tag:blogger.com,1999:blog-34489276427398503342024-03-05T23:31:57.806+00:00The Political EconomistTracking the recovery. Tracking markets. Writing all things political econ.Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.comBlogger400125tag:blogger.com,1999:blog-3448927642739850334.post-52287042046938479252022-03-05T18:57:00.003+00:002022-03-05T18:57:46.055+00:00Introducing: the ambition-to-competence ratio in kleptocracies <div style="text-align: justify;">Russia's invasion of Ukraine has inspired me to come up with an interesting theoretical concept. I'll lay it out first, and then try to explain the reasoning behind it and how it can be used to explain potential outcomes of Russia's Ukraine invasion. </div><div style="text-align: justify;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEjMIro5r6kbT24ER38DkZSr6DF57XP0Pc6YhB0uY4DL7OV8Biv-kc6uyijFOofT5JiOxlCuxQGblgBhzLKGoZPmSIuFUV_aP9Je90-BIxY1KtmIQBMQoNxqWreKwVva3mDx1prs3UlpTm5GnNCEnJ792T7-eIgzz8u-B4fGP5t4-y60DDmhSVCcUVkewA=s779" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="567" data-original-width="779" height="466" src="https://blogger.googleusercontent.com/img/a/AVvXsEjMIro5r6kbT24ER38DkZSr6DF57XP0Pc6YhB0uY4DL7OV8Biv-kc6uyijFOofT5JiOxlCuxQGblgBhzLKGoZPmSIuFUV_aP9Je90-BIxY1KtmIQBMQoNxqWreKwVva3mDx1prs3UlpTm5GnNCEnJ792T7-eIgzz8u-B4fGP5t4-y60DDmhSVCcUVkewA=w640-h466" width="640" /></a></div>The ambition-to-competence ratio of government officials is an exponential function of the <a href="https://en.wikipedia.org/wiki/Kleptocracy" target="_blank">kleptocracy</a> level of a country. It is best defined as ambition plus loyalty divided by one’s intrinsic level of competence: </div><div><br /></div><div><b>A-C ratio = (ambition + loyalty ) / intrinsic competence </b><br /><br /><div style="text-align: justify;">In high-level kleptocracies, where the government is completely subdued to a ruling elite looking to expropriate wealth of the country they govern (e.g. the dictator and his cronies, oligarchs, or the military), government officials rise in rank based on their ambition and their loyalty. Their competence is inversely related to their rank in government. </div></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">This means that in kleptocracies it is possible (and even desirable) to move up the hierarchy purely based on ambition and loyalty. In fact, if your competence grows, you decrease your chances of rising to the top. You must either conceal your competence or have high enough loyalty to offset it. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In countries with low kleptocracy levels, your competence has to be high enough to work as a public official, meaning that the ambition-to-competence ratio in non-kleptocracies is low. This doesn't necessarily imply that public officials in non-kleptocracies are all of high competence. It only means competence plays a more important role when they rise through the ranks. </div><div><br /><div style="text-align: justify;">Why the convex relationship? Because high ambition combined with a lack of competence is ideal for kleptocratic environments. Incompetent individuals cannot reach the top in just societies, regardless of their ambition or loyalty. They can hope to get, at best, to the middle of a hierarchy, but not the top. In kleptocracies there is no limit to how high you can go. Putin is a prime example. A government official with enough ambition and loyalty to get close to high office, seizing his opportunity to take full power. He is not an incompetent individual, so he hides his competence enough or has to compensate with enough ambition and/or loyalty to offset the effect of the denominator.</div></div><h3 style="text-align: left;">How Putin’s golden cage of power is closing in on him</h3><div style="text-align: justify;">Ok, got it. But what's this got to do with Ukraine? I have no intention of going into geopolitics, or doing a psychological deconstruction of Putin. I purely wish to examine the power relations behind Putin’s decision to invade Ukraine.</div><div style="text-align: justify;"><br /></div><div><div style="text-align: justify;">Based on the massive news coverage of the invasion, I can’t help at noticing a pattern emerging behind the reasons as to why it happened. A pattern that tries to rationalize the reasons behind the invasion.</div><br /><div style="text-align: justify;">People are seeking answers, obviously. But in that quest for answers amidst a cacophony of explanations, judgments get easily clouded by bias. The first response by many - taken aback by the decision to invade - was that Putin had lost his mind, that he is in the late stages of Hitleresque madness, albeit more dangerous given his access to nuclear weapons. Then came the ex-post rationalizations with the benefit of hindsight. A dictator turned himself into a monster. He was always aiming for Ukraine, it was obvious. Putin’s KGB-induced Cold-War-driven hatred and resentment towards the West aims to revive the glory of the Soviet Union, and Ukraine is only the first step towards further military expansion. Putin is doing all this to send a message to NATO that any expansion into the Ukraine is unacceptable to Moscow. And so on. All these narratives are viable, perhaps even true, but not for the obvious reasons one might think.</div><br />Allow me to present my own biased judgment.<br /><h3 style="text-align: left;">The propaganda machine </h3><div style="text-align: justify;">Putin has no inherent ideology. He deals with two currencies - money and power, where power to him is the crucial mechanism for obtaining money. Putin’s power and wealth are not absolute - as there is no such thing - they are relative to his presidency. If he ever leaves office, he will either be killed, imprisoned, or killed while in prison. There’s no retirement for him.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Therefore, his number one priority is, and always was: stay in power for the rest of your life. Everything he does is subjected to that one goal.</div><br /><div style="text-align: justify;">However, there is a misconception as to how powerful Putin really is. We cannot see anything that happens behind the curtain in the Kremlin. All we see coming out is pure propaganda. Like that recent video of Putin talking to the head of his intelligence agency. The man is clearly fearful of Putin who comes out as very authoritative and quite scary. An immediate reaction of people watching is: that man should be afraid for his life. But remember, this is a video that the Kremlin put out. It is exactly what Putin wants the world to see. I’m not saying that the emotion there wasn’t genuine. It most certainly is. But it is also staged to showcase Putin from only one very specific angle. Just like every single one of his public appearances, shirt-on or shirt-off, horseback or karate-chopping people into submission. Or that one time, a decade ago, when he called off a strike in a factory forcing an oligarch to sign the negotiation papers, and then demanding his pen back. The emotion there is surely real. But the scene is misleading. It is set up perfectly to present the leader in the best possible way to the public. Who then goes on and formulates a personality cult, where Putin is exactly what each voter wants him to be - a strong leader that can unite Russia and bring back its former glory, stolen from them by the evil Western powers.</div><h3 style="text-align: left;">An empire of corruption </h3><div style="text-align: justify;">The truth, however, is quite different. Putin is a kleptocrat, running an empire of corruption.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">This is not the type of corruption most people in the West are used to seeing - bribery, fraud, kickbacks in exchange for public services. No. This is a state that is run like a well-oiled mafia organization, where the legitimate force of the state is misused to serve the private interests of the ruling elite, on top of which is Putin himself. The don.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As soon as he came to power he used the threat of violence - a crucial pillar of power - to force the ruling oligarchs into submission. He turned them into his <i>caporegimes</i> (high-ranking officers in the mafia), and through them has controlling interest in almost the entire Russian economy, from oil and gas to banking. Through his oligarch proxies he holds hundreds of billions of dollars all around the world. For the oligarchs, loyalty to the don is all that matters.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Any attempt on his hold on power is swiftly shot down. Enemies get exiled, poisoned, or killed. Violence is used generously to protect his position. Because if he loses power, access to money is lost, and the threat of violence is gone. That’s when oligarchs replace their loyalty.</div><h3 style="text-align: left;">A prisoner of power </h3><div style="text-align: justify;">His position of power is literally his prison. A golden cage constantly closing in on him.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Keeping that golden cage from collapsing requires tremendous effort. That’s why there is that persistent need to signal strength, power, dominance over others. It’s all a deceptive facade of a weak man fearing for his position of power.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">That, of course, makes him very dangerous. As he is ready to use every tool at his disposal to prove to those around him they should still fear him. An unexpected, irrational move, like the invasion, might be just the type of move that confuses his enemies.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Recall another dictator in a similar situation. When Kim Jong-un took power in North Korea after his father’s death, many in the domestic hierarchy thought he was weak. He was never meant to become Supreme Leader; it was his brother who was lined up. There were even speculations that the generals (or other elites) might overthrow him quickly.</div><br /><div style="text-align: justify;">What did he do to showcase his power? Started threatening the US with nuclear assault. He kept doing that repeatedly since 2012 to solidify his power domestically. There was even a brief stand-off between him and Trump in 2017. It was all one big bluff. It was Jong-un’s way of showing to domestic elites that he is indeed strong enough. If he could have started a war to showcase strength, he would have. North Korea doesn’t have the muscle or the backing of China to do that, so all he <i>can</i> do is bluff.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Putin on the other hand can and does start wars. He does it for the exact same reason - to prove his strength and solidify his power.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">He started four of them.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In 1999, while still Russia’s PM, he organized the war in Chechnya, as a reaction to the terrorist attack in the Moscow theater. Many claimed he used this opportunity as a show of strength to seize power in the first place. In 2008 he invaded Georgia under the same pretenses as with Ukraine today. In 2014 he annexed Crimea and opened up his conflict with Ukraine. In 2022 he finally invaded Ukraine, presenting the biggest threat thus far to global security.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Some might blame insanity for this latest invasion, stating the obvious: it was a huge mistake, he overplayed his hand. Others are suggesting a geopolitical endgame and a reemergence of the Cold War era. Many are fearing nuclear war. <b>But in essence this looks more like an internal power struggle, where Putin is signaling his strength not to the West, but to his own subordinates.</b> Ukraine is a collateral victim, picked out carefully to mask the true intentions.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">People are rightfully fearful that if Putin is cornered, he might do something irrational like a nuclear missile strike. What if he already is cornered and the invasion <i>was</i> this irrational move?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Again, we cannot observe what is happening within Kremlin. We can only see the outcomes. The invasion of Ukraine is a either a desperate move by a man who must reestablish his dominance, or an irrational act of a madman.</div><h3 style="text-align: left;">Ambition-competence ratio in kleptocracies </h3><div style="text-align: justify;">Which is it? Remember, Putin’s only goal is self-preservation. He can use the sanctions to galvanize the nation behind him. The Russian media is already downplaying the war, giving very limited info on it.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Starting a nuclear war is unlikely given his internal constraints. Even if he’s pushed into a corner with no way out, and acting out of pure vengeance, the military is unlikely to oblige. Everyone can sense when someone’s time is up.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Particularly those who want to replace him. This is the key. And it brings us back to the ambition-competence ratio. Among the officials surrounding Putin, there are certainly many with ambition to take over. They would never admit to this ambition, even privately, but it is there. As we've already concluded, the worst the kleptocracy, the stronger the ambition-to-competence ratio among the ruling elites. What we're looking for now is another individual similar to Putin 23 years ago, carefully assessing and waiting for his opportunity from the shadows. The <a href="http://im-an-economist.blogspot.com/2014/03/what-happened-to-our-dream-of-democracy.html" target="_blank">iron law of oligarchy</a> at full show (from Acemoglu & Robinson's <i><a href="http://www.fintp.hr/upload/files/ftp/2012/3/vukovic.pdf" target="_blank">Why Nations Fail</a></i>). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Putin is well aware of this. He know's his limitations and his weaknesses, but he does not know from where the backstabbing will come. This makes him paranoid, and it could have pushed him over the edge to initiate the invasion in the first place. Make up a threat against an external enemy (US and NATO), pick a collateral victim who will act as a proxy enemy (Ukraine), rally the troops, rally the domestic sentiment through strong propaganda, and act quickly to prevent any such scenario. It worked before, why shouldn't it work now?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The only thing he miscalculated was the push-back from the Ukrainians. The push-back wasn't there in 2014 for Crimea, so Putin expected an easy victory once again. Just like in Georgia or Chechnya. Do it quickly, declare victory, and disable your internal opponents from advancing. The West? They stood by before, they'll do it again. Sanctions? Don't be ridiculous. Europe is too dependent of Russia, they won't go that far. Well, the situation escalated beyond his control. </div></div><div><h3 style="text-align: left;">Two scenarios </h3><div style="text-align: justify;">Having this in mind, there are two scenarios that might play out, neither of which includes a nuclear assault.</div><br /><div style="text-align: justify;">Putin either (1) digs up a scenario where he presents himself domestically as a clear winner, thus strengthening his position. The invasion is justified by gaining international recognition of Crimea as Russian, by pushing NATO away from Ukraine and making them neutral (i.e. adjacent back to the Kremlin), or by recognizing the two new separatist regions as autonomous states. He might, to that end, use one of the following narratives: “I protected our people in the separatist regions, they remain independent”, “We showed Americans and the NATO not to mess with us”, “Ukraine is now ‘de-Nazified’” or whatever. This was most likely his goal in the first place: to <b>achieve such victory vis-a-vis the West, so as to present himself triumphant domestically.</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Or (2) the troops start losing ground, he gets cornered, disobeyed, & thrown out of power, leading to his demise. <b>He is removed from his golden cage, which will now be occupied by someone else (iron law of oligarchy).</b> Scenario (2) is less likely for now, but don't underestimate the ambition of those in his shadow. Particularly if the financial sanctions make them more and more nervous.</div></div>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-85211887243629132462021-11-05T15:05:00.000+00:002021-11-05T15:05:09.706+00:00The politics of bailouts: How political connections of banks conditioned their bailout during the financial crisis<p style="text-align: justify;">My <a href="https://link.springer.com/article/10.1007/s11127-020-00871-w" target="_blank">new paper</a> (open access; meaning free to read) is out in the <a href="https://link.springer.com/journal/11127/volumes-and-issues/189-1" target="_blank">new edition</a> of Public Choice (published online first in February this year). This was my second PhD paper at Oxford, and one I am particularly fond of given the importance of the topic and one of the cornerstone arguments of my upcoming book <i>Elite Networks: The Political Economy of Inequality </i>(more on that below). </p><p style="text-align: justify;">What's the main finding? </p><p style="text-align: justify;">In short, I looked at the effect of political connections on the
allocation of TARP funds to US banks, and found that TARP recipients that lobbied the government,
donated to campaigns, or whose top execs had direct connections to politics
