Monday, 28 December 2015

Hits and misses: Evaluating last year's predictions

This is becoming a sort of a post-Christmas tradition on the blog - each year in the weak after Christmas I offer a wrap up of the year by evaluating my last year's predictions. Once again, I have to say, it was a good year in terms of what I got right (I managed to even beat my own predictions from 2014: 85% compared to last year's 75%), but there were a few events that went under my radar (the Greece situation triggered by Syriza's victory, and the refugee crisis). 

The title of last year's predictions was: "2015: Back to Realpolitik and back to growth". My main prediction was that most economies in the West would return to having steady rates of economic growth (which came true), and that debates over the economy will be overshadowed by the return of realpolitik and muscle-flexing between Russia and the West. I've also stated that "low oil prices will be the key in prompting a stronger recovery", which they were, and I managed to exclude Russia from that prediction in that low oil prices, coupled with sanctions, would hurt their economy even further. Russia will end 2015 with negative growth (the first three quarters were negative), but it was Russia in particular where the debate over the declining economy due to low oil prices and a stumbling ruble was overtaken by its military conquests in foreign lands (Ukraine and Syria). 

All in all, I offered quite a positive economic outlook, but a grim political one. I could say that this came true, however the political outlook was grim for reasons I failed to predict. 

Let's give it a run around topic by topic:

The Hits:

1. "will the central bankers raise interest rates next year? This is now becoming increasingly likely. The FED will be first to do so amid a stronger recovery in the US." 

Yes! Prediction achieved in the very last minute! Two weeks ago the Fed raised interest rates from 0.25 to 0.5% for the first time since 2008. Furthermore they've announced the rates to continue rising throughout 2016 as well. Since investors saw this coming, the announcement hasn't unsettled markets so much (as I anticipated), but it did add strength to the dollar and it did cause problems for the emerging markets (and will continue to do so). 

1.1. I was also right in saying that the ECB and the BoJ will not increase rates this year.

2. "Europe (Eurozone) will continue to grow at around 1% as it did this year, however this won't mean that a robust recovery has started. Unemployment will stay high (particularly in France and Italy), despite some members improving their unemployment situation (Spain, Greece, Ireland, Portugal). Inflation will stay low (the threat of deflation is becoming Europe's serious long run issue), budget deficits will be lower than this year, and we might even see some structural reforms implemented (however their distribution will certainly be skewed and limited to a few countries). So in Europe the year is expected to be a year of positive trends, but they still won't be felt by the majority of its citizens."

A spot on prediction, growth rates were indeed around 1% (current prediction is 1.5% but this may go down in Q4), where despite a good two opening quarters, the third was a bit of a disappointment of only 0.3% growth. Unemployment unfortunately stayed high (again, particularly in France and Italy, but it started to decrease in Spain, Ireland, Portugal and even Greece, so the average is slightly lower than last year 11.6% to 11%), inflation low (around 0%), while budget deficits on average did decrease (from 3% to 2.5%, EU average), but not as a consequence of structural reforms. Finally, the last prediction is also unfortunately true - currently it's still a jobless growth in Europe. 

2.1. "The "it" country in Europe in terms of growth this year will be Ireland (3.5%)." 

Ireland was definitively the "it" country, but its growth for 2015 will probably be even bigger than what I've predicted. The current forecast is around an impressive 6%! This will surely continue into 2016 as well. Kudos to Ireland for engaging a truly robust recovery, with unemployment, debt to GDP, and the budget deficit all going down, and exports going up. And all that with inflation around 0% (i.e. without a monetary stimulus; or in other words - borderline deflation did not hurt their recovery). 

3. Regarding the political situation in the US, I stated Hilary will be the Democrat's strongest nominee (kind of a no-brainer), but that it was too close to call for the Republicans. Good prediction as well, since Trump (and Carson?) came out of nowhere! 

4. "In Japan, the growth rate will be positive, although less than 1%. It still suffers from many of the same problems as it did in the past 20 years, and Abenomics has clearly failed as the remedy it was hoping to be. The rise in consumption tax has hurt them much more than expected. ... It seems that nothing works to prompt Japanese growth. Any short-term macro policies aimed at boosting growth are counterbalanced by a problematic fiscal situation. Japan remains in its limbo state for another year." 

Unfortunately, this too came true. Japan was stuck with around 0.5% GDP growth, and with Abe's economic policy still unable to kick-start the economy.

4. "For Germany next year won't be a year with strong economic growth. It will be around the European average of 1%. Introducing the minimum wage should have a neutral net effect on growth... The biggest drag on growth will be a balanced budget. But the Germans are well aware what they are sacrificing for this. ... And finally, low oil prices will certainly help Germany in the following year."

Growth was around the European average, estimated at 1.7%. Overall, Germany's fiscal prudence did cause a drag on growth, but this was all expected and planned. 

5. UK: "The main prediction is that the Conservatives will stay in power, and that UKIP will become a parliamentary party...I don't think there will be a National government of Conservatives and Labour, as some tend to predict." 

Got that one right, and I made the prediction in the beginning of the year when none of the pundits got it right and when many were in fact talking about a grand coalition between Labor and Conservatives. I sought my bragging rights back in June.

5.1. "As for the economy, it will continue on a stable growth trajectory with around 2.5% GDP growth, and more importantly with unemployment declining and the budget deficit decreasing. Housing prices will continue to rise in Britain, although perhaps not as much in London, at least in the super-prime property market."

GDP growth was predicted to be exactly 2.5% for this year, both unemployment (from 6.1% to 5.4%) and the deficit (5.7% to 4.4%) went down, while housing prices continued to go up (this market is turning into quite a bubble). 

