Saturday, 30 May 2015

Austerity (and inequality) in corrupt countries - a conference with Joe Stiglitz

This week I had an opportunity to attend an international conference "Challenges of Europe: Growth, competitiveness and inequality", where the keynote speakers were none other than 2001 Nobel prize winner Joseph Stiglitz, and Columbia University professor Jan Svejnar

I went there to present a paper I co-authored with two Croatian economists, Dejan Kovac and Nikola Kleut. The paper is called "How do firms respond to anticipated shocks? Duration analysis of Croatian companies throughout the crisis". The paper is pretty good, but let's be honest, that was clearly not the main reason I went there - the main reason was to get to know people like Stiglitz and Svejnar. Which I can happily say I did. 

From left to right: myself, Prof Joseph Stiglitz, and my friend and
co-author Dejan Kovac
The keynote speeches from the two notable economists were both very interesting, but also quite different. Svejnar went first and presented his paper called "Do Billionaires Help or Hurt Economic Growth?", while Stiglitz followed with his more or less standard policy-oriented discussion on "The Euro, the European Crisis and Inequality". I actually found Svejnar's presentation more interesting, which is not surprising primarily because the stuff Stiglitz was saying on Europe isn't new to me, as I've extensively written on the subject myself. Stiglitz made a few excellent points on the Euro's fault for the Eurozone recession, on how Europe was never an optimal currency area which is why the Euro project was doomed from the start, attacking the way the idea of convergence was being executed, implicating external imbalances (CA deficits), and so on - all the things I absolutely agree with (see my in-depth analysis of the Eurozone sovereign debt crisis). 

Wealth inequality and economic growth 

Svejnar on the other hand caught my attention immediately when he started to present his research paper. He gathered information from Forbes on the world's richest individuals across countries and was trying to test whether they have a positive effect on growth (the right-wing argument) or a negative one (the left-wing argument). The main explanatory variable measuring wealth inequality was the share of billionaire wealth to total GDP, to total physical capital stock, and to total population, measured only for those countries that had billionaires (in $ terms). He found that the overall effect is actually negative, however he decided to decompose the wealth inequality measure into billionaires that were politically unconnected and politically connected to see what drives the total effect. It turns out that it is the politically connected billionaires that are causing the adverse effect on economic growth. See the table below (click to enlarge):

Source: Bagchi, Svejnar (2013) "Does Wealth Inequality Matter for
Growth? The Effect of Billionaire Wealth, Income Distribution
and Poverty." IZA discussion paper
Notice that the significance levels for the politically connected measure of wealth inequality are much higher than for the overall effect (particularly when looking at billionaire wealth to total capital stock - columns (2) and (5) - which I consider to be the best measure of wealth inequality out of the three used). The story is clear; in countries where billionaires made their fortune thanks to political connections allowing them to control and build monopolies, the effect of their accumulated wealth and the consequential inequality on economic growth is extremely negative. In cases where the billionaires weren't politically connected there is no effect between inequality and growth.

Comparing the top 5 and bottom 5 countries in their ranking of politically connected wealth inequality with respect to their corruption levels, the clustering is quite obvious: the more unequal countries (the higher their billionaires' wealth) are the ones with the highest levels of corruption:

Source: Bagchi, Svejnar (2013) "Does Wealth Inequality Matter for
Growth? The Effect of Billionaire Wealth, Income Distribution
and Poverty." IZA discussion paper
The full paper is here, co-authored with Sutirtha Bagchi. 

The real European problem

This is a very important finding in terms of the whole austerity debate. Going back to Stiglitz and his keynote presentation, what he said on the conference was more or less standard and expected stuff. However, what he said in an interview for the Croatian television the day before was what I found slightly problematic. Stgilitz is a famous critic of austerity policies. And who can blame him when austerity all across Europe was mostly being done from a wrong, tax-based approach. Just look at the average income tax, VAT and corporate tax rates across Europe and how they all increased by a few percentage points during the crisis. Europe became obsessed with cutting the budget deficit, and from a political perspective cutting the deficit is always better to do with tax hikes than with spending cuts - because when you cut spending you're hurting some groups directly, which don't like it and will probably protest (unless you make linear cuts which is always the worse solution with the most negative effect on consumption), but when you raise taxes you virtually create the same effect as with linear spending cuts (a drag on consumption), but people don't seem to be as bothered with tax hikes as with spending cuts. How often do you see people protesting after a tax hike? In terms of electoral chances it's much more dangerous to cut spending to various socio-economic groups (pensions, various benefits, subsidies, public sector wages, etc.), than to raise taxes for all consumers for example. 