received better bailout deals.</p><p class="MsoNormal"><o:p></o:p></p><p class="MsoNormal" style="text-align: justify;">Let’s unpack this.<o:p></o:p></p><p class="MsoNormal" style="text-align: justify;"><span lang="EN-US">In 2008, </span><span style="background: rgb(252, 252, 252); color: #333333;">as the crisis unfolded in the US, the banking industry
elevated its lobbying and campaign spending activities. </span>You might remember the
panic days in Sep & Oct ’08 where it seemed like the financial world is
collapsing. Getting bailed out was a priority for many banks, especially the biggest ones which had regular daily meetings with top government officials (Treasury Secretary Paulson and Geithner of the New York Fed). </p><p class="MsoNormal" style="text-align: justify;">By the end of 2008 and during 2009, the banks that spent the
most on political campaigns and lobbying, on average, received the largest
bailout packages (relative to size of assets). Is that relationship causal?</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJmw3Fl-k8y458VTECjV-81HO2gnC2ZuySG2Uav7yE_kGkqfxv-k5XoZk_-qRyG2uOXQaLXY_fbxCCqH1ru_76zqWeQ3K99URHdeTGlKyAelWpMa601KYzbdN26MxONODFw8iA6KU8kn66/s708/Figure1.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="471" data-original-width="708" height="266" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhJmw3Fl-k8y458VTECjV-81HO2gnC2ZuySG2Uav7yE_kGkqfxv-k5XoZk_-qRyG2uOXQaLXY_fbxCCqH1ru_76zqWeQ3K99URHdeTGlKyAelWpMa601KYzbdN26MxONODFw8iA6KU8kn66/w400-h266/Figure1.png" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody><tr><td class="tr-caption"><i>Actual (black) and counterfactual (gray) inflation-adjusted <br />lobbying spending of financial firms (y-values in millions of dollars). <br />Counterfactual lobbying is the estimated size of lobbying <br />expenditures had it not been for the crisis.</i></td></tr></tbody></table></td></tr></tbody></table><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPXJWuPZ19kI-3vcTfujlHDNvgmWIUJwIl-r0KBybW_5o9qRDV2IcAzFuUbrQos3kYh6X9JaVsGPqhg1FfwS4hsxx9EkonTXBhX205ON_0cbJ8qSJ_CHs0gB9TnSmWZxdXi8cA6ihM4x3t/s695/Figure2.png" imageanchor="1" style="margin-left: auto; margin-right: auto; text-align: center;"><img border="0" data-original-height="493" data-original-width="695" height="284" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPXJWuPZ19kI-3vcTfujlHDNvgmWIUJwIl-r0KBybW_5o9qRDV2IcAzFuUbrQos3kYh6X9JaVsGPqhg1FfwS4hsxx9EkonTXBhX205ON_0cbJ8qSJ_CHs0gB9TnSmWZxdXi8cA6ihM4x3t/w400-h284/Figure2.png" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i>Total number of financial services firms lobbying, peaking in 2009. <br />The straight vertical line denotes the start of the bailout <br />allocation process (October 28, 2008)</i></td></tr></tbody></table><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">Based on the graphs above, no. The problem is that
riskier banks lobbied and donated more because they are more prone to risk, implying
they also will have a greater chance of getting bailout funds. Risk exposure, not political connections, could thus be the main explanation for bailout
allocations.</div><p class="MsoNormal"><o:p></o:p></p><p class="MsoNormal" style="text-align: justify;">To prove causality we must address this problem by using some
randomization in outcomes between treated and controlled units. Recall my <a href="http://im-an-economist.blogspot.com/2021/10/nobel-prize-for-causal-inference-why-it.html" target="_blank">previous blog on the econ Nobel for causal inference</a> to understand why. </p><p class="MsoNormal" style="text-align: justify;">It just so happens that during the 2008 panic, the US was
in the midst of an election campaign for the President and the new Congress. That context allows me to exploit very close electoral races (decided within a 1% margin) between
Congressmen as sources of as-good-as-random assignment of politicians connected
to TARP recipients.</p><p class="MsoNormal"><o:p></o:p></p><p class="MsoNormal" style="text-align: justify;">Why close races? Because in such
close races a random element like luck (e.g. rain on election day) is most likely to have
tipped the outcome, meaning that bare winners and losers—and firms attached to
them—are supposed to be statistically interchangeable.</p><p class="MsoNormal" style="text-align: justify;"><span style="text-align: left;">I apply two methodological approaches based on natural
experiment design: <a href="https://en.wikipedia.org/wiki/Regression_discontinuity_design" target="_blank">regression discontinuity design</a> and <a href="https://en.wikipedia.org/wiki/Instrumental_variables_estimation" target="_blank">instrumental variables</a>. </span><span style="text-align: left;">Basically, I compare connected firms whose politicians won
narrow elections to connected firms whose politicians lost narrow elections.</span></p><p class="MsoNormal"><o:p></o:p></p><p class="MsoNormal">The RD estimation finds that a connected politician’s
close electoral victory increased the bailout allocation for that politician’s
connected firm by around 13%, on average.</p><p class="MsoNormal"><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjv1THMnxRbyLvr9AIvhDXl8MpHxpMyK6AsleX1SeLAXQnsV4141SMbNkLJ_qMAkc3a7cK3oGlfH-Zs4Hz_3nEMJ0lJI6_ToiR_f5s1jgm-kwxv7lEpQ9q-kW5LJvMmo511fhDi7sKcweOS/s716/Bandwidth_10.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><i><img border="0" data-original-height="521" data-original-width="716" height="291" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjv1THMnxRbyLvr9AIvhDXl8MpHxpMyK6AsleX1SeLAXQnsV4141SMbNkLJ_qMAkc3a7cK3oGlfH-Zs4Hz_3nEMJ0lJI6_ToiR_f5s1jgm-kwxv7lEpQ9q-kW5LJvMmo511fhDi7sKcweOS/w400-h291/Bandwidth_10.png" width="400" /></i></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;"><i>The effect of a connected political victory on the <br />share of bailouts to total assets (y-axis) for close races</i></span></td></tr></tbody></table><br /></p><p class="MsoNormal" style="text-align: justify;">The IV approach finds that firms with more connected
politicians who won closely contested elections received more TARP funds (the
effect is a 19% increase in TARP funds for a one-standard-deviation increase, which is about 12
more connected politicians winning close elections). It is easy to see how the effect grows stronger for
firms which had more connected politicians, meaning that those at the upper
extremes of the distribution (the biggest 8 banks e.g.) will yield higher
benefits from their political connections.</p><p class="MsoNormal" style="text-align: justify;"><span style="text-align: left;">These are two different effects, but they both suggest a
similar conclusion: being politically connected clearly made a difference in
the allocation of TARP funds among those financial institutions who received
them. </span><span style="text-align: left;">The results do not imply that some banks were deliberately
favored over others, just that favored banks benefited because of their
proximity to the right people in power. If being politically connected matters
in general, in times of crisis it matters even more.</span></p><p class="MsoNormal"><o:p></o:p></p><p class="MsoNormal" style="text-align: justify;">Hopefully the study will provide a blueprint for further
research on political influence and the distribution of government funding,
particularly during times of high-stress events or serious economic hardships (e.g.
public procurement & bailouts during COVID).</p>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-39724554502922785852021-10-12T09:19:00.004+01:002021-10-12T09:20:29.827+01:00Nobel prize for causal inference: why it matters<p style="text-align: justify;">This year's <a href="https://www.nobelprize.org/prizes/economic-sciences/2021/summary/" target="_blank">Nobel prize in economics</a> was awarded to three brilliant economists, David Card, Joshua Angrist, and Guido Imbens for revolutionizing the way economists (and social scientists) do empirical research. Specifically, Card got it for his contributions to labor economics, and Angrist and Imbens got it for causal inference, but all three made breakthrough contributions of applying the scientific method to economics. In the field, we call it the "credibility revolution".</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh59RtoR4WJhYNBblHHwk7C5EMTfs9wKk2b0-orwEbnKQTsQuL9gtpNkqR45nccus185Sbogne9HQmDlGHwQYk3VK5vdYr0XQQ21mz7x64DJ0Mpa1u4iBOjCiUPN4mAGF9SwZy6DWpandzv/s793/Nobel2021.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="694" data-original-width="793" height="560" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh59RtoR4WJhYNBblHHwk7C5EMTfs9wKk2b0-orwEbnKQTsQuL9gtpNkqR45nccus185Sbogne9HQmDlGHwQYk3VK5vdYr0XQQ21mz7x64DJ0Mpa1u4iBOjCiUPN4mAGF9SwZy6DWpandzv/w640-h560/Nobel2021.png" width="640" /></a></div><br /><p style="text-align: justify;">I am very familiar with the work of all three as I've used their papers very often while learning about causal inference, teaching it, and citing it in my own empirical research. I also had the honor of receiving comments on one of my papers (the recently published <a href="https://link.springer.com/article/10.1007%2Fs11127-020-00871-w" target="_blank">Politics of Bailouts</a>) from Josh Angrist at a conference I co-organized. </p><p style="text-align: justify;">The way I wish to pay respects to the three of them is by explaining to you, my dear reader, why this Nobel prize in particular deconstructs that typical malevolent narrative that the economics Nobel is not really a Nobel, but rather a prize of the Swedish central bank in memory of Alfred Nobel. Why? Because this prize (like many in the past 20 years) awards empirical economists who made groundbreaking contributions in applying the true scientific method to the field. With their work, and the work of many others following in their footsteps, the field began to slowly progress from the economic orthodoxy of the pre-1990s to a much more developed field that actually has the right to start calling itself a science.</p><p style="text-align: justify;"><span style="text-align: start;">For example, the <a href="https://davidcard.berkeley.edu/papers/njmin-aer.pdf" target="_blank">Card and Krueger (1994) paper</a>, cited by the Nobel committee for its brilliant contribution to the field, was a state-of-the-art paper when it was published. Truly the pinnacle of the field back then. Twenty-something years later, we used it in our PhD causal inference class to pluck holes through it. We were given the data and asked to find all the errors in the paper, and explain why something like this wouldn't pass the review process today. Imagine that. Such a brilliant contribution back then wouldn't even be published today. That's how far economics (and political science, and the social sciences in general) has come today. Pure theory papers are rare. Doing some back of the envelope regressions of say, economic growth against a host of variables to see which one has a significant impact - a standard in the 1980s for example - is laughable today. Today, it is almost impossible to get an econ PhD from a decent University (say, top 400-500), without applying causal inference in your paper. </span>Economists who still do simple regressions (or worse, elaborate their ideas without any data or proof) are by no means scientists.</p><p style="text-align: justify;">Economics will <a href="http://im-an-economist.blogspot.com/2017/09/is-economics-getting-better-yes-it-is.html" target="_blank">never be physics</a> (even though economists love to use complex math to mimic physics). It is more likely to follow in the footsteps of medicine and psychology (<a href="http://im-an-economist.blogspot.com/search/label/Behavioral%20economics">behavioral economics</a> in particular does that), by using randomized experiments or even quasi-experiments with some random variation that enables the researcher to chose treatment and control groups. </p><p style="text-align: justify;">Why does all this matter so much? Because of the implications this new way of doing economic research will bring forward to economic policy. Thus far, the economic orthodoxy based on old theories has driven many policy conclusions. Some of the old theories were, in fact, proven correct by empirical research, but many were challenged. This has yet to be reflected in economic policy. An additional problem with economic policy is the political arena where such policies are being devised. That's why I do my empirical research in political economics, to understand how political interests shape and discourage beneficial economic policies. Sometimes it's not just about the research findings. But good research findings, based on good empirical design are still essential. It won't be long before politicians will no longer be able to dismiss them with the typical "I need a one-handed economist" argument. </p><h3 style="text-align: justify;"><b style="text-align: left;">So what is causal inference and why does it matter?</b></h3><p>If we could summarize causal inference in one cliche it would be: <i>correlation does imply causality</i>. </p><p style="text-align: justify;">How do you prove anything in social science? For example,
that action A actually <i>causes </i>outcome B? For example, do better grades in school lead to higher incomes in
life? If you just look at the data (below), the relationship is clearly linear and
positive. But does it make it causal? No!</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4ByBROMJpu6R6smVBdEHo7RCPD9jde_gWSiAm4TQArsSuXdScZ9kxP974niKI6UPurQyiHKDKs5aDGatule6qCjxipZbnk1muCbgYac6Mgz_eB30YBA31EYzWMDo1CU1S2kBWRB_Ad1IL/" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="430" data-original-width="552" height="312" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4ByBROMJpu6R6smVBdEHo7RCPD9jde_gWSiAm4TQArsSuXdScZ9kxP974niKI6UPurQyiHKDKs5aDGatule6qCjxipZbnk1muCbgYac6Mgz_eB30YBA31EYzWMDo1CU1S2kBWRB_Ad1IL/w400-h312/image.png" width="400" /></a></div><br /><p style="text-align: justify;">There can be a host of <i><b>unobserved</b></i> factors that might
affect both grades in school and salaries later in life. Like ability. Competent individuals tend to get better
grades, and have higher salaries. It wasn't the grades in that caused their
salaries to be higher, it was intrinsic ability.</p><p class="MsoNormal"><o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">This is called an <i><b>omitted variable bias</b></i> - an issue that
arises when you try to explain cause and effect without taking into
consideration all the potential factors that could have affected the outcome
(mostly because they were unobservable). <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">Ideally we would need a <b>counterfactual</b>: what would the
outcome be if history played out differently. What would my salary be if I didn’t
go to college? Or in the absence of having metaphysical powers, we could
compare individuals with different outcomes and grades, but everything else
being the same. <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">Or we could compare twins. Genetically identical, same
upbringing, same income, etc. Give one a distinction grade and the other a
non-distinction, and see how they end up in life. Problem is, we cannot really interfere
with people's lives just for the sake of proving a point. <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">An alternative is to simply match students into
comparable groups based on all of their pre-observed characteristics: gender,
parental income, parental education, previous school performance, etc. Problem with
this is that we can only match students based on things we can observe. We
still cannot observe innate ability. <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">The best way to prove causality in this case, as
uncovered by our Nobel winners, is to first ensure that there is random
assignment into treated and controlled groups. This is essential. <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">Why? Because <b>randomization implies statistical
independence</b>. When we randomly pick who will be in the treatment and who will
be in the control group, we make sure that the people in each group are
statistically indistinguishable one from another. That way any difference in outcomes between the two
groups should be a result of the treatment (in this case better grades), and
nothing else.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhljlUNkr8YB3s36MKOyifb2aFtDIF_vJgIcQIWe473D8vZP00D0WQxfazKgHiDrgaJfPSSF9sr371qroJp7yphOWR8lgYrwZ8wQ0DT8_qsOK_SwynXJYmGSkxmR5SHCBgG6qGRyNNCyjUf/s598/AngristImbens.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="509" data-original-width="598" height="340" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhljlUNkr8YB3s36MKOyifb2aFtDIF_vJgIcQIWe473D8vZP00D0WQxfazKgHiDrgaJfPSSF9sr371qroJp7yphOWR8lgYrwZ8wQ0DT8_qsOK_SwynXJYmGSkxmR5SHCBgG6qGRyNNCyjUf/w400-h340/AngristImbens.png" width="400" /></a></div><br /><p class="MsoNormal" style="text-align: justify;">Angrist did this incredibly with taking <a href="https://sites.duke.edu/niou/files/2011/06/Angrist_lifetime-earningsmall.pdf" target="_blank">random assignmentof Vietnam war veterans</a> (through the random draft lottery) to see how the
experience of war of a randomly selected group affected their incomes later in
life, compared to their peers who were lucky enough to avoid the draft.</p><p class="MsoNormal" style="text-align: justify;"><o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">Angrist and Krueger did it by looking at <a href="https://www.jstor.org/stable/2937954" target="_blank">people born in firstand final quarter of a year</a> (obvious random assignment), where those born in Q1
have worse education and income outcomes to those born in Q4. <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">But what if we cannot randomly assign by birth or lottery? Then we need a