6. Ukraine: "in 2015 it is likely to remain in its current status quo. Putin, facing domestic pressure of a declining economy for the first time in his 14-year reign, won't risk new conflicts over Ukraine, but is very likely to increase nationalist and protectionist rhetoric back home, primarily to protect his strong position. It is this rhetoric that will dominate the scene next year." 

Quite accurate. Ukraine remained in its status quo, Crimea is still annexed, there are no new conflicts, while Putin did very well to protect his position back home. 

7. Russia: "Russia is facing a serious economic crisis, in many ways self-imposed - dependency on oil and gas, cronyism, and foreign policy interventions have finally caught up with Putin. History is repeating itself for Russia, only this time their position of power was short-lived. However Putin won't go down that easily. That's why I expect a resurgence of Realpolitik in foreign relations." 

Linked with the previous issue, and with the overall prediction regarding how low oil prices will adversely affect Russia, it did face a serious economic crisis, but Putin came up with an anticipated response: building up his military power and showcasing it abroad. 

8. "In China growth will fall below 7%, slightly below expectations ...  based on reports on weak property sales, a decline in fixed investments and the manufacturing sector, and expected low inflation and lower consumer spending."

This has finally happened as well, China is experiencing a slowdown in growth. Despite the worries from the Chinese government, this is still a more than decent performance from China, and was actually expected (one cannot grow indefinitely at double-digit levels).   

9. "IIndia after a gloomy year expect the growth rate to accelerate under new leadership of Narendra Modi. There are many reasons for optimism in India; low oil prices will ease the pressure on high inflation and the current account deficit (India imports 70% of its oil consumption). This will enable India's central bank to cut interest rates in order to help the government promote some structural changes to India's economy ... All this will help its economy grow above 6% next year." 

All this has happened, low oil prices have eased the pressure and helped fuel higher growth, to which the central bank responded by cutting interest rates. Economic growth will probably be around 7% this year, outpacing China for the first time in decades.

10. "As for the rest of the emerging markets? A strong dollar certainly doesn't help, neither does the announced increase in interest rates from the Fed. Low commodity prices and low oil prices will hit the commodity and oil exporters (particularly in Africa and South America). Bond yields are on the rise in most of the emerging markets, so I do expect another growth slowdown next year for the EMs." 

So true, the emerging markets have fallen behind the developed world in economic performance. Considering that they've failed to achieve convergence in living standards this is even more worrying for them. A strong dollar coupled with low commodity prices depressed them further, and even caused havoc in some countries (like Venezuela and Argentina). 

11. Oil prices: "next year the price of Brent oil will probably drop below $50 per barrel at one point and will remain low throughout the first half of the year."

Indeed it did. The price continued to be low throughout the year (currently at $37). However the biggest impact wasn't so much on Russia as it was on the emerging markets, particularly Venezuela (the decline in oil prices struck a huge blow to their socialist model which was severely punished at the polls).

The Misses: 

1. "In the United States I predict around 3% growth for next year, driven by a resurgent Silicon Valley boom, and by low oil prices. ... low oil prices will certainly provide a net benefit for the US economy. It might, however, hurt a lot of newly formed shale gas producers and hence contract their exports (along with a stronger dollar)."  

The growth rate was strong, but it will most likely fall a bit short of the 3% target. Current estimates have it around 2.5% (close to last year's 2.4%). The decline in oil prices has however failed to pick up consumption as anticipated, while some oil companies have slashed investments as a consequence. I did state that it was difficult to predict how precisely the low oil prices will affect the US economy, since it is, at the same time, the largest producer, consumer and importer of oil, but I did state that it will entail a net benefit for the economy. This is still left to be seen, but to be fair, I will place this entire prediction under the miss category, as the factors which I thought would be key in prompting US economic growth failed to do so. 

2. "The country with the worst performance will be either Cyprus or Croatia (both probably around 0%, perhaps even negative growth)."

Argh! I never seem to get this one right! Someone always surprises me. I was way too bearish on Croatia and Cyprus, while Greece went completely below my radar. I simply did't see Syriza coming. More on that below.

3. "I predict that the Conservatives will enjoy a minority government, with UKIP (and what's left of the LibDems) giving them support to form the government..."

Even though I got the general prediction on the UK elections correct, I was wrong about the scope of victory for the Conservatives and I slightly overestimated UKIP's influence. It turned out that the Conservatives didn't need any coalition partner and that they've done it all on their own. To be fair I also failed to predict that the SNP will take so many seats away from Labour. 

4. "I wouldn't be too surprised to see the US putting troops back on the ground and leading the fight against ISIS. In his final two years in office Obama has nothing to lose with such a decision. But again, this will only happen if the conflict escalates beyond control and ISIS starts gaining more power." 

Ok, this one was a so-so prediction. I hedged by saying that "if things escalate beyond control" (vague as this may sound) the US would put troops on the ground. From today's point of view it looks like another superpower will beat them to it - Russia is increasing its military presence in the Middle East, and I would be surprised to see them lead the charge in 2016. But more on that in the next post. 

Under the radar:

1. Syriza and Greece. The story that occupied the first half of the year. And just by the end of 2014 I was thinking Greece is finally going to be OK. Not very high economic growth, but definitely a positive outlook, and then the elections happens, Syriza wins (single-handedly), and it all falls down the drain. To do a quick recap see here, here or here. I was actually correct on Greece many times before. It still serves to be one of my most precise predictions, when back in October 2011, I predicted exactly the scenario that would occur a few years from then, following a terrible response strategy from EU's policymakers. On Greece I have had a stellar forecasting record, which is why I was particularly unsettled as it went under my radar by the end of last year. I won't make that mistake again in 2016. 

2. The refugee crisis. And Europe closing its borders. 
No one saw it coming. At least not in the scope that it occurred, where in 2015 alone almost a million migrants have entered the EU by sea. In 2014 it was nowhere near this much. 