Anyway, the problem with how austerity was being conducted in Europe is obvious: it had a negative effect on economic growth, as tax rates depressed consumption in times of great deleveraging (people and companies paying off their debts). Naturally the economies were doing bad. Countries like Germany, driven by their own example of unification and the 2003 Hartz reforms, were saying it is necessary to bear the pain during which time countries should engage in reforms. But this never happened. The peripheral Eurozone countries (including Croatia) never really did any reforms during the crisis. And this is the real problem. Not all of these countries are the same, nor should they all engage in the same set of reforms, but they all have one important characteristic: they are all corrupt. Their governments used the favorable pre-crisis economic times (low borrowing costs) to accumulate huge debt levels and to finance various political concessions. Greece, Italy, Spain, Portugal, Cyprus or Croatia - they all had political elites driving their countries to the slump by applying a faulty growth model based on debt, and misusing the convergence mechanism Stiglitz was addressing. Citizens and companies seized the same opportunity; consumer debt levels went sky-high in peripheral Europe. This is why they were all running large current account deficits - imports of consumer goods swamped domestic markets. Living standards were fueled by debt, and it was only a matter of time before this unsustainable system was brought to a halt. The Euro crisis simply brought all the existing domestic instabilities of these countries to the fore. And Stiglitz is right - the Euro is to take a large blame for enabling this type of a growth model.  

Austerity and corruption 

However the response to this type of growth model in peripheral Europe is hardly more government spending. Classical counter-recessionary measures imply that in crisis times countries should boost government spending in the short run to offset the lack of spending in other sectors of the economy. However this type of policy can to some extent be applied in countries like the US, UK, Germany or Japan (whose borrowing costs will never get affected by too much debt, since the demand for their debt is always high), even though this too is debatable. In countries of peripheral Europe, Croatia in particular, the asymmetry of information and adverse selection are simply too high for these types of policies to work, even in the short run.

Stiglitz made an excellent point that according to the efficient market hypothesis money should always flow to where it's most productive. However because of asymmetric information this doesn't always happen. Conclusion: markets are imperfect. This effect is even more profound when governments push money into the system. When the Croatian government increases public spending to build infrastructure projects, to subsidize public or private sector firms, or to boost investments, there is an immense adverse selection effect. Money flows to politically connected firms and individuals. This is something I prove empirically for Croatia: public procurement is highly subject to corruption, and the higher the corruption in public procurement, the greater the reelection chances of local politicians (up until a certain cut-off level). The interlink between corrupt politicians and quasi-entrepreneurs is just too big, and is creating a substantial drag on domestic growth. The same thing can be observed in Greece, Italy, or Spain. There is no substantial difference. Corruption is systemic. Conclusion: governments are imperfect.

From my experiences abroad, I realize this is difficult to grasp for people living in institutionally stable societies like the United States. To Americans (or any other person living in a country where rules are well-defined) the pinnacle of corruption is the FIFA probe - giving bribes to secure lucrative deals (like becoming the host nation of the World Cup). Corruption in Balkan and Mediterranean countries is much more than that - it is systemic and it is institutionalized. Laws are being changed to legalize criminal acts. Politicians literally have no sense of accountability. Very often they are the heads of organized crime themselves! It sounds impossible to believe, doesn't it? Not according to a multitude of examples from Italy, Greece or Croatia (not to go any further). 

Furthermore, systemic nepotism is affecting all spheres of society; under-qualified individuals (often party members) have taken over the public sector, thus driving away the more qualified ones. This is significantly affecting how the private sector conducts business as well. "There is simply no other way, this is how the system works", a discouraged Croatian entrepreneur will always say.

In the last decade more than 150,000 working force Croats left the country. And these are only those registered via the official statistics. Other peripheral economies are facing the same problem. Nepotism is so embedded in peripheral Europe, it's hard for anyone outside to realize this. It is the single most responsible cause of adverse selection on the labor market in these countries. And consequently on government efficiency and the performance of the domestic economy. Here's a good example: someone with an Ivy League degree cannot get a job in Croatia's public sector if they aren't "well connected" (read loyal party members - which Ivy League degree holders are usually not). Anyone who's slightly better than the domestic quacks in any field is immediately a threat the quacks are trying to protect themselves against. It is becoming almost impossible to change and fight this. 