trick, something that generates an <b>as-good-as random assignment;</b> a natural
threshold of some sort. Using our grades example, in the UK a distinction threshold is 70 (first
honours). If you get just marginally below, 69, you get a second.Comparing someone with 75 to someone with 60 is no good;
there will obviously be differences. But 70 to 69 are likely to be very
similar, with one being slightly luckier. So we compare only students between
69 and 71, where those above 70 are the treatment, and those below are the
control.</p><p class="MsoNormal"><o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">If there is a large enough jump, a discontinuous
jump over 70 threshold where those awarded a distinction have
statistically significant higher earnings than those who just barely failed to
make it to the distinction grade, then we can conclude that better grades cause higher
salaries. If not, if there is no jump and the relationship remains linear, then
we cannot make this inference.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQNxphJ8Nchz6sVSWtwjvMXOuKZPFL5rorTxP6QvifQZfRwD3fsGFKvHslIM5XxaITrsUimv-NcpAHO3pVoop-0gD5OJgEKooytkt_nGHBTYGLBlB94bR5-Fa8_3qIdNaDqUxInAJMkVfq/" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="723" data-original-width="839" height="344" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQNxphJ8Nchz6sVSWtwjvMXOuKZPFL5rorTxP6QvifQZfRwD3fsGFKvHslIM5XxaITrsUimv-NcpAHO3pVoop-0gD5OJgEKooytkt_nGHBTYGLBlB94bR5-Fa8_3qIdNaDqUxInAJMkVfq/w400-h344/image.png" width="400" /></a></div><p></p><p class="MsoNormal"><o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">This design is called a<b> regression discontinuity design
(RDD)</b>. Imbens excelled at this in particular. <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">Card’s most famous contribution (with Krueger) was to use
differences in differences (DID) to show how <a href="https://davidcard.berkeley.edu/papers/njmin-aer.pdf" target="_blank">minimum wage increases impact employment</a>. They used fast food restaurants in NJ and PA, after NJ increased
the minimum wage to show that employment actually went up, not down. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjm_bpoMmLYTCJbHVqQ9is2_NDQXJUyDKY33mM-IK7stJA39d26J92GL6BYvERADxb2TSlB-h-93B2rs1wSGrKLxSNoY5PEE9RjomeiVxDBYoexqDUaelYBD0J1U37sFdGqTIZRM6qw58U2/s642/CardKrueger.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="505" data-original-width="642" height="315" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjm_bpoMmLYTCJbHVqQ9is2_NDQXJUyDKY33mM-IK7stJA39d26J92GL6BYvERADxb2TSlB-h-93B2rs1wSGrKLxSNoY5PEE9RjomeiVxDBYoexqDUaelYBD0J1U37sFdGqTIZRM6qw58U2/w400-h315/CardKrueger.png" width="400" /></a></div><p class="MsoNormal" style="text-align: justify;">As mentioned earlier, this particular paper, state-of-the-art at the time, did
not satisfy the parallel trends assumption for DID design (employment trends should
have been identical in both states prior to the policy change and changed only in
NJ afterwards), but Card made amends with other stellar papers on labor economics using even better research design. Like his paper on observing labor market outcomes of <a href="https://davidcard.berkeley.edu/papers/mariel-impact.pdf" target="_blank">125,000 Cuban immigrants coming to Florida</a> in 1980 (you know, the plot for Brian de Palma's <i>Scarface</i>). <o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;"><b>The point here was to show how one should think about conducting
natural experiments in the social sciences. It’s not about using some profound model or complex math. It’s
about a change in the paradigm of drawing explicit conclusions from
correlations and trends.</b></p><p class="MsoNormal"><o:p></o:p></p>
<p class="MsoNormal" style="text-align: justify;">Finally, I want to end by paying homage to professor Alan Krueger, who tragically took his own life in 2019, and who would have surely been up there yesterday, given that two of the most important contributions made by Angrist and Card, cited by the Nobel committee, were in both cases co-authored with Krueger. To borrow one of his quotes: </p><i><blockquote>“The idea of turning economics into a true empirical science, where core theories can be rejected, is a BIG, revolutionary idea.”</blockquote></i><div>Indeed it is. </div><div><p class="MsoNormal"><br /></p><p class="MsoNormal">P.S. For those who want to learn more, I recommend a reading list:</p><p class="MsoNormal"></p><ul style="text-align: left;"><li>First, start with the Nobel committee's explanations. <a href="https://www.nobelprize.org/uploads/2021/10/popular-economicsciencesprize2021-3.pdf" target="_blank">A popular version</a></li><li>And a <a href="https://www.nobelprize.org/uploads/2021/10/advanced-economicsciencesprize2021.pdf" target="_blank">very good in-depth version</a></li><li>Then, if you’re a beginner, no better place to start than <a href="https://www.amazon.com/Mastering-Metrics-Path-Cause-Effect/dp/0691152845" target="_blank">Angrist and Pischke: Mastering Metrics</a></li><li>Then evolve into <a href="https://www.amazon.com/Natural-Experiments-Social-Sciences-Design-Based/dp/1107698006" target="_blank">Dunning: Natural Experiments in the Social Sciences</a></li><li>Then go for: <a href="https://www.amazon.com/Mostly-Harmless-Econometrics-Empiricists-Companion/dp/0691120358" target="_blank">Angrist and Pischke: Mostly Harmless Econometrics</a> (this was my bible for causal inference)</li><li>And finally, for advanced reading, use: <a href="https://www.amazon.com/Field-Experiments-Design-Analysis-Interpretation/dp/0393979954" target="_blank">Gerber and Green: Field Experiments</a>.</li></ul><p></p><p></p></div>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-49724744938025547032021-09-01T12:23:00.001+01:002021-09-01T12:26:52.288+01:00The bond market is showing no signs of recession. Yet. <p><i>This article was first published on <a href="https://seekingalpha.com/article/4439416-the-bond-market-no-signs-of-recession" target="_blank">Seeking Alpha on July 15th 2021</a>. This article contains updated graphs for the subsequent month and a half (a new version will look at the situation again in October). </i></p><p style="text-align: justify;">A lot of investors and analysts like to look at various stock market indicators for signs of widespread market hubris, overconfidence, greed (& <a href="https://money.cnn.com/data/fear-and-greed/" rel="nofollow" target="_blank">fear</a>), or an upcoming contraction. Many like to point out that stock valuations are at their extremes, particularly in the tech sector, or that, for example, the <a href="https://www.multpl.com/shiller-pe" rel="nofollow noopener" target="_blank">Shiller PE ratio</a> is running at a 39 multiple (the only time it was higher was prior to the 2000 dot-com bust).</p><!--x-tinymce/html--><p style="text-align: justify;">Many such indicators certainly have merit for uncovering sentiment, and while they can be good indicators of whether a bubble is reaching its climax (e.g. the Shiller PE ratio), whether a market is overheating, or that a correction is due, a much better indicator of an upcoming contraction is the bond market. </p><p style="text-align: justify;">This is not only true historically (e.g. via the inverted yield curve), it also makes much more sense. The majority of investors are typically not discouraged from investing due to too high market PE multiples, nor are they timing market entry based on bubble-like indicators. The most important factor for investors has always been the Fed and its interest rate decisions. And the biggest and most important market that depends entirely on the Fed's monetary policy decisions is - <b>the bond market. </b></p><p style="text-align: justify;">Investors, when examining the performance of stocks, typically forget about the bond market as it is far less amusing, more complex and hence more difficult to understand, and much less transparent than the stock market (there is no centralized place to trade and even look up bond prices, particularly for the retail investor). However, disregarding the bond market is a mistake given that it represents the most powerful tool in finance - debt, and by extension interest rates given on this debt. It is full of big players, institutional investors and asset managers of big funds, who are quick to make adjustments based on anticipated and actual interest rate changes; adjustments that almost immediately impact equities, as well as the entire economy. <b>The bond market is much bigger, more liquid and more important than the stock market, especially for early signs of rate changes and hence recessions. </b></p><p style="text-align: justify;">With that in mind let us examine several indicators that can come in handy when figuring out the sentiment of bond markets, all of which can be good determinants of reversal signs and upcoming recessions:</p><ol><li>Inverted yield curve (spread between 10-year and 2-year T-bill)</li><li>Yield spread between corporate bonds and Treasuries</li><li>Yield spread between two-year T-bills and the federal funds rate</li><li>Yield spread between the LIBOR and the federal funds rate</li></ol><h4><strong>1. The inverted yield curve (spread between 10-year and 2-year T-bill)</strong></h4><p style="text-align: justify;">Thus far the best predictive indicator of broad market sentiment and turning points for market downturns has been an inversion of the yield curve. When the yield curve inverts, i.e., when the spread between the 10-year and the 2-year T-bill turns negative, this has usually signaled an upcoming recession in 6 to 12 months' time.</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhG2bAC5XbEciQjP_CEnZGJGmk0kiTvWvHpGAwtS9fQ-5LwoH2YTXdH256MaunvQ9044t9Wl17c0_1vogPEJ9Q0UWlSBMoAqroaPr0c2TJMJKY6EXhFqzYUMdbLm6uPiMZ4LHK0-LHgfwoc/s1168/fredgraph.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="450" data-original-width="1168" height="246" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhG2bAC5XbEciQjP_CEnZGJGmk0kiTvWvHpGAwtS9fQ-5LwoH2YTXdH256MaunvQ9044t9Wl17c0_1vogPEJ9Q0UWlSBMoAqroaPr0c2TJMJKY6EXhFqzYUMdbLm6uPiMZ4LHK0-LHgfwoc/w640-h246/fredgraph.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">Figure 1: Spread between 10-year and 2-year T-Bills. Source: </span><a href="https://fred.stlouisfed.org/series/T10Y2Y" rel="nofollow noopener noopener noopener" style="text-align: left;">FRED</a></td></tr></tbody></table><p style="text-align: justify;">Why does the yield curve invert? Usually, the yield curve is an upwards facing curve (see Figure 2), meaning that investors demand greater interest rates for investing in assets with a longer maturity, which makes sense. You buy a 30-year T-bill and expect to be compensated annually for borrowing your money for such a long period of time (provided that you hold till maturity, which is what most institutional investors do). It's a matter of risk and liquidity premiums; there is greater risk for holding long-term assets. But when the reverse happens, <b>when investors demand greater interest rates on short-term than long-term bonds, they expect short-term interest rates to fall sharply in the future</b> (as a result of a recession, when the Fed cuts interest rates via the federal funds rate).</p><p style="text-align: justify;">When investors expect short-term yields to go down, they buy bonds with longer maturities. Greater demand for long-term bonds increases their price and reduces their yield. The short-term rates stay high given the central bank's decisions on the federal funds rate – short term yields usually follow the federal funds rate (see below on the relationship between the funds rate and the 2-year T-bill). So as more and more demand for long-term bonds is materializing, their rates go down and this produces an inverted yield curve.</p><p style="text-align: justify;">This is a self-perpetuating and reinforcing mechanism that sends signals to investors on how the market is feeling, and at the same time drives reactions of market actors.</p><p style="text-align: justify;">During times of economic growth or a fast recovery, the yield curve is upwards sloping because <b>investors expect the Fed to increase short-term interest rates in the future, so there is lower demand for long-term bonds </b>(or an increase of supply when governments issue many new long-term bonds to finance their deficits, thus reducing their prices and increasing their yields).</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEingOp01qU6T5TBXSRteQMdwVUV1icrSmmL6do317HmSdiL6gUb2UHebqwlAvpHM6Jq-oo3AvTY0K3UmSmu3sMGMbA38pTBREJxPUxmTHkb7Ka57NYk-3GE0G8xS2wQIq3JseyTffw2RnyJ/s831/Yield+curve+comparison+May-August.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="477" data-original-width="831" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEingOp01qU6T5TBXSRteQMdwVUV1icrSmmL6do317HmSdiL6gUb2UHebqwlAvpHM6Jq-oo3AvTY0K3UmSmu3sMGMbA38pTBREJxPUxmTHkb7Ka57NYk-3GE0G8xS2wQIq3JseyTffw2RnyJ/w640-h368/Yield+curve+comparison+May-August.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">Figure 2. The US T-bill yield curve for July 14th 2021. Source: </span><a href="https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield" rel="nofollow" style="text-align: left;">US Treasury </a></td></tr></tbody></table><br /><p style="text-align: justify;"><span style="text-align: left;">When the economy starts to overheat, the Fed usually raises short-term interest rates. But then investors expect that short-term interest rates will have to fall in the future, so they buy long-term bonds which decreases long-term rates (during recessions there is usually greater demand for bonds, as investors move out of stocks). Coupled with the Fed’s increase in short-term rates the yield curve begins to flatten and invert.</span></p><p style="text-align: justify;">Thus far, <b>the yield curve is still a long way from being inverted</b> (see Figure 2). It is slightly flatter from a few months ago, as the 10-, 20-, and 30-year yields have decreased by about 30-40 basis points, while the lower maturity yields have gone up by a few basis points. Not until these trends pick up more rapidly will the yield curve start showing signs of a recession. </p><h4><strong>2. The spread between corporate bonds and Treasuries (corporate spread)</strong></h4><p style="text-align: justify;">This is more of a <b>coincident rather than leading indicator</b> (will tell something is wrong when it happens), but it useful to look at for signs of a recovery. </p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgSmz9Hm5e5fuWxhkJND_IdiIojUQKxA3w7jHKSN-UTH20jGwjN4o9FMFebvSoDOC5PmoePlKxHlETF95RGsvaH65WxLQMN8eWGd_o_9fl2UtUWWlzrJnCyI4SVKeHLc5oApkRCGzCmcQq3/s1168/fredgraph+%25281%2529.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="450" data-original-width="1168" height="246" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgSmz9Hm5e5fuWxhkJND_IdiIojUQKxA3w7jHKSN-UTH20jGwjN4o9FMFebvSoDOC5PmoePlKxHlETF95RGsvaH65WxLQMN8eWGd_o_9fl2UtUWWlzrJnCyI4SVKeHLc5oApkRCGzCmcQq3/w640-h246/fredgraph+%25281%2529.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">Figure 3. Corporate spread; spread between Baa corporate bonds and the 10-year T-Bills. Source: </span><a href="https://fred.stlouisfed.org/series/BAA10Y" rel="nofollow noopener" style="text-align: left;">FRED</a></td></tr></tbody></table><p style="text-align: justify;"><span style="text-align: left;">In times of economic optimism, corporate spreads are tight (and reflect current low interest rate environments). In times of economic weakness, corporate bond investors expect cash flow issues which might increase corporate defaults. Hence, they demand higher interest rates for riskier corporate bonds instead of low-risk Treasuries. The indicator is a good measure of risk aversion of investors. The wider the spread, the greater the risk aversion. </span></p><p style="text-align: justify;">Currently, corporate spreads are tight, a typical sign of a low interest rate environment. No surprises there. </p><p><strong>3. Yield spread between two-year T-bills and the federal funds rate</strong></p><p style="text-align: justify;">The 2-year T-bill is, according to many, considered to be a better indicator of turning points in markets than the 10-year T-bill. The reason is its <b>close correlation with the federal funds rate</b>, because the yields on short-term maturities are largely determined by the cost of money. The same is true for other short-term bonds, like the <a href="https://fred.stlouisfed.org/series/T1YFF" rel="nofollow noopener noopener">1-year</a>, the <a href="https://fred.stlouisfed.org/series/T3MFF" rel="nofollow noopener noopener">6-month</a>, or the <a href="https://fred.stlouisfed.org/series/T6MFF" rel="nofollow noopener noopener">3-month T-bill</a>.</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjw-qsjujYI70h30qUpyZASAQP_dcs8-CYtQ4ziuxC_glOURz5BXXvy0TjhiZd7RIWMZuaLv4kKFSQjWDZvvjto1zpBdGZRfk2pmejuVdg7V16mkb9ZV41p48gSYa26ZUH9iEWjsYLHeYRr/s950/2year-Fedfunds.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="510" data-original-width="950" height="344" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjw-qsjujYI70h30qUpyZASAQP_dcs8-CYtQ4ziuxC_glOURz5BXXvy0TjhiZd7RIWMZuaLv4kKFSQjWDZvvjto1zpBdGZRfk2pmejuVdg7V16mkb9ZV41p48gSYa26ZUH9iEWjsYLHeYRr/w640-h344/2year-Fedfunds.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">Figure 4. 2-year T-Bill minus the Federal funds rate, for the past five years<br /><br /></span></td></tr></tbody></table><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a data-height="508" data-width="848" href="https://static.seekingalpha.com/uploads/2021/7/14/52266816-16262583791663995_origin.png" rel="lightbox" style="margin-left: auto; margin-right: auto;"><img alt="" data-height="383" data-width="640" height="383" src="https://static.seekingalpha.com/uploads/2021/7/14/52266816-16262583791663995.