3. Corbyn and Trump? Fair enough, but literally NO ONE saw these two emerging. Not even themselves by the end of last year. Surely. For 2014 I was right in predicting that anti-establishment extremist parties will dominate the May EU elections, but I never thought that the extremists will start dominating within party lines. It still doesn't have to end well for either of them, but the trend is certainly interesting, and will be closely monitored. 

All in all, it was a messy year. With hopes that 2016 will be better (predictions coming up in the next post), I wish all my readers a happy new year!

Thursday, 17 December 2015

Graph of the year: The Fed increases interest rates!

It has happened. The Fed has raised short-term interest rates for the first time since the start of the financial crisis in 2008. And immediately they've doubled it! The rate went up from 0.25% to 0.5%, with a pledge to be gradually increased further in the years to come. In Janet Yellen's own words: "This marks and end to an extraordinary seven year period." 

Source: The Economist
An increase of interest rates in theory implies several things. Central banks increase interest rates when they want to curb the expansion of the economy, or in other words to prevent its overheating. A quarter of a basis point increase hardly means the US economy is overheating, but in the wake of the liquidity trap during the crisis and the recovery, and particularly Fed's September 2012 announcement that it will purchase mortgage securities as long as it takes until the labor market "improves", this move is viewed as a careful and gradual "return to normal". More importantly, the signal this move sent throughout the world's markets is immense. 

First of all, it confirms that the US has fully recovered from the crisis and is now embarking on a steady growth trajectory with unemployment declining consistently for the past 5 years. Even my favorite labor market indicator, the civilian employment-population ratio has improved - it is slowly but steadily rising for the past year and a half. It is still, however, a good 4 basis points below its pre-crisis peak. As I've emphasized a number of times before, this is obviously a new normal for the US (Europe as well - see here and here), as those 4 p.p. of people who lost their jobs during the crisis will probably never return to the labor market. 

Second, the signal it sends to markets worldwide is both encouraging and worrying at the same time. In the US an increase of interest rates should imply higher savings since credit is now becoming a bit more expensive (bad for debtors, good for creditors), and more importantly a stronger dollar (higher domestic interest rates appreciate the currency). It should also put a downward pressure on asset prices, as it did but by a small margin. Since the move was well expected throughout the year the domestic markets adjusted easily well before the announcement. The same is true of the dollar - it went up against most currencies today, but this is nothing new. It has been rising steadily against the euro for the past year and a half. By now the USD/EUR exchange rate is likely to actually reach its parity! It's good to hold dollars right now. Especially if you live in the Euro Area. 

The dollar growing stronger will inevitably hurt emerging markets. In a 6-year period when US interest rates were at their historic lows, the dollar was gaining strength, primarily because the demand for dollar was increasing. Now as the Fed keeps increasing interest rates (and it surely will already in March 2016), the dollar will only grow stronger. How strong depends on which currency we're comparing it to. Against the euro? Very likely. Against the Rubble? Almost certainly. Against many of the emerging markets' currencies? Also, almost certainly. 

Why is this such a big problem for emerging markets? First and foremost since most of their debt is denominated in dollars. The stronger the dollar, the more expensive it is for them to repay their debt. This has all happened once before in the 90-ies, particularly in Latin America. Back then it was called the "original sin" - having dollar-denominated debt backed by local-currency revenues. The weaker your domestic currency (for example because of the lack of demand for newly-printed domestic currency), or the stronger the dollar (or whichever foreign currency the country has borrowed in), the worse it becomes for the country to pay off its debts. In today's slow-paced global recovery, most emerging markets (and most developed economies) are already overburdened with debt. They have trouble meeting payments as it is. A strong dollar coupled with higher interest rates (read: higher borrowing costs) will only make things worse. Believe it or not, the past 6 years were good times for taking on new debt (restructuring it - meaning replacing old expensive debt with new, cheaper one). Now the real troubles will start, particularly as the emerging markets are expecting slower growth next year. 

Finally, regarding domestic inflation, the move is welcomed according to most critics. The Fed has announced that this move is the first step to ensure that inflation is contained in the time to come. Throughout the past 6-7 years inflation in the US has been really low, borderline deflation. This is why many inflation doves have claimed that the Fed need not increase interest rates as long as there is no real threat of inflation. However, inflation hawks were saying this is a matter of time, due to the huge amount of money pushed into the US economy over the crisis and recovery period (M1 money stock went from $1,400bn to over $3000bn over only 6 years). The problem is that most of this money has stayed out of the real economy - it has been primarily used to clear banks' balance sheets. Even private sector companies were hoarding cash. But most importantly the real reason why all this money-pumping hasn't resulted in high inflation, neither in the US or in Europe, was because the velocity of money was low. See further explanation here. Anyway, it's a good thing for the Fed to react already to the potential of a price increase. As soon as the velocity of money picks up, there will be an increased pressure on prices. The Fed was smart to anticipate this. 

Source: The Economist
NOTE: The FT has a fantastic, easy-to-understand, coverage of what happens when interest rates rise. I recommend to everyone to take a look.

Sunday, 13 December 2015

Adios Chavismo y Kirchnerismo

Over the past month we witnessed two major political changes in the South American continent. Venezuela and Argentina have ousted their long-lasting socialist parties and have turned center-right. The scope of this change is even greater considering the fact that two dominant Latin American political economy ideologies were punished at the polls: Chavism and Kirchnerism.