In this kind of a systemically corrupt system, the only way to break the connection between quasi-entrepreneurs and politicians is to impose massive spending cuts aimed at breaking up the link between business and politics, followed by long-lasting reforms of the legal system. The problem is much deeper than depressed consumption. This will without doubt cause a huge negative effect on GDP (as the direct and indirect share of government-dependent entities in the economy is roughly 70% of GDP), but it is the only way to break the downward spiral of political connectivity, nepotism and economic depression. 

Sunday, 24 May 2015

In memoriam: John Nash

It is with great sorrow to report the news that one of the greatest minds in human history died yesterday in a car crash with his wife while they were returning home from an airport. John Forbes Nash Jr., to most widely known as one of the founders of cooperative game theory whose life story was captured by the 2001 film "A Beautiful Mind", is truly one of the greatest mathematicians of all time. His contributions in the field of game theory revolutionized the way we think about economics today, in addition to a whole number of fields - from evolutionary biology to mathematics, from computer science to political science. 

John Nash was born in 1928 in Bluefield, West Virgina. Even as a child he showed great potential and was taking advanced math courses in a local community college on his final year of high school. In 1945 he enrolled an undergraduate mathematics major at the Carnegie Institute of Technology (today Carnegie Mellon). He graduated in 1948 obtaining both a B.S. and an M.S. in mathematics and continued onto a PhD at the Department of Mathematics at Princeton University. There's a famous anecdote from that time where his CIT professor Richard Duffin wrote him a letter of recommendation containing a single sentence: "This man is a genius". Even though he got accepted into Harvard as well, he got a full scholarship from Princeton which convinced him that Princeton valued him more. 

While at Princeton, already on his first year (in 1949) he finished a paper called "Equilibrium Points in n-Person Games" (it's a single-page paper!) that got published in the Proceedings of the National Academy of Sciences (in January 1950). The next year he completed his PhD thesis entitled "Non-Cooperative Games", 28 pages in length, where he introduced the equilibrium notion that we now know as the Nash equilibrium, and for which he will be awarded the Nobel prize 34 years later. It took him only 18 months to get a PhD! He was 22 at the time. 

While at Princeton he finished another seminal paper "The Bargaining Problem" (published in Econometrica in April 1950), the idea for which he got from an undergraduate elective course he took back at CIT. It was Oskar Morgenstern (the co-founder of game theory and the co-author of the von Neumann & Morgenstern (1944) Theory of Games and Economic Behavior) who convinced him to publish that bargaining paper. The finding from this paper will later be known as the Nash bargaining solution. Princeton was full of top academics at the time and Nash took full advantage of that, even though he didn't learn maths by attending classes, he did it by trying out his own ideas. As he came to Princeton he sought out Albert Einstein to discuss physics with him (as physics was also one of his interests). Einstein reportedly told him that he should study physics after Nash presented his ideas on gravity, friction and radiation. 

Illness and impact

After graduating he took an academic position at MIT, also in the Department of Mathematics, while simultaneously taking a consultant position at a cold war think tank, the RAND Corporation. He continued to publish remarkable papers (his PhD thesis in The Annals of Mathematics in 1951, another paper called "Two-Person Cooperative Games" in Econometrica in 1953, along with a few math papers). He was given a tenure position at MIT in 1958 (at the age of 30), while he married his wife Alicia the year before. However, things started to go wrong from that point on in his personal life and career. In 1959 he was diagnosed with paranoid schizophrenia, forcing him to resign from MIT. He spent the next decade in and out of mental hospitals. Even though he and his wife divorced in 1963, she took him in to live with her after his final hospital discharge in 1970. 

Nash spent the next two decades in relative obscurity, but his work was becoming more and more prominent. Textbooks and journal articles using and applying the Nash equilibrium concept were flying out during that period, while most scholars that built upon his work thought he was dead. It was not only the filed of economics - where the concepts of game theory were crucial in developing the theory of industrial organizations, the public choice school and the field of experimental economics (among many other applications) - it was a whole range of fields; biology, mathematics, political science, international relations, philosophy, sociology, computer science, etc. The applications went far beyond the academia; governments started auctioning public goods at the advice of game theorists, business schools used it to teach management strategies. 