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">Figure 5. 2-year T-Bill minus the Federal funds rate, for the past twenty years, signalling a recession in 2001, 2008, and 2020. Source: </span><a href="https://fred.stlouisfed.org/series/DGS2" rel="noopener" style="text-align: left;">DGS2</a><span style="text-align: left;"> and </span><a href="https://fred.stlouisfed.org/series/EFFR" rel="noopener noopener" style="text-align: left;">EFFR</a></td></tr></tbody></table><p><a data-height="508" data-width="848" href="https://static.seekingalpha.com/uploads/2021/7/14/52266816-16262583791663995_origin.png" rel="lightbox"></a></p><p style="text-align: justify;">The logic here is similar to that of the inverted yield curve. If the cost of money (the federal funds rate) is higher than the yield on the 2-year T-bill, <b>investors buying the T-bill incur a <em>negative carry</em>, because the yield they are earning on the T-bill is lower than their borrowing costs.</b></p><p style="text-align: justify;">Whenever the 2-year yield dips below the federal funds rate, this was followed by the Fed lowering the federal funds rate a few months afterwards. Investors tolerated negative carry for only a short period of time, before the Fed reacted.</p><p style="text-align: justify;">This is therefore a leading indicator, with an even quicker reaction time than the yield curve inversion. When the 2-year yield dips below the funds rate, the Fed will very soon start lowering rates, so be prepared.</p><p style="text-align: justify;">In other words, when the spread turns negative, this too is a sign of an upcoming recession. Right now it is not showing signs of turning negative. Both the 2-year and the funds are are low, and will continue to stay low until at least the end of next year. </p><p style="text-align: justify;">To stay informed, it is also helpful to track expectations about the Federal funds rate: <a href="https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html" rel="nofollow noopener noopener">CME FedWatch Tool: Countdown to FOMC - CME Group</a>. Expectations are already forming for mid-2022 about the increases in the funds rate, so keep track of that next year. </p><h4><strong>4. Yield spread between the LIBOR and the federal funds rate</strong></h4><p style="text-align: justify;">The 3-month LIBOR is the interbank interest rate, the rate at which banks lend to each other. When the LIBOR spikes, <b>it indicates fear among banks</b> – they are afraid to lend to each other and their reference interest rate goes up. A good example of this was the 2008 financial crisis, in particular the September to November period, where fear and panic were at their absolute highs, while lending was frozen. This was the highest spike in the spread ever witnessed, going up to 400 basis points. Even the COVID spike was not nearly as high, but it did send a signal of temporary fear among the banks, which was soon alleviated.</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a data-height="441" data-width="766" href="https://static.seekingalpha.com/uploads/2021/7/14/52266816-16262584911992643_origin.png" rel="lightbox" style="margin-left: auto; margin-right: auto;"><img alt="" data-height="368" data-width="640" height="368" src="https://static.seekingalpha.com/uploads/2021/7/14/52266816-16262584911992643.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">Figure 6. LIBOR rate (3-month) minus the Federal funds rate</span></td></tr></tbody></table><p><a data-height="441" data-width="766" href="https://static.seekingalpha.com/uploads/2021/7/14/52266816-16262584911992643_origin.png" rel="lightbox"></a></p><p style="text-align: justify;">The reason this spread is important is that it tells us to which extent banks are concerned with counterparty risk and liquidity (and by extension systemic risk of the banking industry). It is thus a coincident indicator of recessions (it jumps when the recession already happens), but the higher it is, the stronger the crisis impact on banks, which typically indicates a prolonged recovery (such as the 2008-09 aftermath). Also interesting, it tends to go negative just before episodes of crisis, due to the same reasons as described above. Currently it is signalling a stable situation in the banking sector, meaning that there should be no lasting impact on the speed of the recovery. </p><h4>Other useful bond market indicators </h4><p style="text-align: justify;">I recommend reading <a href="https://www.amazon.com/Strategic-Bond-Investor-Third-Strategies-dp-1260473678/dp/1260473678/" rel="nofollow">The Strategic Bond Investor</a> from PIMCO's Anthony Crescenzi (a new 2021 version of the book is out, covering the COVID crash in March 2020). In addition to the aforementioned yield spreads, he points out a few other interesting indicators of tracking bond market sentiment centered around understanding the behavior of speculators vs institutional investors (i.e. "dumb money" vs "smart money"). </p><ul><li style="text-align: justify;">For example, it is useful to keep track of aggregate duration surveys, which measure to which extent portfolio managers are exposed to risk (higher exposure to risk means you raise duration by increasing the average maturity of your bond portfolio, as longer-term bond prices are more sensitive to interest rate movements). These increases/decreases of duration are typically measured against the benchmark, the <a href="https://www.bloomberg.com/markets/rates-bonds/bloomberg-barclays-indices" rel="nofollow">Bloomberg Barclays Index</a>. The higher the duration over the benchmark, the more chance of a reversal. However, in the aftermath of the current crisis, it is doubtful whether portfolio managers will increase their duration too high over the benchmark because they expect short term interest rates to rise over the next two years and this could hurt their longer duration exposure. </li><li style="text-align: justify;">A second useful indicator is to track the Commodity Futures Trading Commission’s <a href="https://www.cftc.gov/MarketReports/CommitmentsofTraders/index.htm%20" rel="nofollow">Commitments of Traders report</a>. The COT report categorizes holders of positions in US Treasury futures contracts. It shows whether the futures activity is driven by speculation or standard commercial activity (like currency hedging). The standard hedging activity is driven by the end users of contracts, the so-called "smart money" institutions like primary dealers, insurance companies, pension funds, etc. On the other side are speculators seeking to make short-term profits. A market top or bottom can be anticipated by extreme positions from speculative traders in the futures market. They suffer from heard mentality and accumulate too much of such assets in the end of a market trend (extrapolating short-term trends and recent experiences, hubris-driven investing, overly optimistic, overconfident, etc.). Currently, the speculative traders in the futures market are not holding such extreme positions. </li><li style="text-align: justify;">Finally, as with equities, Treasury futures too have a <a href="https://www.cmegroup.com/market-data/volume-open-interest/exchange-volume.html" rel="nofollow">put-call ratio</a>, measuring the ratio between the daily trading volume in put versus call contracts. Extremes will also signal potential pull-backs in the market, particularly if there are other outside risks involved in the bond market (like political risks; think back to the Greek sovereign debt crisis in Europe). This indicator is best viewed by comparing the 10-day average with the 1-year average. When the 10-day average is sharply above the 1-year, this is extreme fear and a pull-back is imminent. Investors are then buying more futures puts than calls, expecting a decline in bond prices. The extremes are typically between 0.8 on the short end and 1.8 on the long end. Currently the rates are around 1.2-1.4, and are not riding very high compared to the 1-year average. </li></ul><h4>Conclusion and implications</h4><p style="text-align: justify;"><b>None of the indicators shown above suggest a reversal of trends or an upcoming recession anytime soon. </b>This is because investors still look to the Fed and their interest rate decisions. This is also why inflation has become such a hot topic. Because of higher inflation expectations investors expect the Fed to start lowering its rates earlier than 2023, what was initially communicated. And with earlier than expected rate increases we can assume the bond market to signal these changes sometime in 2022. Currently it hasn't budged, despite the numerous overheating indicators in the stock market. But as both history and common sense tell us, the bond market will give us a much better idea of when the reversal will happen. </p><p style="text-align: justify;">Therefore, keep a close eye on bonds rather than equities for a sign of a recession, and don't pay much attention to predictions of imminent crashes on <!--StartFragment-->YouTube, especially the ones <a href="https://seekingalpha.com/article/4431920-inflation-scare-is-temporary-fed-should-not-yet-raise-interest-rates">predicting hyperinflation</a>. The equities can still face a correction hear and there (similar to the S&P500 and the DOW corrections in August and October 2020, or January, February, and June 2021), but thus far, it is safe to keep being long in equities. </p>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-19611582747599747472021-01-29T12:03:00.003+00:002021-01-29T12:55:00.113+00:00The GameStop conundrum <p style="text-align: justify;">This week we saw a huge play come to its climax. For a while the retail investor community at <a href="https://www.reddit.com/r/wallstreetbets/" rel="nofollow">r/wallstreetbets</a> (WSB) on Reddit has been pumping several stocks that have been targeted by short sellers (mostly in the form of big hedge funds). GameStop (<a class="ticker-link" href="https://seekingalpha.com/symbol/GME">GME</a>) was among the most prominent ones (others include <a class="ticker-link" href="https://seekingalpha.com/symbol/AMC">AMC</a>, <a class="ticker-link" href="https://seekingalpha.com/symbol/BB">BB</a>, <a class="ticker-link" href="https://seekingalpha.com/symbol/BBBY">BBBY</a>, <a class="ticker-link" href="https://seekingalpha.com/symbol/NOK">NOK</a>, etc.). The pump was done on the aforementioned subreddit, spilling over onto other social media platforms like Twitter where many retail investors, bystanders, billionaire businessmen, and even celebrities have joined in to push the stocks up in the massive short squeeze against the short sellers. </p><!--x-tinymce/html--><p style="text-align: justify;">Why has this caught so much attention? The motivation of the WSB community was driven by the fact that many short positions in these companies were overleveraged. <a class="ticker-link" href="https://seekingalpha.com/symbol/GME">GME</a> for example had a <a href="https://seekingalpha.com/news/3654580-gamestop-ends-the-day-up-90-to-add-more-pain-for-short-sellers">short interest at 140% of its float</a>. This means that there was more demand for borrowing stocks to be sold short than the number of stocks in circulation (<a href="https://www.tradersinsight.news/traders-insight/securities/stocks/gamestop-showed-short-interest-float-how-could-that-be/" rel="nofollow">this article</a> explains the mechanism really well). Obviously the short-sellers were too exposed to the risk of this price going up, and the WSB community saw an opportunity to exploit this by doing exactly that: pushing the price up to break the shorters. All they needed was to build momentum. Last Friday was when the stock first took off (up 50%, from $43 to 64$), but it was from Monday this week when the stock really started rallying. It finished Wednesday at $347, up 540% since last week. The hedge funds shorting the stock are <a href="https://markets.businessinsider.com/news/stocks/gamestop-short-sellers-squeezed-losses-reddit-traders-army-cohen-palihapitiya-2021-1-1030006226" rel="nofollow">estimated to be down by at least $5bn</a> (this was the estimate based on Tuesday data) as a result of the squeeze. The total short loss yesterday was <a href="https://finance.yahoo.com/news/losses-short-positions-u-firms-134105387.html">estimated to be around $70bn</a> (for other companies as well, not just GME). </p><p style="text-align: justify;">Then yesterday, all the major brokerage houses decided to shut down buy orders for <a class="ticker-link" href="https://seekingalpha.com/symbol/GME">GME</a> and <a class="ticker-link" href="https://seekingalpha.com/symbol/AMC">AMC</a> (among a few others), in order to limit their own potential losses out of fear of their clients not being able to make collateral to cover the losses, <a href="https://news.ycombinator.com/item?id=25949669">which would then fall on them</a>. This sparked outrage among the WSB traders and around the entire retail investor community, given that a limit to buy orders naturally sent the price down (from $357 to $193). This allegedly allowed hedge funds to either close or <a href="https://www.reddit.com/r/wallstreetbets/comments/l747eg/citadel_reloaded_their_shorts_before_they_told/">reload their short positions</a>, thus easing the pressure, albeit temporarily, from the brokers (also, Robinhood reportedly <a href="https://www.nytimes.com/2021/01/29/technology/robinhood-fundraising.html">raised $1bn yesterday</a> from its investors). Price is back up to $380 before trading today, and will probably continue to go higher, given that retail investors are looking for other avenues using brokers that haven't placed any stops on trading.</p><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj69r843zoT8OjIBYriwZRRNV-YkVEAP8zPxzjRQjlfvOvi1sfz9S4ty0fkiXldXupNagrQF2mHF6vRLRtsDkQjmlwSy5_U6ZyhfZb-BmyP4KAfoA0N3DFhEOwq2p36EOMa6kOW68D3jXFm/s630/GME.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="147" data-original-width="630" height="150" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj69r843zoT8OjIBYriwZRRNV-YkVEAP8zPxzjRQjlfvOvi1sfz9S4ty0fkiXldXupNagrQF2mHF6vRLRtsDkQjmlwSy5_U6ZyhfZb-BmyP4KAfoA0N3DFhEOwq2p36EOMa6kOW68D3jXFm/w640-h150/GME.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;">GME price movements from Friday, Jan 22 to before-hours trading on Monday, Jan 25th</td></tr></tbody></table><br /><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh1UKN0JCwtCohB3FB0UECgiU2kwrP2aD5WI_PyawUURli3YQ8s3d-pcdWs_CH7GDm5i6V3s-2Ry-a_MZmpgUyQRog_PS0ONAAsP1UUaZx229smm9Tjf92S8u8r6nuIvVZ1Sxw7leLmDtIe/s671/GME_4.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="155" data-original-width="671" height="148" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh1UKN0JCwtCohB3FB0UECgiU2kwrP2aD5WI_PyawUURli3YQ8s3d-pcdWs_CH7GDm5i6V3s-2Ry-a_MZmpgUyQRog_PS0ONAAsP1UUaZx229smm9Tjf92S8u8r6nuIvVZ1Sxw7leLmDtIe/w640-h148/GME_4.png" width="640" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;">GME price movements from Thursday, Jan 28th to before-hours trading on Friday, Jan 29th</td></tr></tbody></table><br /><p style="text-align: justify;"><b>Short-selling is a risk-amplification strategy</b></p><p style="text-align: justify;">Why is all this problematic? A <em>hedge</em> is defined as a protection against risk. Basically if you are long in certain equities (or other assets) you typically take a small short position as well (mostly in the form of put options on the stocks you are long in), to act as protection in case of a major market decline. So if the markets go down 10, 20, 30%, your put protection (on individual stocks or the market index in general) makes sure you fall down much less, or even profit from the decline. Taleb calls this an <a href="https://medium.com/@mytraderjourney/antifragile-investing-how-to-win-in-the-stock-market-during-chaotic-times-61b06e49500a" rel="nofollow">antifragile strategy</a> - you gain from disorder. Your losses are limited only to the size of your position, while your gains are exponential. Hence, the best way to hold short positions that can amplify your gains during bad times (whether we're talking about a general market decline or an individual stock decline) is to trade option contracts. </p><p style="text-align: justify;">A classic short-selling strategy is much more risky than holding a put option contract. For one, your losses during short-selling are potentially infinite, while your put losses are limited to the size of the put. In classic short-selling you borrow shares from a market maker and oblige to return it back to them, for a fee, at a pre-specified date. You sell them immediately as you bought them and hope that the price would go down. If it does, you buy them back at that lower price and return them, pocketing the price differential as profit. However, if the stock price goes up instead of down, you have to borrow more money to buy back the shares. The higher the price goes, the worse off you get, meaning that your potential losses are bounded by how high the price goes up (in theory infinite, but in practice the worse short-sales gone wrong have delivered losses of several hundred percent). </p><p style="text-align: justify;">A hedge fund that engages in classic short-selling is, therefore, not hedging against risk, it is amplifying its exposure to risk (unless, of course, a fund is investing based on privileged insider information - the trading risk is basically zero in that case, but there is a risk of getting caught breaking the law).