However, to be honest, the defining figures behind these political and economic ideologies weren't themselves punished by the voters. Chavez died, his successor Maduro still remains in power, but it was the Socialist party that lost the parliamentary elections (by a landslide), while Cristina Kirchner had to step down after serving two consecutive terms in office - it was her chosen successor that lost the November Presidential run-off. The Venezuelan elections can still however result in a blow to Maduro since the opposition gained a two-third majority in Parliament, meaning they can change the constitution limiting the President's power or call a referendum on Maduro's leadership if he blocks the opposition's amnesty law (a lot of opposition leaders are - surprise, surprise - in prison). In fact prior to these elections it was said they represented a pre-referendum for Maduro. With a turnout as high as 75% this was indeed a huge blow to Chavismo, but not yet its final demise. 

Economic voting: incumbents punished due to a declining economy

Either way these two events could mark an end to an era, not only in these two countries, but possibly in South America in general. What happened at the elections was actually a very simple case of economic voting - both the Argentine and the Venezuelan economy were in dismal states after a decade and a half-long socialist experiment. 

In Venezuela inflation in 2015 was over 150% (projected to go over 200% in 2016), GDP fell by 10% with a further 6% projected decline in 2016, and with unemployment soaring at 18%. Price and currency controls were imposed causing shortages of basic goods (food and medication) not to mention huge queues in supermarkets (the price controls are primarily responsible for such high inflation rates). The percentage of people living in poverty is a whopping 73% (up from 23% only a few years ago), while the health system has completely collapsed. It's easy to see why this happened. Venezuela's socialist "Bolivarian revolution" agenda was based almost exclusively on its vast oil reserves. The revenues from oil were used to fund social welfare programs as well as buying power and influence abroad. As oil prices have fallen dramatically over the past year and a half, the government simply couldn't afford all of its expenditures. While poverty was declining and living standards improving during Chavez's reign, all this was funded thanks to high oil prices and large government revenues. The socialist mindset has reached an impasse once more - they ran out of money. Naturally the economy collapsed. 

Source: The Economist
In Argentina, the situation was only slightly better, although there too the economy was crumbling. After another default on its debt in July 2014, and following a slump in commodity and oil prices, their foreign currency reserves have been drained, making it even more difficult in attracting foreign investment. The fact that Kirchner nationalized the biggest domestic oil company YFP taking it away from the Spanish Repsol, in addition to nationalizing the airline company, the railway system and the largest pension fund, didn't help either. Furthermore, similar to its like-minded socialist leaders in Venezuela, the government persistently misreported the key statistics about the economy. 

Inflation is also high, officially estimated at 14%, but with independent domestic economists calculating it to be around 25%. It too is a consequence of capital, currency and price controls, and it too is denting domestic purchasing power and living standards. Arguably one of the most devastating economic decisions by Kirchner was to implement the so called "supply law". Under this absurd piece of legislation the Argentine government has prohibited companies to set prices too high, thereby generating "too much" profit, or producing "too little", thus successfully constraining them from both ends and literary pushing them into bankruptcy. Of course the concepts of "too high" or "too little" are not defined, as long as the "extraprofits" can be detained. Nothing embodies Kirchnerism more than this move - after nationalizing all the biggest industries, the small and medium-sized businesses were also contained by a typical central planning agenda. Couple this with other laws that undermined legal contracts and basic property rights, not to mention Kirchner's capture of the justice system, it's also easy to see why things went so wrong in Argentina. 

Source: The Economist
Limited access orders 

Underneath their populist surface both Chavism and Kirchnerism were nothing more than rules of Robin-Hood-like, extractive elites which have designed and perpetuated a system of cronyism, corruption and personalization of power and key institutions. They are an almost perfect depiction of the North, Wallis and Weingast (2009) limited access order (LAO). Let me remind the readers of what LAO implies: "an institutional framework in which well-organized ruling elites manipulate the economy by generating privileges based on the personalization of governing institutions. They define such societies as natural states, or the more precise limited access orders, in which intrapersonal relationships between the powerful and the political elites serve as the base of all political and economic outcomes. The elites are then successful in preventing the development of the civil society and ensure a long-run constellation of existing political relationships."

Or in the framework of Acemoglu and Robinson (2012) this is a typical example of an extractive political order, which necessarily designs economic institutions to be extractive as well. It can also be extended to fall under the iron law of oligarchy, since the pattern of governance of these countries resembles their former autocratic regimes, the very same ones they fought against. But just like under any extractive political system, there is a limit to its growth and expansion. In both cases it was the natural resources (oil in Venezuela and land in Argentina) that held the elites in power, allowing them a chance to expand their socialist agenda when prices were high and money was pouring. 

Many dictators in the world depend on the availability of resources. If they have no resources to exploit then they form alliances with global superpowers (US, EU, Russia, China) and depend on their foreign aid. In some cases the dictators are ruthless to everyone and take all the money for themselves. This is a shortsighted strategy as it often leads to the leader being deposed and, well, murdered (Gadaffi, Caucescu, Saddam, etc.). In other cases they are more socially sensitive and only kill and imprison those who directly oppose them, while giving huge populist concessions to their voters. This strategy, only seemingly better, is also misguided as it places a too high emphasis on the country's natural resources. When prices start to fall, it's good as over for the dictator. This is why Putin's biggest challenge thus far was the rapid decline in oil prices that began last year, which evidently hurt Russia's economy. However Putin was clever enough not to put all of his eggs in one basket, plus he faced different circumstances. Kirchner and Maduro on the other hand, they didn't even have that choice. 

As for their legacy, it will be extremely hard for the opposition to fix the dismal state of their economies. Even more so as expectations are certainly riding very high from the voters. This is why one shouldn't exclude the scenario of Kircherism and Chavismo returning to the big stage after a few years. Hopefully this won't happen as the voters have learned their lesson. But in politics, just like in economics, it's never that simple. 