Arguably the most famous applications were to the cold war games of deterrence that explain to us why the US and Russia kept on building more and more weapons. The Nash equilibrium concept explains it very simply - it all comes down to a credible threat. If Russia attacks the US it must know that the US will retaliate. And if it does, it will most likely retaliate with the same fire-power Russia has. Which will lead to mutual destruction of both countries. In order to prevent a full-scale nuclear war (i.e. in order to prevent the other country from attacking), the optimal strategy for both countries is to build up as much nuclear weapons as they can to signal to the other player what they're capable of. This will prevent the other player from attacking. If they are both rational (i.e. if they want to avoid a nuclear war and total destruction) they will both play the same strategy and no one will attack. Paradoxically, peace was actually a Nash equilibrium of the arms race!

Long-overdue recognition 

Little did Nash have from all this. He had no income, no University affiliation and hardly any recognition for his work (not counting the citations). But this all changed in the 1990s when he was finally awarded an overdue Nobel Prize in Economics in 1994, with fellow game theorists John Harsanyi and Reinhard Selten "for their pioneering analysis of equilibria in the theory of non-cooperative games". Here is the Nobel Prize lecture and here is an interview with him conducted 10 years after winning the prize. 

His remarkable and actually very painful life story was perfectly depicted by his autobiographer and journalist Sylvia Nasar in her two books; "A Beautiful Mind", based on which the movie was made, and an even better one "The Essential John Nash", which she co-edited with Nash's friend from college Harold Kuhn (also a renowned mathematician). As Chris Giles from the FT said in his praise of the book: "If you want to see a sugary Hollywood depiction of John Nash's life, go to the cinema. Afterwards, if you are curious about his insights, pick up a new book that explains his work and reprints his most famous papers. It is just as amazing as his personal story." The book contains a facsimile of his original PhD thesis, along with eight of his most important papers (from game theory and mathematics) reprinted. 

After the Nobel Prize success things got better for Nash. By 1995 he recovered completely from his "dream-like delusional hypotheses", stating that he was "thinking rationally again in the style that is characteristic of scientists." Refusing medical treatment since his last hospital intake, he claimed to have beaten his delusions by gradually, intellectually rejecting their influence over him. He rejected the politically-oriented thinking as "a hopeless waste of intellectual effort". He remarried his wife Alicia in 2001, and started teaching again at Princeton. He continued his work in advanced game theory and has moved to the fields of cosmology and gravitation

The Phantom of Fine Hall, as they used to call him in Princeton due to his mystique and the fact that he used to leave obscure math equations on blackboards in the middle of the night, will never cease to raise interest, praise and awe. Nash was another perfect example of a thin line between a genius and a madman. Luckily in the end the genius side prevailed.  

So what is the Nash equilibrium? 

The reason why this concept was so revolutionary was because it significantly widened the scope of game theory at the time. In the beginning, following the von Neuman and Morgenstern setting, game theory was focused mostly on competitive games (when the players' interests are strictly opposed one to another). These types of games were known as zero-sum games, limiting to a significant extent the power of game theory. Nash changed that by introducing his solution concept so that basically any strategic interaction between two or more individuals can be modeled using game theory, where the most unique solution concept is the Nash equilibrium. Games are not zero-sum, they aren't pure cooperation nor pure competition. They are a mixture of both. 

The idea of the Nash equilibrium resonates from the simple assumption of rationality in economics. The term rationality in economics is not the same as common sense rationality we all think about upon hearing this term. It refers to the idea that each individual will act to achieve his or her own objective (maximize their utility), with respect to the information the person has at his/her disposal. The concept of rationality in economics is therefore idiosyncratic - it depends on whatever a particular individual deems rational for themselves at a given point of time. It rests upon the idea that a person will never apply an action that hurts him/her in any way (lowers his/her utility). 

The Nash equilibrium is the most general application of this idea. A non-cooperative game, according to Nash, is "a configuration of strategies, such that no player acting on his own can change his strategy to achieve a better outcome for himself". In other words if there exists another strategy that can make an at least one individual better off, then the outcome does not satisfy the condition for a Nash equilibrium. 