</p><p style="text-align: justify;">In other words, if the hedge funds held their short positions via put options they would have only lost the size of the position - and this would happen <em>only if</em> the WSB crowd would keep inflating the bubble until the options expired (which would take a few months or maybe a year, depending on which option contract was bought). In the current case, the time interval the WSB crowd has to endure is much shorter, given that brokerages apply margin calls on major loss positions. Earlier this week, the fund alleged to be most exposed to the <a class="ticker-link" href="https://seekingalpha.com/symbol/GME">GME</a> short, Melvin Capital, received a <a href="https://www.wsj.com/articles/citadel-point72-to-invest-2-75-billion-into-melvin-capital-management-11611604340" rel="nofollow">$2.75bn credit line</a> from other hedge funds, Citadel and Point72. Reports suggest that Melvin lost 30% in the first three weeks of January. </p><p style="text-align: justify;">The moral of the story here is that when you open yourself to high risk, be prepared for incurring high losses. It is no ones responsibility to bailout over-leveraged funds. Doing so is called moral hazard, something that we all became particularly aware of during the 2008/2009 bailouts. </p><h4 style="text-align: justify;">No, this is not driven by fundamentals</h4><p style="text-align: justify;">There are many investors trying to point to the irrationality of this short squeeze, typically citing the firm's poor fundamentals. True, GME's fundamentals are bad, it's a company that is losing its demand (as players are shifting to online gaming), closing shops around the country, and was particularly hit by the COVID pandemic. After all, the short sellers had to have made some sort of due diligence before deciding to short. The valuation driven by the surge in stock price is surely massively overestimated. But this is missing the point. </p><p style="text-align: justify;">The arguments from the other side citing the potential for improving the fundamentals (with the company planning to shift to the online gaming niche) are also missing the point. This is not about fundamentals. Even if it started this way, with the short-sellers and the early long investors being at odds over their differing opinions about the company's future, this is no longer the point of discussion, and is by no means inflating the bubble. </p><p style="text-align: justify;">This stock in particular is driven by pure emotion, by people that have been hurt by the 2008 financial crisis and are demanding revenge. The reason this keeps going up is that <a href="https://www.reddit.com/r/wallstreetbets/comments/l6omry/an_open_letter_to_melvin_capital_cnbc_boomers_and/" rel="nofollow">many people still feel that pain</a> and now have a chance to "kick it to the establishment". Sure, there are also speculators out there hoping to make a quick profit and selling at various points in time, but the massive buyers are all those individuals who want to hold this to the bitter end.</p><p style="text-align: justify;">This can therefore not be explained by anything we have learned in financial analysis: nor the fundamentals, nor the technicals, not even the standard explanations of behavioral economics like speculative, greedy heard behavior. Sure, this is a form of heard behavior, but not necessarily driven by greed. Especially when many of the investors in the community pledge to donate their profits to charity. Underestimate them at your peril. </p><p style="text-align: justify;">In conclusion, yes, the bubble will deflate at one point, when the hedge funds are beaten and when they start covering their losses (and pull the market down temporarily). A very similar thing happened to the <a href="https://www.reuters.com/article/us-volkswagen-idUSTRE49R3I920081028" rel="nofollow">stocks of Volkswagen back in 2008</a>, when the short squeeze made the company briefly the most valued company in the world. That squeeze however was not driven by retail investors, but by Porsche, which ended up with a 75% stake in the VW. What we have today is a slightly different story: the fight of the "little man" against the symbols of the industry. And the little man is winning. </p>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-17265187217504722452021-01-04T10:41:00.001+00:002021-01-05T10:03:17.856+00:00Again no inflation? Velocity of money and the E-P ratio reexamined<p style="text-align: justify;">A lot of investors are wondering when exactly can we expect inflation to hit our economies? An economist's answer - only in the long run. </p><p style="text-align: justify;">This bad joke is turning out to be true. Despite the huge, unprecedented (sic!) rise in money supply over the past year, it is unlikely we will experience a rapid increase in inflation over the coming two years. Why is this so? </p><p style="text-align: justify;">Let's start with a fascinating development on the money markets. <a href="http://im-an-economist.blogspot.com/2012/02/graphs-of-week.html" target="_blank">Velocity of money</a>, that important indicator derived from <a href="https://www.economicsdiscussion.net/money/quantity-theory-of-money/fishers-quantity-theory-of-money-equation-example-assumptions-and-criticisms/31214" target="_blank">Fisher's quantitative theory of money (MV=PQ)</a> measuring the circulation of money in the economy (how fast goods are bought and sold), became detached from the real economy approximated by the employment-population (EP) ratio. </p><p style="text-align: justify;">For those new to the blog, I have been particularly fond of tracking these two indicators, and for a very good reason - I find them a realistic portrayal of the situation in the real economy. The velocity of money has, thus far, been a great indicator of economic activity. When it goes down it means that less money is circulating in the economy, less goods and services are being bought and sold, which implies a recession. If it is not recovering, it usually means that consumption is lower and hence the economic recovery will be slower. </p><p style="text-align: justify;">Closely correlated with the velocity of money over the past few decades has been another great indicator of real economic activity - the <a href="http://im-an-economist.blogspot.com/2012/01/understanding-unemployment.html" target="_blank">employment-population (EP) ratio</a>. I consider the EP ratio to be a much better indicator of labor market strength than the unemployment rate. It counts the total amount of people who have a job divided by total population. The unemployment rate only captures people who want to work (those actively looking for a job). It doesn't account for anyone outside the labor force. I used the EP ratio as a signal to track the recovery of the US and EU economies after the previous crisis, given that unemployment data suggested that unemployment was going down, but the EP ratio kept being stubbornly low and stuck at 58% in the US for over four years. This meant that unemployment wasn't going down due to strong job creation but rather as a consequence of many people leaving the labor force (some retiring early, others postponing entry into the labor market). The ratio hadn't started truly recovering until mid-2014 and has been steadily increasing until March 2020. It never got back to the pre-2008 crisis levels of 63%, but since the fundamentals of the US economy changed, this development made sense. </p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJtHgUX5frbOpH2PwtVcIMHPlcEFCMqKHmjAdeQfKa3afcY_HdAlSgKMTy9C4nUBHFWmv4Vg11UgqRYn0s-tTVq28-dIdRwKhUFC5o3y1yFMJduTPUQfa1ID3lwxaKQOkk-YHil7h_SM-v/s1168/fredgraph.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="450" data-original-width="1168" height="246" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJtHgUX5frbOpH2PwtVcIMHPlcEFCMqKHmjAdeQfKa3afcY_HdAlSgKMTy9C4nUBHFWmv4Vg11UgqRYn0s-tTVq28-dIdRwKhUFC5o3y1yFMJduTPUQfa1ID3lwxaKQOkk-YHil7h_SM-v/w640-h246/fredgraph.png" width="640" /></a></div><div><br /></div><div><br /></div><div style="text-align: justify;">However, during that entire period of a gradual recovery in the EP ratio, the velocity of money kept declining. For the first time ever these two indicators moved against one another, which is a very strange occurrence. One would think that more people getting jobs would increase spending (which it did), which would, consequentially, increase the circulation of money in the economy - the rate at which goods are exchanged. But it didn't. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Why? For that we must look to the Fed. Velocity of money is defined as nominal GDP divided by M2 money stock. <a href="https://fred.stlouisfed.org/series/BOGMBASE" target="_blank">Money stock</a> has been growing much faster than nominal GDP so velocity obviously went down. Velocity of money reached its first historical low in Q2 2017, at 1.43. Until Q2 2020, of course, when it dropped down to only 1.1 (mind you, this is an indicator that has typically been around 1.8 to 2 throughout the past half century). It has again finally been united on the same trend as the EP ratio, albeit only briefly. The EP ratio started its own V-shaped recovery whereas the velocity of money is still incredibly low, especially for a (supposedly) booming economy. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">What does this all mean? For one thing <b>it explains why we're not witnessing any inflation</b>. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As <a href="http://im-an-economist.blogspot.com/2014/05/why-no-inflation.html" target="_blank">I wrote back in 2014</a>, the last time I looked at these relationships: <span face="Roboto, sans-serif" style="background-color: white; color: #757575; font-size: 15px; text-align: justify;"><br /></span></div><blockquote style="text-align: justify;"><i>"This again does not mean that high velocity will lead to high inflation, but low velocity will surely prevent inflation from occurring. Basically we can say that the decline in the velocity of money has offset the average annual money growth." </i><br /><div><p></p></div></blockquote><div><p style="text-align: justify;">But what happens when employment and consumption pick up again? Will the velocity of money pick up and will this increase inflationary pressures? That depends. Notice that the only reason why velocity of money is low is because the expansion of the monetary supply is greater than nominal GDP growth. In other words, the <b>market growth over the past decade has been driven to a large extent by the Fed's expansionary policies. </b>This was not a standard robust economic recovery. It was a recovery driven artificially by expansionary monetary policy. </p><p style="text-align: justify;">To put it more bluntly, all that money created by the Fed never got translated into the real economy. The biggest beneficiary were the equity markets. What's happening in the second half of 2020 is merely a continuation of a trend from the past decade. Aggressive expansionary monetary policy is driving markets high but because none of this money is going to the real economy in boosting nominal GDP, there is no consequential increase in inflation. </p><div style="text-align: justify;">What about low interest rates? Shouldn't low rates imply easy money? Not at all, according to Milton Friedman:</div></div><div><blockquote><div style="text-align: justify;"><i>"Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. </i></div><i><div style="text-align: justify;"><i>After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."</i></div></i></blockquote><div style="text-align: justify;">Low interest rates, according to monetarist theory, typically suggest that inflation will go down. Especially in post-crisis times like these. We already have such a scenario - <a href="http://im-an-economist.blogspot.com/2013/07/the-perplexity-that-is-japan.html" target="_blank">Japan</a>, with its three-decade-long low interest rates and borderline deflation. Its monetary base expanded to truly unprecedented levels, as did its debt-to-GDP, but there has been no consequential inflationary pressure. Quite the opposite actually. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Our societies are therefore converging towards a Japanese scenario where interest rates will have to continue to be low (don't expect 3-4% rates at any time over the next decade), monetary expansion will continue, velocity of money will be low, and a large part of nominal GDP growth will be driven artificially. Banks and big companies will continue hoarding cash. This is now turning into pure psychology - as long as there is faith in such a system, growth will continue. <i>This </i>is the new normal. </div></div>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-38310792763288700622020-09-14T08:24:00.005+01:002020-09-14T08:29:20.877+01:00The corporate debt bubble: CLOs and company bankruptcies<div style="text-align: justify;">In addition to <a href="http://im-an-economist.blogspot.com/2020/09/monetary-and-fiscal-bubbles-after-covid.html">monetary and fiscal bubbles</a>, another potential issue that could be exacerbated by a prolonged period of low interest rates are rising corporate debt levels of publicly listed nonfinancial companies. Total corporate debt of such companies has already reached historical highs by surpassing <a href="https://fred.stlouisfed.org/series/BCNSDODNS">$10 trillion in Q1 2020</a>, and is likely to keep growing in the months to come. Adding to this another 5.5 trillion of corporate debt from SMEs and other non-listed companies <b>the total corporate debt size in the US is now at 73% of GDP</b>. This is still lower than household debt in 2009 which reached almost 100% of GDP, and with lower rates of growth. However, corporate debt will keep on rising – as it did during the 2009 crisis – as a necessary consequence of the pandemic and increasing risk exposure of many companies.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Leveraged loan market and CLOs</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">About $1.4 trillion of that market (also at historical highs) is comprised of <b>leveraged loans</b>, which include all loans securitized in something called <b>collateralized loan obligations (<a href="https://www.investopedia.com/terms/c/clo.asp">CLOs</a>)</b>. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Similar to their namesake counterpart, collateralized debt obligations (<a href="https://www.investopedia.com/terms/c/cdo.asp">CDOs</a>), CLOs are financial derivatives constructed of <b>corporate loans given to companies with low credit ratings</b>. These are typically companies which cannot qualify for a traditional bank loan (like start-ups or companies which have not yet started making significant revenues out of their business model), or companies which are already too overborrowed and cannot sell their bonds directly to investors. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">For these companies this is helpful as it gives them alternative access to capital. Problem is that some of them use the money from such loans to buy back stocks or pay out dividends, thus presenting a better image of themselves to their shareholders. The obvious negative consequence is piling up more and more corporate debt, making such loans even more risky and with a greater probability of default. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">All this is creating a systemic imbalance in the economy. If companies are using debt to buy back their stocks, or are simply exploiting the low interest rate environment, an economic downturn could severely impact their earnings. This will make it even more difficult to service those debts which would <b>significantly increase the threat of bankruptcy</b>, and by extension increase the risks for banks. </div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjgVC8kQVTjaEgDi5ibDgNZHcevFMZB8equdsvG67bTLiLo1D0W5iG2JpDWH6zvEWz94RVxxK8PGAOmAr5RSkeb8i6tNPn2-Q6tknRIYyYjSZr4OVD1UAX2cJFDhMsSqbqu50bwW5icbuex/s364/LeveragedLoans.png" style="margin-left: auto; margin-right: auto;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjgVC8kQVTjaEgDi5ibDgNZHcevFMZB8equdsvG67bTLiLo1D0W5iG2JpDWH6zvEWz94RVxxK8PGAOmAr5RSkeb8i6tNPn2-Q6tknRIYyYjSZr4OVD1UAX2cJFDhMsSqbqu50bwW5icbuex/w500-h391/LeveragedLoans.png" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: justify;">Expected leveraged loan defaults according to Fitch.</span></td></tr></tbody></table><div style="text-align: justify;"></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Risk sources in the leveraged loans market</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">There are <b>several sources of risk for banks in the leveraged loans market</b>. Frist there is exposure to revolving credit facilities and warehouse facilities – short-term funding for firms with liquidity problems – of around $780 billion. Second there is exposure through the arrangement of syndicated loans where banks are at risk of keeping more shares than they wanted through pipeline exposure if investors for some reason do not pursue with investment as agreed. US banks have an exposure of around US$65 billion through this mechanism. Finally, there is exposure through third party CLOs, the market for which is over $700 billion (3.27% of GDP), where the cumulative losses of the top three US banks would be around $40 billion in the worst-case scenario of massive corporate bankruptcies. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Altogether all these sources of increased risk for banks from exposure to leveraged loans represent around <a href="https://www.fsb.org/wp-content/uploads/P171219.pdf">60% of common equity tier 1 capital</a> for 59 US banks, which is a considerably large exposure. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The <b>biggest defaults on leveraged loans are expected in sectors with highest sensitivity to the pandemic</b>: energy, non-food retail, restaurants, travel/leisure. Total volume of high-risk sectors accounts for approximately $225 billion or 16% of the leveraged loans market. By the end of 2021 defaults could go up to $200 billion, while defaults of leveraged loans will top $80 billion in 2020 and $120 billion in 2021 which is in both cases higher than the previous record of $78 billion defaults in 2009, however the default rate is projected to be slightly below the 10.2% in 2009 (as shown in the figure below). Higher expected defaults of such loans could destabilize banks holding large volumes of CLOs. </div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5fOtlp39mCpIR-lj3wDNDVmm-lLoy0iXtugb18LFEwQ5XyBTlsFInOWWbsYe2RAANfkwkEZylgZKsVOzZ9b6vgN2b7h0vv9G97SofxJVizGftcoyiqhC_zD8tshAPkyx0w_SJ2LAm2YXI/s638/CorporateDebtRating.png" style="margin-left: auto; margin-right: auto;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5fOtlp39mCpIR-lj3wDNDVmm-lLoy0iXtugb18LFEwQ5XyBTlsFInOWWbsYe2RAANfkwkEZylgZKsVOzZ9b6vgN2b7h0vv9G97SofxJVizGftcoyiqhC_zD8tshAPkyx0w_SJ2LAm2YXI/w625-h249/CorporateDebtRating.png" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: justify;">Distribution of US corporate debt by rating category. Source: Fitch.</span></td></tr></tbody></table><div style="text-align: justify;"></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Investment grade bond issuance and holders</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In the overall corporate debt market about $8 trillion are corporate bonds. The majority (72%) of rated corporate bonds in the US are investment grade (>BB). That being said, and the fact that so far in 2020 issuance of investment grade corporate debt has reached $1 trillion, a closer attention needs to be payed to the investment grade itself. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The majority, around 54%, of investment grade debt is rated BBB or Baa (Moody’s) and it is clear to see how the number of issuers is disproportionally lower in comparison to the amount issued (see figure above). This implies higher risk of defaulting because amounts borrowed are concentrated between a smaller number of borrowers. If BBB rated debt gets downgraded (and as of June 20th 20% of BBB is on negative outlook in comparison to 6% at the beginning of the year), it automatically becomes “junk”. These downgraded bonds alone have added $88 billion of supply to the high-yield bond market so far this year. This is particularly important in the current pandemic where a company’s ability to return the borrowed money becomes less probable and <b>a downgrade in ratings becomes a possibility</b>. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><a href="https://www.fsb.org/wp-content/uploads/P191219.pdf">According to the Financial Stability Board (FSB)</a>, a worsening of the macroeconomic scenario could lead to a higher rate of downgrades, particularly of highly leveraged corporates, and more defaults. Analysis suggests that bonds issued by highly leveraged corporations are not necessarily downgraded during times of good economic growth but are downgraded more frequently once macroeconomic conditions deteriorate. Historical data also show a correlation between the level of corporate leverage and downgrades since both <b>increase during periods of economic downturns. </b></div><div style="text-align: justify;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjz-qM2W-E3i-zPPPkG_ZCanBpSI2FzefEVGNdEIT7Sx45gvXFCs8l7yI0hvNSMgaLQek6SZ_0Rgm-mgSz9KnvhUftiO5BKR-x3lUCpqklKr0PkNjKhUO48LhG-U5AnLQ86dUve1sxoKhgw/s321/InvestmetnBondIssuance.png"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjz-qM2W-E3i-zPPPkG_ZCanBpSI2FzefEVGNdEIT7Sx45gvXFCs8l7yI0hvNSMgaLQek6SZ_0Rgm-mgSz9KnvhUftiO5BKR-x3lUCpqklKr0PkNjKhUO48LhG-U5AnLQ86dUve1sxoKhgw/s320/InvestmetnBondIssuance.png" /></a><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhfo4rP905DnZwaraVN96NH0lzFpw1x0CcpGxjyFLnHFFN6eJNlz8J_wZowCnQmXKWEUKs_Tts2IaMZcFtqDnqp1IzfkQV75ip0-PchzPV711vCmSxv8kcTE_r6IP3mELq3IHw-mtR-ZZm/s320/InvestmentBondHolders.png" /></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Given that this debt is being used as a tool for refinancing, M&As, and leveraged buyouts (especially in March, April and May 2020), which does not necessarily lead to a prosperous future of the company, pilling up debt in still uncertain times of COVID-19 is not a sound business strategy. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Furthermore, structurally higher non-financial corporate leverage has a procyclical effect on debt and equity prices of publicly listed corporates and, as such, can amplify financial market shocks. In other words, <b>companies increasing leverage now as a consequence of the COVID pandemic, are becoming even more vulnerable and increasing their risks of bankruptcy. </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Historically, investment-grade bonds witness a low default rate compared to non-investment grade bonds. However, if the downgrades persist certain holders like life insurances, where the industry has increased its exposure in this class by about 75% over the past 10 years, could be urged to boost their capital buffers because the risk-weighted ratio would be changed. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In the last two years US insurers had about 30% of their total bond exposure invested in BBB corporate bonds. As of May 2020, top five mutual funds had at least 68% of their investments in investment grade corporate bonds. Pension funds decreased their involvement in fixed income but their investments in corporate bonds seem to account for about 15% of total investments on average. <a href="https://www.blackrock.com/corporate/literature/whitepaper/policy-spotlight-us-bbb-rated-bonds-a-primer.pdf">According to a Blackrock report</a>, almost 54% of BBB corporate bonds mature in or after 2026, while only a little over 3% of BBB bonds are set to mature in 2020 which reduces refinancing risk. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Expecting downgrades, bankruptcies, and deleveraging </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In conclusion, the US leveraged loans market will almost certainly continue to grow. The biggest holders of those loans have stable protective buffers, while the amounts invested in leveraged loans in relative terms (in comparison to total assets) are not considered as a major default threat yet. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">On the other hand, the recent growth of BBB-rated corporate bonds poses much more concern. The majority of corporate debt invested in BBB-rated debt is by its structure one step away from getting downgraded to “junk” status which could then cause a <b>chain reaction of investors selling those bonds, followed by a further bond price deterioration and overall financial instability</b>. A downgrade does not immediately imply default but non-investment grade debt historically had bigger chances of defaulting. Furthermore, the systemic downturn also depends on investors’ willingness to hold downgraded bonds and on other investors taking advantage and buying recently downgraded bonds. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The situation and predictions in the corporate bond market change on a weekly basis as more bonds get downgraded, more companies default and the COVID-19 uncertainties are still present. Therefore, to be able to make clearer conclusions, the reevaluations and analyses of the corporate bond market need to be followed constantly in the next few months. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">One thing is certain, with such huge debt levels one can <b>expect large deleveraging from the private sector</b>, which is likely to mirror potential austerity measures of governments in the years to come.</div>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-7164657248314501032020-09-06T10:27:00.006+01:002020-09-07T20:39:33.820+01:00Monetary and fiscal bubbles after COVID<p style="text-align: justify;">In the <a href="http://im-an-economist.blogspot.com/2020/08/riding-on-high-why-is-market-hitting.html" target="_blank">previous blog</a> I analyzed the stunning divergence between the markets and the real economy. I emphasized three particular reasons for why this is happening: (1) huge monetary and fiscal stimuli that started the V-shaped rebound on the markets in March; (2) exuberant (and by all means irrational) expectations driven primarily by the so-called retail investors (the subject of one of my next blogs), and (3) the asymmetry between firms driving the market (the top 5 big tech firms) vs the unlisted SMEs laying people off and declaring bankruptcies. </p><p style="text-align: justify;">In this blog I will touch upon the potential instabilities of the first effect: the monetary and fiscal stimuli. </p><p style="text-align: justify;">While the stimuli were designed to calm the market panic back in March, its continuation - particularly from the Fed - is creating massive instabilities elsewhere. Specifically, there is ample evidence of a
growing <b>monetary bubble</b>, unavoidable <b>fiscal instabilities</b> due to
rising debts and deficits, and even a <b>potential corporate debt bubble</b>
which, due to the increasing risk of bankruptcy of many businesses, could be a
potential blow for the banking industry.</p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">Let us examine the first two in greater detail (the debt bubble will be a subject of a new blog post).
<o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><b><span lang="" style="font-size: 14pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">1) Monetary bubble<o:p></o:p></span></b></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">The monetary bubble started as a <a href="http://im-an-economist.blogspot.com/2012/09/more-on-monetary-stimuli.html">response tothe Great Recession</a>. The rapid expansion of both the monetary base (M0) and
money stock (M1) has been (wait for it...) unprecedented (see Figure below), but it was deemed
necessary by many economists in order to bring back confidence into the economy
particularly during episodes of rising uncertainty during the <a href="https://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html" target="_blank">Eurozone sovereign debt crisis</a>. <o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">The 10 years of “QE infinity” fueled the
longest bull market in history. The Fed started to raise rates in 2015 which
decreased the monetary base, but M1 money stock kept rising, meaning that the
markets kept being overflooded with money. The reason this never caused an
inflationary spiral is due to there being almost unlimited demand for the
dollar worldwide. In fact, there is a greater threat of deflation <a href="http://im-an-economist.blogspot.com/2014/05/why-no-inflation.html">than inflation</a> at the moment for the US economy.<o:p></o:p></span></p>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgrWrf0-VVT1lRBKqdOA1_unq5JL425oVzdd1ofuKYW9RLNEaT7Mx9p1TGqNa8iSG0jfVUxJM8rHKLJww7UMzZFzPU6-OkFPQDM4ZAK_JHwqCKHaY5bbP31rk6vl9ez6S1GVw6GU_f2OR6w/s1168/fredgraph.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="450" data-original-width="1168" height="241" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgrWrf0-VVT1lRBKqdOA1_unq5JL425oVzdd1ofuKYW9RLNEaT7Mx9p1TGqNa8iSG0jfVUxJM8rHKLJww7UMzZFzPU6-OkFPQDM4ZAK_JHwqCKHaY5bbP31rk6vl9ez6S1GVw6GU_f2OR6w/w625-h241/fredgraph.png" width="625" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="font-size: 13.3333px;">Figure 4. Comparison of M1 money stock and monetary base (M0) in the United States. Source: <a href="https://fred.stlouisfed.org/series/BOGMBASE" target="_blank">St. Louis FRED database</a>.</span><br /></td></tr></tbody></table><p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">However, the negative effect that was created in the past decade that is being
amplified today are <b>distorted expectations. Investors expect the Fed to
provide constant liquidity</b>. By keeping interest rates too low throughout
the longest bull market in history the Fed created impetus for another big
bubble, far greater than the one it was criticized for back in 2001 that
resulted in the mortgage crisis.<o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><b><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">The market is clearly addicted to Fed stimuli</span></b><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">. In order for it to
continue to grow the Fed would need to do more of the same for the next decade,
just as it did since 2009, but this time on levels so high that they will
inevitably cause huge distortions of market signals and potentially send the US
economy into a <a href="http://im-an-economist.blogspot.com/2012/10/dangers-of-low-interest-rates-case.html">deflationary Japan-like two decade stagnation</a>. <o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">As a direct response to the pandemic-induced
lockdowns the Fed simply did more of the same: massive quantitative easing in
order to help the economy overcome the panic (M0 and M1 went up by a whopping
30% from March to May 2020). While their reactions coupled with government
stimuli offered the necessary confidence and relief to the wider economy, its
main effect was to send markets back up, thus <b>adding even more distortions
to market allocation decisions</b> and pushing investors back into equities
when the fundamentals are still weak and the markets highly overvalued. It was
like treating a crystal meth patient with more crystal meth.<span style="mso-spacerun: yes;"> </span><o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">The Fed, in the medium term, is in a lose-lose
situation. Whatever it does it will risk <b>undermining its credibility and
adding to the instability</b>. If it raises interest rates it will take
liquidity off the markets and almost certainly send the stock market down a negative
spiral. If it continues to push more money into the markets it is entering
deeply into uncharted territory risking a huge collapse in the years to come. <o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">In conclusion, continuous stimulus from
the Fed in terms of lower rates at this point is likely to cause more harm than
good, already in the medium run. <o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><b><span lang="" style="font-size: 14pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">2) Fiscal bubble <o:p></o:p></span></b></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">Federal debt to GDP in the US has been rising
since the end of 2008. It has risen from 60% before the Great Recession to
around 100% in 2012 and has roughly remained there during the entire
historically long bull market. This was not a fiscally stable position to begin
with, and the COVID pandemic only made it worse, <b>skyrocketing debt-to-GDP to
131%</b> in June 2020 (see Figure 5). This is a larger debt-to-GDP ratio than
during the </span><a href="https://www.longtermtrends.net/us-debt-to-gdp/"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">aftermath of World War II</span></a><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">, when the ratio stood at
120% (but has decreased quickly due to a rapid post-war recovery which is an
unlikely scenario today). In 2012 the US was on the verge of “<a href="http://im-an-economist.blogspot.com/2012/12/cliffhanger-fiscal-clif-bargaining.html">falling from a fiscal cliff</a>” with the political standoff between the President and Congress
triggering significant uncertainty in the economy. The fiscal cliff scenario
was averted but the debt levels remained unsustainably high, and are now higher
than ever before in modern US history. <o:p></o:p></span></p>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhczHo9JkMHcvc5Xrfb6fYsb0A_OMYn1tJHMA3J2hIo20ndFiX8KdvLdbp9yxts8gWzHSgENbh3TYow1PK-OV3M02-2s4K2ezp7zy5lfrEXon7szzVYuK3SseyS-8Ahjf25rx9jWtKtR7Ve/s597/US_debttogdp.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="347" data-original-width="597" height="364" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhczHo9JkMHcvc5Xrfb6fYsb0A_OMYn1tJHMA3J2hIo20ndFiX8KdvLdbp9yxts8gWzHSgENbh3TYow1PK-OV3M02-2s4K2ezp7zy5lfrEXon7szzVYuK3SseyS-8Ahjf25rx9jWtKtR7Ve/w625-h364/US_debttogdp.png" width="625" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span lang="" style="font-size: 10pt; line-height: 14.2667px; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">Figure 5. US debt to GDP ratio. Source: St.Louis FRED data on </span><a href="https://www.usdebtclock.org/"><span lang="" style="font-size: 10pt; line-height: 14.2667px; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">Total Federal Debt</span></a><span lang="" style="font-size: 10pt; line-height: 14.2667px; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;"> and the real-time </span><a href="https://www.usdebtclock.org/"><span lang="" style="font-size: 10pt; line-height: 14.2667px; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">US debt clock</span></a><span lang="" style="font-size: 10pt; line-height: 14.2667px; mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">.</span></td></tr></tbody></table>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;"><br />The federal budget deficit is even worse. The </span><a href="https://www.cbo.gov/publication/56335"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">Congressional Budget Office (CBO) made a projection of 3.7tn</span></a><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;"> for 2020 which is a <b>staggering
18% of GDP</b> and represents a fivefold increase from the 2019 budget deficit.