Saturday, 28 November 2015

In memoriam: Douglass North

Douglass C. North, one of the greatest economists of our time, a Nobel prize winner responsible for reinventing institutional economics, died this week at the age of 95. His passing follows those of other notable institutional and political economists in the past few years, such as Elinor Ostrom, James Buchanan, Ronald Coase, and his Nobel co-recipient Robert Fogel, all champions of the new approach to examining economic interactions, and all, just like North, with groundbreaking contributions to the field. Together with Olivier Williamson and Ronald Coase, he was attributed as the pivotal co-founder of the New Institutional Economics school of thought, a school of thought I personally favor and advocate. 

Out of all academics North arguably led the most exciting life. He was a navigator for the US Merchant Marines during WWII, a passionate photographer, a deep-sea fisherman, an heir to an insurance fortune, a pilot (he had his own plane), a ranch owner, fancied fine dining and music - in short, a man who enjoyed life (read his detailed autobiography here). A Marxists in his youth ("as were many of us at a certain age", as Deirdre McCloskey put it), he changed his political economy standpoints after studying economics, political science and philosophy at the University of California, Berkeley, where he also received his PhD in economics. In 1952 he became an assistant professor at the University of Washington, while in 1983 he moved to Washington University in St Louis, where he remained throughout the rest of his career. 

Cleometrics and the buildup to the examination of institutional change

North's contributions to economics and in particular economic history are monumental. His first big contribution came in the 1960s where he helped found cliometrics, an application of quantitative techniques in the study of history (named after the mythological Clio, the muse of history). His first book The Economic Growth of the United States from 1790 to 1860 had the transformative influence on the field of economic history. In his own words, "it was a straightforward analysis of how markets work in the context of an export staple model of growth." Throughout that decade North was focused on transforming economic history into cliometrics, something he proved to be very successful at, organizing conferences and even a graduate program in economic history at the University of Washington in the early 70-ies.  

Interestingly, his work at the time on cost reductions in the shipping industry turned him towards examining transaction costs and institutions. He realized that the neoclassical theory is too restrictive on its assumptions over zero transaction costs and exogenous, efficient institutions. So he went on to change that as well: “What we need is a body of theory which encompasses the traditional models of the economist and both widens its scope and allows us to include an explanation of the formation, mutation and decay of organisational forms within which man cooperates or competes.”

Institutions thus became the forefront of his research from thereon. In particular he focused on how and why institutions change and evolve over time, and he did it all within the realms of neoclassical theory. It was the perfect way to combine history and economics. By many his best book Structure and Change in Economic History (1981) came as a result:
"In Structure and Change in Economic History (1981) I abandoned the notion that institutions were efficient and attempted to explain why "inefficient" rules would tend to exist and be perpetuated. This was tied to a very simple and still neo-classical theory of the state which could explain why the state could produce rules that did not encourage economic growth. I was still dissatisfied with our understanding of the political process, and indeed searched for colleagues who were interested in developing political-economic models."
From here also follows his criticism of neoclassical economics in that it cannot explain all the factors necessarily for the understanding of the extremely complex process of economic change. He argued that political systems do not design institutions that promote growth, quite the contrary. Because of high transaction costs in the process of changing the political status quo, political elites lack the motivation to do it. They become entrenched in a low equilibrium, happy with their current levels of rent-extraction, and perfectly unwilling to initiate the process of institutional change that would be beneficial to their societies. 

To further understand why this is the case, North started to examine a system of beliefs and social norms, or in other words - informal institutions. 


In that search for answers to explain the process of institutional change, another monumental piece was published, Institutions, Institutional Change and Economic Performance (1990), in which North for the first time very precisely defines what institutions are. In his own words:
Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction...Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change.” (North, 1990, pg. 3)
He furthermore makes a very important distinction in defining formal and informal institutions. Formal institutions represent the aforementioned "rules of the game": rule of law, enforcement of contracts, property rights and the constitution. Their goal is to promote political stability and ensure the proper functionality of markets. The complete implementation of such institutional arrangements will lead to a good and stable political system. Informal institutions, on the other hand, imply social norms, traditions, customs and code of conduct. They are embedded in a person’s mentality and system of beliefs and will influence the nation’s view on the optimal political system. 

Informal institutions can provide an explanation of why the system fails to consolidate even when there exists a set of formal institutions. More importantly it will tell us why this set of formal institutions will still yield inefficient results if set up in a system of values not ready for democracy, or whatever social system we are envisioning. Informal institutions don’t change overnight as do the formal institutions and laws; rather they accumulate over time and by doing so form the necessary conditions for the formal institutional reforms to yield efficient results. However, the relationship between them is mutual. A continuous influence of formal institutions tends to be a prerequisite for a proper reshaping of informal institutions.

Although a substantial amount of variables that differ across countries affect how its citizens will feel about a particular political system and the proper institutional setting, an assumption is that whatever affects them, informal institutions are unlikely to be changed in the course of a single generation. Due to this characteristic they might be a constraining factor once a rapid change of formal institutions occurs. On the other hand they might also enhance a democratic order but only in the long run and always followed by a long and gradual accumulation of democratic capital. A positive influence can be generated if informal institutions are changing long enough (under the influence of pro-democratic formal institutions) so that they become widely accepted social norms. The example is the length of democracy in the West where a long and continuous democratic tradition embedded on the assumptions of pro-democratic formal institutions generated a spontaneous change of informal institutions.

All of these findings and efforts landed North the Nobel prize in economics in 1993, jointly with another brilliant economic historian Robert Fogel. Officially they were rewarded "for having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change". Read his Nobel prize lecture here.

Violence and Social Orders

As Arnold Kling has put it, there is no other Nobel laureate that has produced anything as good as his book Violence and Social Orders (co-authored with Wallis and Weingast), after receiving the prize (read Kling's excellent review here). It is truly remarkable that a man in his late 80-ies/early 90-ies can produce such an astonishing piece of work (and if you're doubting the scope of his contribution just hear him give this interview three years ago). 

