (where the south is better off), or the US. In socio-economic terms particularly. Every nation has within-country regional inequalities, where one part of the country is worse off (better off) than its most (least) successful region. In Germany the most successful region is probably Bavaria, so in comparison east Germany looks particularly bad. But that is no different than e.g. Lombardia vs Calabria in Italy, or South East and the Greater London area vs Yorkshire and North East in Britain. In each case the richest region is twice as rich as the poorest. In Germany however the divide carries an unavoidable cultural paradigm as well. 

For example consider the following two maps:

On the right side we have the share of foreigners in the total population, while on the other the relative success of the extremist NPD (Nazi) party. (I already discussed the electoral divisions along the Berlin Wall in the city, where the eastern part of the city voted highly in favor of the socialist party - not the social democratic SPD, but the successor of the former socialist party that ruled DDR - while the west of Berlin overwhelmingly supported Merkel's CDU). Anyway what is most interesting here is how the extremists (obviously highly opposing immigration) win in areas where there are very few foreigners to begin with! Perhaps in one way it makes sense - they fear that what they don't know. But I'll leave that discussion for another time. 

Saturday, 8 November 2014

In memoriam: Gordon Tullock

More than a decade after Mancur Olson, and almost two years after James Buchanan and Elinor Ostrom, another champion of public choice theory has passed away, at the modest age of 92. Gordon Tullock, together with James Buchanan (both pictured below), founded the public choice school of economics, or as they saw it "the theory of politics without romance". Their legacy still remains the single most influential theory that explains how politics interacts with economics, and how one cannot fully grasp all the economic phenomena and outcomes without understanding the logic of politics.

This is Tullock's (and Buchanan's) by far the biggest contribution to economics and even more so to political science. They taught us that politicians should be modeled and observed the same way market agents are modeled and observed; driven by self-interest and self-preservation. Before public choice theory governments were always modeled exogenously as a 'social planner' that unambiguously and without any negative effect corrects for market failures. It was basically the "deus ex machina" of the market system. Public choice theory and its numerous scholars to date exposed this as nonsense. Politicians and bureaucrats are people too, they too suffer from the same biases, lack of knowledge (informational asymmetry), and self-interest as do market agents. They get captured by well-organized interest groups, they focus on short-term goals aimed at securing re-election, they engage in corruption, and they seldom care of the public interest. This is why public choice theory necessitates the use of institutional and constitutional restraints on human behavior. The 'rules of the game' must be tilted in favor of the markets, not in favor of the expanding power of politicians and bureaucrats. The foundation of public choice theory was laid out in their most influential book, "The Calculus of Consent". I highly recommend it to all my readers. 
The founders of public choice theory: James Buchanan (left)
and Gordon Tullock (right)
Tullock was much more focused on the political aspect of the story. He studied the transaction costs of the political process just like Coase studied the transaction costs of firms. The biggest of such costs is rent-seeking, a term he didn't himself devise (Anne Krueger coined the phrase in 1974), but his 1967 paper "The welfare costs of tariffs, monopolies and theft" remains the single most influential paper on rent-seeking to date. Rent-seeking is a process of gaining private benefits through the political process (by lobbying or logrolling for example). It implies gaining protection for a certain privileged group, which in return promises political support, large campaign contributions, and even bribes. This protection varies from giving a monopoly status to a certain company, regulating market entry than hampers competition (such as introducing licences to specific occupations), imposing tariffs to import goods to protect the domestic industry, handing out subsidies to politically chosen "winners"; etc. Rent-seeking most precisely paints the picture of how politicians, when they follow their self-preservation incentives, create outcomes that reward special interests, very often at a huge cost to the 'public interest'. 

However Tullock also noticed that even though lobbying for political favors generates high returns to those who lobby, the actual lobbying expenditures are relatively low. This is called the Tullock paradox. The issue is why is there so little money in politics (here's a great paper on that topic btw), and why there isn't even more corruption than what we partially observe? One possible explanation is that voters simply don't like the sight of corruption, which makes politicians and lobbyists careful, and subject to restraints. The threat of punishment by the voters is very strong. My research focuses on finding the cut-off level of corruption (rent-extraction) - the optimal point - a politician needs to respect (balance) in order to maximize his/her stay in power. But this is just one of the possible explanations of the paradox, see this video for more. 