A deficit this large will imminently cause major disruptions in the years to
come and will spark fierce debates among economists and call for radical policy
actions. Expect the return of the <a href="http://im-an-economist.blogspot.com/2012/11/another-one-on-tax-hikes-vs-spending.html">stimulus vs austerity</a> debate throughout 2021
and 2022 (and possibly beyond). And expect even more <b>political
radicalization as a consequence of austerity and budget cuts</b> to put the
fiscal situation under control. We could even witness another credit ratings
downgrade of the US economy and almost certainly of many European economies. <o:p></o:p></span></p>
<p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-hansi-font-family: Calibri;">Forward-looking expectations on the markets
right now are simply <b>ignoring these fiscal realities</b> which will cause
problems in the years to come.<span style="mso-spacerun: yes;"> And this is before even taking into account the situation with the corporate debt market and inevitable bankruptcies, a topic of the next blog post. Stay tuned. </span><o:p></o:p></span></p>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-1193932174515633962020-08-30T11:11:00.000+01:002020-08-30T11:11:14.793+01:00Riding on a high: why is the market hitting records in a recession?<div style="text-align: justify;">The US National Bureau of Economic Research (NBER), the official tracker of the US business cycle, <a href="https://www.nber.org/cycles/june2020.html">declared that the recession in the country started in February 2020</a>. According to NBER February was the peak of the business cycle as jobs already started disappearing (even though the huge COVID-driven unemployment claim spikes didn’t happen until <a href="https://www.cnbc.com/2020/05/21/us-weekly-jobless-claims.html">mid-March</a>). Over the next month and a half over 42 million Americans found themselves out of work. The <a href="https://data.bls.gov/timeseries/LNS14000000">official unemployment rate</a> shot up to 14.7% in April (it was 3.5% in February), and has declined back to 10.2% in July, as a more encouraging sign of a recovery driven by business re-openings.</div><div><div style="text-align: center;"><br /></div><div style="text-align: justify;">Due to the effects of COVID-19 the uncertainty in the economy is still huge, and is <i>still</i> the biggest it has ever been according to the <a href="https://www.blogger.com/#">Economic Policy Uncertainty Index</a>. Almost every graph we see during the pandemic has a label “unprecedented” attached to it; we are usually looking at a very steep exponential curve facing up (for unemployment, uncertainty, or fear), or down (for business and consumer confidence, or future expectations). Oraclum's <a href="https://www.blogger.com/#">Fear Reaction Index (FRIX)</a> is also showing a huge spike in negative expectations of businesses and consumers across Europe and the US. People are changing their behavioral patterns and in some cases still voluntarily limiting their mobility and hence their spending (less traveling, working from home, lower exposure to live events, spending less time in restaurants, etc.) while at the same time many are finding themselves in a situation where their jobs are unsafe, which is forcing them to cut down all non-essential spending (like taking loans to buy a car, go on holiday, or refurbish their flat) to brace for an uncertain future. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In the figure below we can see that mobility in the United States (measured by <a href="https://www.google.com/covid19/mobility/">Google's Mobility Reports</a>, or in other words your phone tracking where you're going) is still not back to its pre-pandemic levels. It is between 20 to 40% lower for transit stations, retail & recreation, and workplaces, and 50% lower for restaurants (on average across the country). The trends are slowly rebounding but with mobility still limited, and with many people in high-paying jobs still working from home and reducing their spending - the upper panel is depicting credit card spending by income group - expect aggregate demand to remain sluggish in the following months. </div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOBiYNJYtje8bZSj1ltCp01l-VqjyR4qsfFSwjjiaqbplGSUp9mcGf5-f85FGbtprlElSOga5kCBf8tW-CXI42K27yLMICdYvI3h9-T9OgQ0Z2r-VuTTzQNASxprN_X5bDfQ1Qf4ugQ73s/s1577/mozaik-USA.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1577" data-original-width="1065" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOBiYNJYtje8bZSj1ltCp01l-VqjyR4qsfFSwjjiaqbplGSUp9mcGf5-f85FGbtprlElSOga5kCBf8tW-CXI42K27yLMICdYvI3h9-T9OgQ0Z2r-VuTTzQNASxprN_X5bDfQ1Qf4ugQ73s/s640/mozaik-USA.png" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: start;">Credit/debit card spending, mobility data and restaurant reservations in the United States (data sources: </span><a href="https://github.com/Opportunitylab/EconomicTracker" style="text-align: start;">Opportunity Insights Economic Tracker</a><span style="text-align: start;">, </span><a href="https://www.opentable.com/state-of-industry" style="text-align: start;">OpenTable</a><span style="text-align: start;">, </span><a href="https://www.google.com/covid19/mobility/" style="text-align: start;">Google Moblity</a><span style="text-align: start;">)</span></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Simultaneously, during this “era of unprecedented events” and sluggish aggregate demand, the stock market is almost completely deaf to all the real economy uncertainty. It did react by the end of February and early March (forward-looking), when it lost 34% of its value from its February 20th peak. This decline lasted for about a month, after which on March 23rd it started bouncing back. And it bounced back astonishingly: the S&P500 saw the best 50-day upsurge in its history, up 52.5% from its trough. </div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjerImuOq31Qa_NJsouo0pHXggJ3GfDHf3KVESUC8HRWm3nQxQwMrfD2fMU34EV1N6qjoT6lqjI3PzHGYql-1yKlquBkeTl1WUrKZ76mf8rACV_j3wbjBX8-2dcAD4L5iyBCCnOk3iR3XzO/s1545/S%2526P500_August2020.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="816" data-original-width="1545" height="270" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjerImuOq31Qa_NJsouo0pHXggJ3GfDHf3KVESUC8HRWm3nQxQwMrfD2fMU34EV1N6qjoT6lqjI3PzHGYql-1yKlquBkeTl1WUrKZ76mf8rACV_j3wbjBX8-2dcAD4L5iyBCCnOk3iR3XzO/w512-h270/S%2526P500_August2020.png" width="512" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">S&P500 Year to date performance. Source: </span><a href="https://www.tradingview.com/symbols/SPX/" style="text-align: left;">TradingView</a></td></tr></tbody></table><div><br /></div><br /><div style="text-align: justify;">Just as the majority of the population across the US and Europe were starting to adapt to a life in the quarantine — which <i>at the time</i> no one had an idea of how long it might last — the market started growing robustly and two and a half months later it completely reverted the entire February/March decline. It is now net positive for 2020. All this amidst extremely negative expectations from both consumers and businesses of the months to come, where many jobs will be lost and annual GDP is projected to go down around 8% (in the US). In addition to all of this, the US was engulfed in Black Lives Matter protests around the country, and is facing more uncertainty due to the upcoming Presidential election in November. <br /></div><br /><div style="text-align: justify;">How can this be? Why is there such a stark divide between the real economy which is struggling and is expecting a very turbulent second half of 2020, and Wall Street which is riding on a high? Is the market extremely overvalued or is it on point as it correctly factored in the initial uncertainty regarding the pandemic already in February/March and is now simply looking forward to a very fast (V-shaped) recovery?</div><br />There are three major explanations:<br /><ol style="text-align: left;"><li>The market is riding on a huge monetary and fiscal stimulus</li><li>Future expectations of a quick post-COVID recovery</li><li>Asymmetric effect between publicly-traded companies and SMEs</li></ol>Let’s examine each of these:<br /><br /><b>1) Riding the stimuli</b><br /><br /><div style="text-align: justify;">It is no coincidence that the market started rebounding just as Congress passed the $2 trillion stimulus package in March, the biggest in US history, a lot of which was oriented towards bailing out big companies like the airlines. Even more important than the fiscal stimulus was the monetary one enacted by the Fed, which decided to once again slash its federal funds rate down to <a href="https://fred.stlouisfed.org/series/FEDFUNDS">0.05% in April</a>, opening up room to a <a href="https://www.cnbc.com/2020/04/13/coronavirus-update-here-is-everything-the-fed-has-done-to-save-the-economy.html">$6 trillion injection</a> into the economy through credit and lending programs. This is much bigger than the stimuli and bailout packages administered back in 2008 and 2009.</div><br /><div style="text-align: justify;">Low interest rates allow companies to borrow money at low costs which typically fuels a stock market boom. Investors in that case do not want to buy bonds which will give them low yields, but are instead opting for stocks. Even in a situation where the future is highly uncertain an investment in equities offers a better return than an investment into bonds or currencies. And the Fed is giving a powerful signal that the rates will remain low for as long as it takes which to an average investor is a clear sign to buy equities.</div><b><br />2) Exuberant future expectations</b><br /><br /><div style="text-align: justify;">Stock markets are all about forecasts. Collective forecasts of all investors looking 6 to 12 months ahead. When it’s going up it is because investors, the majority at least, are collectively expecting the economy to bounce back quickly and adapt to the pitfalls of the pandemic (the quarantine, restricted mobility, etc.). While the initial bounce-back was entirely driven by the Fed and the federal government, the continued rise of the markets from May to August was down to optimistic forward-looking expectations: firms will successfully adapt to the pandemic, the reopening will see things return to normal rather quickly, and a vaccine will be found sooner than expected. Typical investor optimism, perfectly encapsulated by the <a href="https://money.cnn.com/data/fear-and-greed/">CNN Money's Fear & Greed Index</a> signaling that the market is currently in the green "Greed zone". </div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLgR56pG1D48UnzaZqgKPev1qvuwXWayNM1QKTfgO_mYiOMn27ziLhHv2tZf9v3ur2KRQSKdxZ_4CcgScFKwwkkRrn2dp9zxGUC8kgUNE8GH5El2hs-MmqPmTyfVYQSguuFnKc02lRGK_7/s642/Fear%2526GreedIndex_August2020.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="327" data-original-width="642" height="261" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLgR56pG1D48UnzaZqgKPev1qvuwXWayNM1QKTfgO_mYiOMn27ziLhHv2tZf9v3ur2KRQSKdxZ_4CcgScFKwwkkRrn2dp9zxGUC8kgUNE8GH5El2hs-MmqPmTyfVYQSguuFnKc02lRGK_7/w512-h261/Fear%2526GreedIndex_August2020.png" width="512" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;">The Index looks at junk bond demand, the volume spread in put and call options, momentum, volatility, etc. Source: <a href="https://money.cnn.com/data/fear-and-greed/">CNN Money</a></td></tr></tbody></table><div style="text-align: justify;"><br /></div><div style="text-align: justify;">When such expectations become prevalent among the majority of investors the markets very easily enter a frenzy and a lot of investors starts buying in, worried that they will miss out on the great opportunity. It doesn’t matter if their expectations are unrealistic, if they're buying stocks of companies that have filed for or are on the verge of bankruptcy, or if their expectations are based on miscalculations over the impeding threat of the virus and an inability to understand fat-tailed distributions of things like pandemics. As long as everyone is buying, time is ripe to enter the market. This logic has time and time again been proven wrong and has very often ended with a negative effect on investors’ finances. At least for the small investors.</div><div style="text-align: justify;"><br /></div><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbizECLT8ylBOeQjrPgBkXBDl8OhNK8rvKLcat4GKKapg5SnTVcnoPK6xFq1vMSN7cuo0NL7OmUcm2OSKN0zjutl0DHDzkfwYjFDBlm7iBlvv7gBMVPJjreQnyr2gloODSHhf7nASahQVs/s1563/WHO_August2020.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="464" data-original-width="1563" height="152" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbizECLT8ylBOeQjrPgBkXBDl8OhNK8rvKLcat4GKKapg5SnTVcnoPK6xFq1vMSN7cuo0NL7OmUcm2OSKN0zjutl0DHDzkfwYjFDBlm7iBlvv7gBMVPJjreQnyr2gloODSHhf7nASahQVs/w512-h152/WHO_August2020.png" width="512" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><span style="text-align: left;">WHO data on </span><a href="https://covid19.who.int/?gclid=CjwKCAjw5vz2BRAtEiwAbcVIL3QNU7YbrObNTwf1FAqplEubXHX2lZUvp2SMxRQHPzGU3XxyPMgz-BoCJ0EQAvD_BwE" style="text-align: left;">daily COVID-19 cases</a><span style="text-align: left;"> across 6 regions</span></td></tr></tbody></table><div style="text-align: justify;"><br /></div><b>3) The firms driving the markets vs the firms that are shutting down and laying off</b><br /><br /><div style="text-align: justify;">Which firms in the US have disproportionately represented the growth in the stock market over the past decade? Big tech companies. Five tech stocks account for 20% of the overall market value of the S&P500: Apple, Amazon, Alphabet (Google), Microsoft and Facebook, all of which, except for Facebook, have passed the $1tn valuation (and Apple passing a $2tn valuation last week). These companies that have seen a huge rebound in market value over the past few months (see graph below) as investors see them as the big winners of the pandemic where more and more things will be switching online. Even the smaller tech stocks of companies like Zoom or Netflix were reaping huge rewards from people staying at home and using more of their services.</div></div><div><br /><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivP80f3bRKAI3zo5Q56Fl7rlDZ3Zw0NZ5cGw5Vyk-aF3TwjQfYaMXqzOeLuceZRMy8zMayf8cKcxctp1Wxq0HG6-mrzBa0__YjBBh97icQRD78wPYzzj5cVbzUX36Chg-pELMI4gAaixG6/s1161/FAAMGs_August2020.png" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="648" data-original-width="1161" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivP80f3bRKAI3zo5Q56Fl7rlDZ3Zw0NZ5cGw5Vyk-aF3TwjQfYaMXqzOeLuceZRMy8zMayf8cKcxctp1Wxq0HG6-mrzBa0__YjBBh97icQRD78wPYzzj5cVbzUX36Chg-pELMI4gAaixG6/w512-h286/FAAMGs_August2020.png" width="512" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;">Comparison of stock performance of the top 5 tech companies in the S&P. Since December 2019 Amazon grew by 48%, Apple by 27%, Microsoft by 25%, Facebook by 18%, and Google by 8%. Source: <a href="https://www.barchart.com/stocks/quotes/FB/interactive-chart">barchart</a></td></tr></tbody></table><div style="text-align: center;"><br /></div></div><div><div style="text-align: justify;">Although not all tech companies have experienced an upsurge in sales, the markets are all about expectations, and expectations are that things are moving online faster than ever. This is the “new normal”. It is thus no wonder that tech companies’ stocks are benefiting from an upsurge in demand for online services.</div><br /><div style="text-align: justify;">On the other hand, companies laying people off have mostly been micro, small and medium-sized businesses who were hit hardest by the pandemic as they had to close shop during the lockdown. This is where the unemployment spike happened but since none of these companies are listed on the stock market their relative performance is not factored in. Not yet at least.</div><br /><div style="text-align: justify;">Other companies that were laying people off were airlines and the hospitality industry, but in their case the major players have been bailed out by the government while their stock prices have been moving up in recent weeks. This is a powerful sign of irrational exuberance; many of these companies have had cash flow problems even before the pandemic, and are now piling up a lot of debt which should hurt their future prospects and send their prices down, not up. Airlines are in for a very rough couple of years. It should be the last thing on an investor’s list to buy right now.</div></div><div><br /><b>Is the market right and what happens next?</b><br /><br /><div style="text-align: justify;">The forward-looking expectations on the stock markets right now which are driving indices up are disregarding several factors that are contributing to a bleak outlook of the economy.</div></div><div><p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;">First, <b>aggregate demand is very likely to keep stagnating or decreasing</b>. The effects of the pandemic are going to be felt in months, even years to come. Many companies that survived the initial blow might not do so in the coming months which will further decrease confidence and depress demand. <b>People are changing their spending behavior</b> and are postponing all major nonessential purchases. High-income individuals are lowering their mobility (less travel, working from home) and are hence spending less (see first figure above, upper panel), while lower-income individuals are afraid of losing their jobs which is increasing their uncertainty and reducing their aggregate spending.<o:p></o:p></span></p><p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;">It is a matter of time before this depressed demand spreads through the economy and by then it will impact even the tech stocks’ performance (although certainly to a much lesser extent than other industries).<o:p></o:p></span></p><p class="MsoNormal" style="text-align: justify;"><span lang="" style="background: white; mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin; mso-color-alt: windowtext;">All the <b>major macro fundamentals are pointing to a bleak outlook.</b> The second quarter US GDP is <a href="https://www.bea.gov/news/2020/gross-domestic-product-2nd-quarter-2020-advance-estimate-and-annual-update">down 32.9%</a>. The Atlanta Fed, </span><span style="background-color: white;">which uses real-time GDP estimates based on available data, is however estimating a <a href="https://www.frbatlanta.org/cqer/research/gdpnow">25.6% rebound in Q3</a> (August 17th estimate</span>), which is still not high enough to offset the negative growth in Q2 and Q1.