The central theme of the book is to offer a comprehensive theory of a society's institutional development with respect to how it reacts to and deals with the problem of violence. The authors present an institutional framework in which well-organized ruling elites manipulate the economy by generating privileges based on the personalization of governing institutions. They define such societies as natural states, or the more precise limited access orders, in which intrapersonal relationships between the powerful and the political elites serve as the base of all political and economic outcomes. The elites are then successful in preventing the development of the civil society and ensure a long-run constellation of existing political relationships. When the institutions of a system are de-personalized it is much harder to evoke clientelistic relationships, making it easier to develop an open access order. In an open access order, the basis of all interactions is a well-defined, de-personalized legal framework, not politically generated privileges, and it is only through such a system that countries can achieve prosperity. I wholeheartedly recommend not only this book, but the majority of his scientific opus. 

Here, as always, is a list of North's most important publications:

  • The Economic Growth of the United States, 1790–1860, Prentice Hall, 1961.
  • "The State of Economic History," American Economic Review, 55(1/2) 1965.
  • Institutional Change and American Economic Growth, Cambridge University Press, 1971 (with Lance Davis).
  • Structure and Change in Economic History, Norton, 1981. 
  • Institutions and economic growth: An historical introduction, Elsevier, 1989
  • Institutions, Institutional Change and Economic Performance, Cambridge University Press, 1990.
  • Institutions, 1991, The Journal of Economic Perspectives, 5(1), pp. 97–112
  • "Economic Performance through Time," American Economic Review, 1994, 84(3) (the Nobel prize lecture)
  • Understanding the Process of Economic Change, Princeton University Press, 2005.
  • Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History, Cambridge University Press, 2009 (with J.J. Wallis and B.R. Weingast).

Saturday, 24 October 2015

"Does the Wage Gap between Private and Public Sectors Encourage Political Corruption?"

A paper of mine (co-authored with Boris Podobnik and H. Eugene Stanley) got published in PLOS ONE! Since PLOS is an open-access journal you can read the whole paper here.

It is primarily a theoretical paper focused on designing a model of corruption networks in democracies. The intuition for the model was a growing disparity between public sector and private sector wages and how this corresponds with greater corruption. This is, naturally, only a correlation, but it served as a motivation to search deeper and uncover how corrupt networks can sustain themselves within a democratic environment. 

There were three main findings/contributions in the paper:
  1. The greater the public sector wage premium (higher public sector wages than private sector wages) in a given country, the greater the possibility of corruption
  2. We design and propose a new reward-to-risk ratio for labor economics (taking into account the relative riskiness of working in each sector)
  3. Democracy does not create corruption, but it can serve as a mechanism to preserve it in the long run. A transition from a corrupt to a non-corrupt state, and vice-versa, can only be purely random. 
And here is the full abstract:
"We present a dynamic network model of corrupt and non-corrupt employees representing two states in the public and private sector. Corrupt employees are more connected to one another and are less willing to change their attitudes regarding corruption than non-corrupt employees. This behavior enables them to prevail and become the majority in the workforce through a first-order phase transition even though they initially represented a minority. In the model, democracy—understood as the principle of majority rule—does not create corruption, but it serves as a mechanism that preserves corruption in the long run. The motivation for our network model is a paradox that exists on the labor market. Although economic theory indicates that higher risk investments should lead to larger rewards, in many developed and developing countries workers in lower-risk public sector jobs are paid more than workers in higher-risk private sector jobs. To determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the public sector wage premium increases with the level of corruption."
Findings in depth 

Much research in labor economics has been focused on uncovering whether workers in public sector occupations are overpaid or underpaid relative to workers in the private sector. However, many of these research efforts failed to take into account that occupations in private and public sectors generally have different rights assigned to them and more importantly different risks of losing a job. This implies that in labor economics we are faced with a similar problem that has existed in finance before Markowitz and Sharpe, where risk was not taken explicitly into account when assessing an investment. Markowitz revolutionized both investment theory and practice by accounting expected return and risk in portfolio construction ("Portfolio Selection", The Journal of Finance 7 (1): 77-91). Inspired by the Markowitz mean-variance model and the Sharpe ratio (The Journal of Portfolio Management 21 (1): 49-58), and in order to quantify how well wages compensate employees for risk in a given sector, we propose an analogous reward-to-risk ratio for labor economics as the ratio between annual wage and sector risk. We define sector risk as the reciprocal business lifetime in a given sector. If it is inappropriate to evaluate an investment return without taking into account its risk, it is equally inappropriate to discuss whether a job in a given sector is underpaid or not without taking into account the risk of that sector. 

Furthermore, according to economic theory, and related to the previous issue, higher risk investments should lead to larger rewards. In contrast to economic and common sense, there is a paradox on the labor market: in many developed and developing countries lower-risk public sector jobs are paid more than higher-risk private sector jobs. In order to determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the wage gap between public sector and private sector jobs in a country increases with the level of corruption. This result inspired us to propose an intriguing hypothesis that the wage gap between public and  private sectors can serve as a motivation for corruption. The greater the public sector wage premium, the higher the motivation for those without adequate skills and education to enter the public sector to achieve private benefits. Even in the US, jobs in the public sector carry greater advantages than jobs in the private sector. They are more secure, less stressful, offer a wider selection of health-insurance plans, better retirement benefits, flexible work arrangements, and more holidays and vacation days per year. The question is: how is this discrepancy, in which the less riskier sector is rewarded with higher wages, sustainable in the long run?