Let's look at an example. The most simplified example of how a Nash equilibrium solution concept works is the Prisoner's Dilemma game. Consider two robbers arrested for a crime. They are both being interrogated by the police in separate rooms. They are presented with two options (strategies): keep quiet (silent) or betray the other guy (betray). If they both remain silent, they both only get a light sentence of a year in prison for obstructing justice. If one betrays the other, and the other guy keeps silent, then the betrayer is released with zero imprisonment, and the other guy gets pinned for the whole crime and gets nine years in prison. If they both betray each other, they both get six years in prison. What's the optimal thing to do?

Applying the Nash equilibrium concept we need to find a strategy that is the best response of one player to whatever the other player may decide. When no players have any incentive to deviate from a set of strategies (strategies are always a pair in two-person games) we can say that this set of strategies is a Nash equilibrium. 

Consider the game depicted in the table below:

Prisoner 2
Silent (cooperate)
Betray (defect)
Prisoner 1
Silent (cooperate)
Betray (defect)
-6,-6 *

It would seem that the best strategy they can apply is for both to keep silent. If they do, they both get only a light sentence. However this strategy set (-1,-1) is not a Nash equilibrium since at least one person has an incentive to deviate. In fact, they both do. If Prisoner 1 decides to defect and betray Prisoner 2, he gets 0 years in prison, while Prisoner 2 gets 9 years (third cell, with payoffs 0,-9). Prisoner 2 applies the exact same reasoning (second cell with payoffs -9,0). In the end since the better strategy is always to betray, they both play the same strategy (betray, betray) and end up with payoffs (-6,-6) which is the Nash equilibrium of this game. From this point no player can deviate and make himself better off. If Prisoner 1 decides to go for silent he risks getting 9 years in prison instead of 6. There is no way for them to reach a cooperative equilibrium in this simplified scenario.

Naturally, cooperative games do exist (as I've discussed earlier on this blog) and they help us understand how game theory solves for example the free rider and the collective action problem. It was Elinor Ostrom (1990) who applied these concepts to reach her optimal solutions in solving the common pool resource problem in small groups with persistent interactions. Robert Axelrod (1984) is another, finding that even though the defection strategy is more rational, sometimes various other factors will result in a cooperative outcome between the players. The Nash equilibrium helped initiate a huge amount of research on these and many other problems within and outside the academia. The reason game theory is usually considered as the most applicable economic theory - in that it can be used to solve real-life problems - is purely thanks to John Nash. 

Rest in peace. 

Most notable papers: 

Wednesday, 20 May 2015

Video: How would a Nobel prize winner run the economy?

From LSE's You Tube channel:

If the video doesn't work (some browsers could do that), see it here.

LSE's Nobel professor Christopher Pissarides is being 'grilled' by Conor Gearty in his Gearty Grillings. The short video surprisingly includes a lot of good ideas on the size of state, labor markets, and the Eurozone troubles. Even though he declares him self an open social democrat, it's obvious he believes in the power institutions and doesn't succumb to any of the typical socialist fallacies. Nor is he being unrealistic about the solutions awaiting Europe. 

Just to remind the readers, Pissarides won the Nobel prize for his search frictions theory in the labor markets. Here's the Nobel prize lecture, and you can find some of his best papers here, and the newest ones here.

Friday, 15 May 2015

Eurozone challenges

Here's an excellent infographic from Boston University explaining in one place and with much detail why the crisis in Europe is still a long way from being over: 

Boston University Online

If I had to sum it up in words, it would go something like this: sluggish recovery, threat of deflation, high unemployment (11.2%), particularly youth unemployment (23%; the worst still in Spain = 51%), lack of access to finance for small businesses (banks are still hoarding cash), low productivity, low wage growth, an increasing threat of poverty, and of course - still huge levels of public debts (corporate and household as well), coupled with an ageing population which is a lethal combination for a sustainable pensions system, particularly to those countries who in addition to huge debts and an ageing population are experiencing net emigration (Spain, Greece and Italy are leading the way). 

So the overall picture is, unfortunately, still bleak, to say the least. At this moment I don't see how Europe is going to avoid being stuck in a Japanese-style decade-long stagnation. It's facing its own "balance sheet recession" as Richard Koo would call it. Japan however had one important caveat, it never faced a problem of high unemployment. Furthermore, if you reach a living standard as Japan has had in the 90s, then going through 20 years with close to zero growth is not that big of a problem. You're still a very rich country. However in Europe many of the Member States are not quite there yet. For most of them it's entirely their fault, but facing a decade or two of stagnation is not good news for a country yet to face the full benefits of EU convergence.