What is most interesting about Gordon Tullock is that he never got any degree in economics, and took only one economics class during his studies of law at the University of Chicago (he was also educated at Yale and Cornell, and received an honorary PhD from Chicago, but none of it in economics). Otherwise he was self-taught. And as a self-taught economist he was considered a close candidate for the Nobel prize in economics (together with Buchanan). That serves to tell you how brilliant of a scholar he really was. Rest in piece professor Tullock. 

His most important contributions are available in a 10 book series (The Selected Works of Gordon Tullock) published by the Liberty Fund:
  • volume 1 Virginia Political Economy
  • volume 2 The Calculus of Consent: Logical Foundations of Constitutional Democracy (with James M. Buchanan)
  • volume 3 The Organization of Inquiry
  • volume 4 The Economics of Politics
  • volume 5 The Rent-Seeking Society
  • volume 6 Bureaucracy
  • volume 7 The Economics and Politics of Wealth Redistribution
  • volume 8 The Social Dilemma: Of Autocracy, Revolution, Coup d’Etat, and War
  • volume 9 Law and Economics
  • volume 10 Economics without Frontiers 

Sunday, 2 November 2014

The ECB stress test: same old, same old

The ECB performed another stress test on Europe's biggest banks. Here is the full report and here is the brief presentation. This stress test represents a yearlong audit of Europe's largest lenders to evaluate their hidden pressures and potential problems that could arise if another recession hits them. The conclusion was that 24 EU banks (out of the 130 tested) are about 25bn euros short of the money they would need to survive another potential financial crisis (this is what a stress test does - it assumes negative economic scenarios such as sharp declines in GDP and in equity markets, or spikes in interest rates, unemployment and oil prices, and then uses a series of simulations to calculate the losses of banks in the next several years to evaluate whether or not they have enough capital to 'weather the storm'). However the ECB has stated that half of these banks which failed the test (12) have already raised enough capital to make up for the shortfall.

What are the consequences on the real economy? If those 24 banks now need to raise additional capital (half of which have already done that), that only further constrains their lending, which is still the biggest cause of the sluggish recovery in the eurozone. Europe is literally between a rock and a hard place; on one hand you need to keep banks safe, but on the other you want them to lend more so as to start a robust recovery. The funny thing is, it has been like this for the past 3 years (recall my earlier blog posts on the subject: here, here and here). Currently the motivation to keep banks safe by making them comply with new regulatory standards and by forcing them to raise more safe capital (which was what partially caused the crisis in the first place) is dominating over the motivation to make them lend more money to the real economy. 

On the other hand the logic can also be reversed: the relative safety of the majority of the biggest banks that underwent the test can imply that they are now finally psychologically free to lend more. The banks have so far constrained themselves in taking new risks before it became clear that they are well capitalized and stable. After all this seems to have been the angle of the ECB: 
"The highly anticipated assessment of European banks was intended to remove a cloud of mistrust that has impeded lending in countries like Italy and Greece and left the entire eurozone struggling to avoid lapsing back into recession. By exposing the relatively small number of sick banks — of the 130 under review — the central bank aims to make it easier for the healthier ones to raise money that they can lend to customers." 
Source: Financial Times
But most importantly it seems that the stress test didn't cause any further market panic this time. Which is certainly good news. Despite catching headlines (Economist, Bloomberg, WSJ), the markets reacted quite well to the news (the euro went up against the dollar, and the EuroStoxx index rose). It also seems that this stress test was more credible than the earlier ones where some banks that were proclaimed to be healthy required bailouts later on (Belgium's Dexia is a notable example, after being declared completely safe and well-capitalized in July 2011, by the end of 2012 in received a 5.5bn euro bailout from France and Belgium). Finally even the analysis have immediately pointed out that they're moving on and that even though this constitutes as good news for bank stocks, from a macro point of view, it's a non-event.

So basically, back to the 'new normal' for Europe. The banks are safe, but at the same time unwilling to take any new risks. The US can serve as an example here, after its banks completed their bailouts, paid the money back, re-capitalized themselves, passed the stress tests, lending was still very low in the first few years. It grew at 1.9% annually. It has only recently picked up, in September this year, when total lending went up by 6.3%, while industrial and commercial loans went up by 12.3% (yearly change). Source: WSJ. If this is any indicator it should mean that Europe's recovery should also soon enough start following the US trajectory (a 2-3% annual GDP growth rate), however neither of the two recoveries were robust enough to close the gap left by the crisis. The labor market in the US is a clear indicator of this, despite the somewhat better US recovery. It points to a new, low-growth equilibrium, and it will stay this way as long as the many structural imbalances still remain unsolved.