We hypothesize that a democratic system (understood under the principle majority rule), creates an enabling mechanism for corruption persistence, even though it is not responsible for creating corruption in the first place. If we operate under a plausible assumption that a large majority of people are generally uncorrupt, why can corrupt subjects in some countries prevail and take power? To resolve this question we apply a network concept based on the model recently published in Nature Physics (Majdandzic, Podobnik, Buldyrev, Kenett, Havlin & Stanley (2014) "Spontaneous recovery in dynamical networks." Nature Physics 10, 34-38). We propose a dynamic network model of corrupt and uncorrupt employees representing two states in the public and private sector. In our model, corrupt employees are more intra-connected to one another and more unwilling to switch their attitudes regarding corruption than the uncorrupt. Inter-links between corrupt and uncorrupt employees serve to switch the attitudes of agents in the competing group. With such inter- and intra-links, corrupt subjects can prevail and become a majority through sudden transitions even though they initially represented a minority. This way it is obvious that in many democracies corruption can be persistent over a long period of time, and the only way to break the mold and flip from a corrupt to a non-corrupt state is via random selection of a non-corrupt individual as head of state.

Wage gap and corruption

A potential criticism may be directed at the assumption of modelling the labor market as a securities market. This is a mere allegory. The point is to suggest that wages in any job have to take into account the relative riskiness of that job (potential of job loss, benefits received, industry risk, etc.), not just the usual factors like location, hours or level of education. Furthermore the standard economics literature linking the wage gap to corruption finds an opposite conclusion to our own - countries which have a greater public sector wage premium usually have lower corruption. These findings are however limited primarily to low-income, developing countries. Naturally, we factor for this difference and observe all types; low-income, middle-income and high-income countries. Here is how that looks:

Source: Podobnik, Vukovic, Stanley (2015) "Does the Wage Gap between Private 
and Public Sectors Encourage Political Corruption?" 
PLoS ONE 10(10): e0141211. doi:10.1371/journal.pone.0141211 
We can see three types of countries corresponding to a concave relationship between the public sector wage premium and the corruption index. There is a group of low-income countries where corruption is rampant and public sector wages are much lower than private sector wages. This phenomenon is well established and explained in the literature. Given the low public sector wages in these countries the bureaucrats, doctors, and teachers are naturally more open to corruption in order to earn some money on the side. However in the group of medium-income countries the situation is reversed; the public sector has higher wages than their private sector counterparts (read the methodological part of the paper to see how we make this comparison) and corruption is still high. Only in the group of high income countries where corruption is low is the wage gap low as well. Finally, only a few high-income countries have private sector wages higher than public sector wages (albeit by a small margin), and these countries are also the least corrupt in the world. Of course, we're talking about Scandinavian countries, Sweden, Denmark, Finland and Norway. Again, this isn't to say that their negative public sector wage premium is the cause of low corruption. But it is interesting to notice a trend in which rich countries with low levels of corruption do not bias domestic wages too much in favor of any sector. 

Saturday, 17 October 2015

Angus Deaton wins the 2015 Nobel prize in economics

Over the past two weeks, in the same schedule as always, we had the opportunity to enjoy the announcements of Nobel prize winners. Last but not least was the Nobel prize in economics (or to be more precise for all those doubters out there, the Sveriges Riksbank Prize in Economic Sciences in Memory of Albert Nobel). And once again the prize went into well-deserved hands. Angus Deaton from Princeton University, a brilliant academic with a distinguished career and list of contributions (recently a member of the National Academy of Sciences), a global fighter against poverty and inequality, and above all an economist with an eye for applicability of his research. What is surprising is that once again, the same as last year, the prize was awarded to a single recipient (a rare occurrence in the past 15 years in this field). However what hardly came as a surprise was the field of research that was finally acknowledged with a Nobel prize - inequality and development, for the first time since Amartya Sen in 1998. The public debate on inequality has gone long enough for the Nobel prize committee to overlook the major contributors in this field. Deaton is certainly one of the biggest. And what a great decision it was to recognize precisely Deaton as the man to shed some light on this enduring debate. After all, as The Economist has recognized a decade ago: "Mr Deaton is perhaps the only economist at work in this area who is acknowledged by all sides both as authoritative and as having no ideological axe to grind."

Deaton received the prize "for his analysis of consumption, poverty, and welfare". His research therefore focused around three seemingly different, yet very much interconnected issues: how consumers distribute spending between different goods, how much of society's income is spent and how much is saved, and what's the best way to measure and analyse poverty. Needless to say it's easy to see Deaton has applied methodological individualism to the study of consumption, welfare and poverty. 

The Committee summarized his main contributions: 
"How do consumers distribute their spending among different goods?Answering this question is not only necessary for explaining and forecasting actual consumption patterns, but also crucial in evaluating how policy reforms, like changes in consumption taxes, affect the welfare of different groups. In his early work around 1980, Deaton developed the Almost Ideal Demand System – a flexible, yet simple, way of estimating how the demand for each good depends on the prices of all goods and on individual incomes. His approach and its later modifications are now standard tools, both in academia and in practical policy evaluation. 
How much of society's income is spent and how much is saved? To explain capital formation and the magnitudes of business cycles, it is necessary to understand the interplay between income and consumption over time. In a few papers around 1990, Deaton showed that the prevailing consumption theory could not explain the actual relationships if the starting point was aggregate income and consumption. Instead, one should sum up how individuals adapt their own consumption to their individual income, which fluctuates in a very different way to aggregate income. This research clearly demonstrated why the analysis of individual data is key to untangling the patterns we see in aggregate data, an approach that has since become widely adopted in modern macroeconomics
How do we best measure and analyze welfare and poverty? In his more recent research, Deaton highlights how reliable measures of individual household consumption levels can be used to discern mechanisms behind economic development. His research has uncovered important pitfalls when comparing the extent of poverty across time and place. It has also exemplified how the clever use of household data may shed light on such issues as the relationships between income and calorie intake, and the extent of gender discrimination within the family. Deaton's focus on household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data."
A brief and very easy to understand explanation of Deaton's main contributions is available on the webpages of the Nobel prize committee, and a more technical explanation is here.

Poverty and inequality 

To present all of Deaton's main findings is quite a demanding task for a single article. His contributions vary from theoretical to empirical, from methodological to applicable. He had an important role in figuring out how to precisely measure poverty in some of the world's least developed countries. The World Bank database on developing countries relies to a large extent on his methodological solutions using household surveys to measure poverty. He basically transformed the field of development economics by giving it access to much better and far more reliable data than it had before. For example in his quest to improve the methodology of measuring poverty he was exploring how the amount of calories a person eats per day affects their productivity, and how the calorie intake will be affected as the poor get more money. Health was also an important part of his analyses of poverty, as was gender discrimination, and how to construct local market price indices to measure relative levels of poverty. 

His research on inequality testifies of his complete lack of any ideological bias. He realized that inequality is a necessary outcome of societal progress. However he never thought that more wealth in the hands of the elites is a good thing, not out of any envy for the rich, but purely from the possibilities of misuse of this power to serve particular interests at the expense of the rest of society. 

He refrained from doomsday predictions about how inequality is bigger then ever and particularly from proposing inapplicable policy solutions in dealing with it. In his fantastic, partially autobiographic (read this essay) book "The Great Escape: Health, Wealth, and the Origins of Inequality" (see here the NYT book review) published in 2013 he delivers a very important and quite an optimistic message:
"By the most meaningful measures — how long we live, how healthy and happy we are, how much we know — life has never been better. Just as important, it is continuing to improve."
A very true and very clear message. There is absolutely no doubt that living standards today are better than ever before (recall previous blog posts here, here and here), that the rate of people living below the poverty line is lower than ever and that even as inequality has increased in particular Western countries, the overall level of global inequality has declined - primarily due to the rapid growth of Asian countries. Deaton provides evidence for all of this. Just read his book

Perhaps it's due to his extensive scientific rigor and unwillingness to succumb to sensationalism that he avoided the media frenzy during the whole inequality debate. But as anyone who read any of his work would agree, Deaton is perhaps the biggest authority in the field precisely because he carries no bias and looks at everything from a purely scientific lens. 

Microfoundations: fixing the demand curve 

Another one of his essential contributions is to tempt economists to move away from aggregate macro variables and place a much higher emphasis on individual level data and evidence-based economics. He wanted to make economics look like a proper science (yes, moving it away from macro is precisely how you do it). The best example in how he managed to do so was via his first big breakthrough - his 1980 article with John Muellbauer called "An Almost Ideal Demand System" (the article was placed in the American Economic Review's top 20 published articles of all time - i.e. in its first 100 years). 

In this article the authors overcame the usual bias of aggregate demand models in which the center of the model would be a rational individual trying to maximize his utility, from which it follows that we can simply aggregate all of such rational individual preferences into an aggregate demand curve. However the theoretical construct was far from what the empirical evidence was showing. In particular older models failed to predict how demand varied with prices and income, nor was the empirical evidence consistent with the rationality assumption. This encouraged Deaton and Muellbauer to construct a better model, based on crude evidence, taking into consideration actual patterns of consumption and demand, and making it simple enough to be empirically tested. They describe how households allocate incomes towards different types of goods based on their total expenditures. With the difference in incomes for poor and rich households it is precisely this type of variation that corresponds to actual patterns of demand. 

The model's flexibility allowed for many modifications and improvements by a number of subsequent researchers and its end result was that it became a standard for evaluating some aspects of economic policy, for constructing price indices, simulating the effect of consumption tax changes, and even for estimating the effect of family size, age and gender on individual consumption choices. Their initial, simple model became a cornerstone for the rest of the academia in the study of consumer choice that was finally being done with micro-level data. And it revolutionized the economic science by making macroeconomic models more microfounded. 

Another big contribution was using individual behavior models to explain why aggregate consumption was less volatile than income (recall the following blog post). Opposed to Friedman's model which states that rational individuals should smooth out temporary income spikes and only react to permanent income increases, Deaton showed that consumption was more volatile than income. This was referred to as the Deaton paradox. 

In a number of other unique predictions and implications, he argued against foreign aid that can be very inefficient in eradicating poverty and famine if it is concentrated in delivering aid in terms of food (or money) to poor countries. He showed that only balanced economic growth achieved primarily by ensuring a proper institutional environment in poor countries will increase food consumption and hence eliminate famine (because ). Furthermore he doesn't believe that living standards and household wealth can be measured only via indicators such as income, but by a whole number of unobservable factors (like internet access for example) that altogether significantly improve living standards. 

In conclusion, a well-deserved prize for a brilliant economist. 

Selected publications:
  • Deaton, A. and J. Muellbauer (1980), “An Almost Ideal Demand System”, American Economic Review 70(3), 312-326.
  • Deaton, A. (1985), “Panel Data from Times Series of Cross-Sections”, Journal of Econometrics, 30(1-2), 109-126.
  • Deaton, A. and J. Muellbauer (1986), “On Measuring Child Costs: With Applications to Poor Countries”, Journal of Political Economy 94(4), 720-744
  • Deaton, A. and J. Campbell (1989), Why Is Consumption So Smooth?”, Review of Economic Studies, 56(3), 357-373.
  • Deaton, A. (1991), “Savings and Liquidity Constraints”, Econometrica 59(5), 1221-1248.
  • Subramanian, S. and A. Deaton (1996), “The Demand for Food and Calories”, Journal of Political Economy 104(1), 133-162.
  • Deaton, A. (2013) The Great Escape: Health, Wealth, and the Origins of Inequality. Princeton University Press