<span><span style="background-color: white;"> For Q2 their estimate was a negative 34.7%, so very close to the actual numbers. This suggests that firms will keep suffering </span></span><span style="background-color: white;">with bankruptcies increasing, meaning that upon finally realizing the extent of the shock</span><span style="background-color: white;"> </span><b>the market could be in for a sobering autumn/winter season</b><span style="background-color: white;">.</span></p><p class="MsoNormal" style="text-align: justify;"><span lang="" style="background: white; mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin; mso-color-alt: windowtext;">Comparing the trend of this recovery to trends of previous recoveries is pointless. This was not a typical economic crisis and the reaction of the economy to the pandemic was completely asymmetric. During the previous 2008-2009 recession the contagion spread from the financial sector into the real economy. Today the reverse is highly likely, particularly with respect to the corporate debt market.<span style="mso-spacerun: yes;"> </span>Furthermore, no simple approximation of previous trends can tell us anything about where the markets might end up by the end of 2020. It is therefore crucial to <b>keep listening at the social sentiment of people</b> <b>and tracking the fundamentals of companies</b> – such as their cash flow and exposure to debt – in order to make an accurate market valuation.</span></p><p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;">Second, <b>the government’s stimulus will run out</b> as it will soon have to start worrying about rising debts and deficits. During the heyday of the pandemic the measures have been implemented with a clear indication that we will deal with debts and deficits later, once the economy is saved. This “later” is coming sooner than expected and is seriously undermining all expectations of a V-shaped recovery. During the previous crisis the aftermath of rising debts almost destroyed the euro as several European economies were on the brink of bankruptcy. Most of them still haven’t recovered from that sovereign debt crisis and will soon be engulfed in another one. This unfortunately signals more uncertainty and instability and calls for further monetary easing on both sides of the Atlantic, further fueling the monetary bubble.<o:p></o:p></span></p><p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;">Third, <b>the virus is still spreading globally</b> as it is hitting South America, Africa and South East Asia, and is on record highs in the United States. It is obviously impossible to predict whether there will indeed be a large second wave but not many companies are prepared in case it does happen. In other words, we are collectively still exposed to another big shock and do not have any hedging instrument or insurance policy as protection. We cannot know for sure whether it will happen but we can take measures to benefit from the shock. Hardly anyone is doing this.<o:p></o:p></span></p><p class="MsoNormal" style="text-align: justify;"><b>How should investors position themselves in light of these trends?</b> A good hedging strategy is crucial. Set aside a fraction of your portfolio into put options on the S&P (or selected stocks that are likely to be hurt the most in case of another crash - look for over-leveraged companies with cash flow problems caused by the pandemic). A put option delivers a limited loss if the implosion never happens (the put simply expires and you lose the amount you paid for the option). But if it does happen the put is activated and the investor gains a convex payoff benefiting from the market decline.</p><p class="MsoNormal" style="text-align: justify;"><span lang="" style="mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-theme-font: minor-latin;">Taking all this into account we can cautiously claim that the market is not right. It is being driven by exuberance which will end soon. No one can predict when this will happen which is why it is a good idea to already start building a strategy of how to benefit from another potential downturn. Even if it never happens.</span></p><div style="text-align: justify;">Finally, I'll leave you with a quote attributed to Keynes: <i>"The market can remain irrational longer than you can remain solvent."</i></div></div><div><br /></div><div><div><i>The first version of this article was published on <a href="https://seekingalpha.com/article/4370736-riding-high-3-reasons-why-market-is-hitting-new-records-in-recession">Seeking Alpha</a>. This is the updated version. </i></div></div>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-79962195778464595482020-08-28T08:55:00.001+01:002020-08-28T09:11:35.713+01:00Welcome to The Political Economist<div style="text-align: justify;">
It's been almost three years since I last wrote anything on my once very active blog. I stopped producing regular content by mid 2014, dropped down to 2 posts per month in 2015 (down from over 10 posts p/m in the years before that) and even though I picked it up again in 2016 with my series of <a href="http://im-an-economist.blogspot.com/search/label/Book%20review">book reviews</a>, by 2017 the blog was basically dead. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Reasons? I have two kids now, I've finished a PhD at Oxford, and I'm running a <a href="http://www.oraclum.co.uk/">company that I co-founded</a>. So yeah, bit busy. I've still been writing. In fact, now more than ever (papers are getting published, the PhD is finished, working on a book project, business stuff, etc.), but I never really motivated myself enough to go back to the blog.</div>
<br />
<div style="text-align: justify;">
Until now, that is. Time has come to revive it! </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Motivation?</b> The crisis, of course. The COVID-induced economic downturn. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The "Don't Worry" blog started after the previous crisis. I was very invested in tracking the consequences of the 2008/09 financial crisis as well as the Eurozone sovereign debt crisis, the subsequent recoveries and in particular the policy responses (stimulus, austerity, etc.). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The same is happening again, only with very interesting consequences. Economies are in turmoil, demand is limited, and the massive monetary and fiscal stimulus will have to be dealt with in the years to come which will surely further cripple demand. On the other hand, as people change their behavior as a response to the pandemic their habits have changed, the workplace environment has changed, the travel & tourism industry are struggling, while tech companies are booming as everything is being shifted online. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">It is therefore a mixture of fortunes for now. Before the banking system potentially enters its own crisis under the pressure of bad loans from bankrupting companies. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Which is why I wanna follow this crisis head on.</b> Track all the interesting indicators from investors, consumers, businesses, governments. And deliver it all to you, my dear reader. </div><div style="text-align: justify;"><br /></div><span><a name='more'></a></span><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Naturally, as with every great comeback, the blog is now under new design, and will deliver exciting new content. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Which new content?</b> Initially the focus will be almost exclusively on the crisis. Tracking the recovery, tracking the key market movements and indicators, explaining the changes in customer behavior and demand (we're actually doing this professionally in my company Oraclum with our <a href="https://www.oraclum.co.uk/frix/" target="_blank">Fear Index</a>), tracking government response strategies, etc. The recovery tracking is already available in Oraclum's <a href="https://medium.com/@Oraclum_UK">Medium blog</a>, many of which will be "reprinted" here as well. Also expect an increasing batch of topics in finance, business, and technology, the general trends of which will be fascinating to follow in the post-COVID world. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Obviously I will continue to deliver many political economy topics as well, particularly those related to my ongoing academic work: corruption, lobbying and interest groups, elite networks (my book project), inequality, economic history and institutions, etc. Also, every now and then I might post comments on novel scientific methods in the field, or dive into some statistics and probability theory. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">But in general, expect a mixture of tracking markets and pressing political econ issues based on my academic work. Business and academia. Finance and philosophy. Sort of...</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Why the name change? </b>It fits my professional interests a bit better. "Don't Worry, I'm an Economist" was back when my focus was much more on macro and economic policies. Ever since the Sovereign debt crisis it has started shifting primarily to political economics (as has <a href="https://www.vukvukovic.org/research.html" target="_blank">my academic work</a>), but also to finance, business, and technology, as some readers have already noticed. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The Political Economist is thus a better fit given my PhD, and given everything that I plan to publish in the field. Tracking the crisis is an added bonus (and obviously the main motivation for the restart). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Thank you for reading and I hope you (still) enjoy it! </div>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-78002104816538634552017-11-22T10:08:00.004+00:002017-11-22T10:12:13.786+00:00Making causal inferences in economics: Do better grades lead to higher salaries?<div class="separator" style="clear: both; text-align: center;">
</div>
<div style="margin-left: 1em; margin-right: 1em;">
</div>
<div style="text-align: justify;">
In a <a href="http://im-an-economist.blogspot.hr/2017/09/is-economics-getting-better-yes-it-is.html">previous post</a> I discussed the changing nature of the economics profession and the importance of achieving the experimental ideal in social science research. I briefly discussed the logic and even some methodological approaches that are useful in achieving randomization, or at least as-if randomization in order to make our treatment and control groups as similar as possible for comparison. In this post I'll use an example that I like to teach to students to illustrate how we can make causal inferences using natural experiment research designs. A quick reminder: natural experiments are not experiments per se. They only provide us a good way to exploit observational data to emulate an experimental setting. </div>
<br />
<div style="text-align: justify;">
Let's use the very basic example and look at the <b>relationship between student grades and earnings</b> – a topic is usually heatedly discussed among students – do better grades result in higher salaries?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Consider the following correlation between grades and earnings shown on the figure below. It uses US data for wages of men and women by high school grade point average (GPA). The higher the GPA the larger the average salary for both men and women, however with a huge wage gap between them in each case (notice how an average woman with a maximum 4.0 GPA in high school still earns less than an average man with a 2.5 GPA - shocking!). The overall pattern is clear. It is very suggestive that higher grades cause higher salaries. But do they really? Or is there some other factor that might affect both grades in high school <i>and</i> salaries later in life? For example ability. More competent individuals tend to get better grades, and they tend to have higher salaries. It wasn't the grades in high school that caused their salaries to be higher, it was their intrinsic ability. This is what we call an omitted variable bias - an issue that arises when you try to explain cause and effect without taking into consideration all the potential factors that could have affected the outcome (mostly because they were unobservable). </div>
<div style="text-align: justify;">
<br /></div>
<div class="MsoNormal">
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: justify;"><tbody>
<tr><td style="text-align: center;"><a href="https://img.washingtonpost.com/blogs/wonkblog/files/2014/05/earnings-gpa.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="311" src="https://img.washingtonpost.com/blogs/wonkblog/files/2014/05/earnings-gpa.jpg" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: <a href="https://www.washingtonpost.com/news/wonk/wp/2014/05/20/heres-how-much-your-high-school-grades-predict-how-much-you-make-today/?utm_term=.6ce5e3252ff5">Washington Post</a></td></tr>
</tbody></table>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">The best way to determine whether there is in fact a causal relationship between the two would be to run the following <b>hypothetical experiment</b> (assuming we posses divine powers). I take a group of students and given them a distinction grade, and then I repeat history and give the same group a non-distinction grade (a sort of parallel universe). In each case we observe the final outcome with two paths of history and we compare the difference in salaries between the first scenario and the second one. What we just did is we constructed a <i><b>counterfactual</b></i> – what would the outcome be if history played out differently. What would be the outcome if Neo took the blue pill instead of the red one (Matrix reference)? What would my salary be if I did not go to college? Would the US attack Iraq if Gore won the 2000 election? We cannot really answer any of these questions.<o:p></o:p></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">However, we <i>can</i> answer the question of will I get a higher salary if I have better grades. Even if we never have the same student with a high grade and a low grade.<o:p></o:p></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">What would be a better, realistic and metaphysically possible way to examine this relationship? We can take comparable students. Twins, if we’re lucky. Genetically identical individuals, with the same upbringing, same income, etc. We give one a distinction grade and the other one a non-distinction, and see how they end up in life. Even though this would satisfy our experimental evaluation problem, there is a clear ethical problem here as we cannot interfere with people's lives just for the sake of proving a point. </span></div>
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">What’s next? </span>We can use the existing data on school performance and the later salaries of its students. Remember, in order to make a good inference we need to have comparable groups of students. So students that are very similar to one another in their ability, except that one group got a distinction, and the other just barely did not.</div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">We can do this in two ways. One would be to simply match the students into comparable groups based on all of their pre-observed characteristics: gender, parental income, parental education, previous school performance, whatever we can think of and measure. This is called a <b>matching strategy</b> and it requires us to be able to measure all the characteristics that could affect student performance later in life. The only difference between our two groups will be their grades. If we do that successfully we can compare the outcome in two very similar and thus comparable groups, and see if better grades resulted in higher salaries.<o:p></o:p></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">However there is again the problem of measuring something like innate ability. If you cannot measure it then even the results from a perfect matching exercise could still be biased.<o:p></o:p></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">In order to rid ourselves of any unobservable variable that can mess up our estimates we need to <b>impose randomization to our two groups</b> – ensure that there is random assignment into treated and control units. Why? Because <b>randomization implies statistical independence</b>. In other words when we randomly pick who will be in the treatment and who will be in the control group, we make sure that the people in each group are statistically indistinguishable one from another. Any difference in outcomes between the two groups should be a result of the treatment (in this case better grades). <o:p></o:p></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">But what if we cannot randomly assign students? In that case we use a neat trick to make sure that we get an (<b>as-if/as good as</b>) randomized sample. We <b>utilize the threshold of getting a distinction grade</b> (you need 70 to get a distinction in the UK) and we compare students just above and just below this threshold. If you get 70 you get a first in your degree. If you get just marginally below, 69, you get a second. The idea is that students in this very small margin, say between 68 and 72 are not really all that different one from another. In other words, they are perfectly interchangeable – a person scoring 69 is just as good as someone getting a 70, but he or she was just unlucky.<o:p></o:p></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">So how do we get to our conclusion? Consider the following artificially created picture. We observe only a narrow group of students around the threshold, in particular between the grades 69 and 71. We assume that all students within this group are comparable based on their inner ability so that we can control for all those unobservables we cannot measure. Then we compare the average earnings for those just above the 70 threshold (the <b>treatment group</b>, everyone from 70 to 71) to those just below the threshold (<b>control group</b>, everyone who got 69). If there is a large enough jump, </span>a <b>discontinuous jump over the 70 threshold</b> where those awarded a distinction have statistically significant higher earnings than those who just barely failed to make it to the distinction grade, then we can conclude that better grades cause higher salaries. If not, if there is no jump and the relationship remains linear, then we cannot make this inference.<br />
<div style="text-align: justify;">
</div>
</div>
<div style="text-align: justify;">
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWzeoizzI0ChKwFQg37B2YtDAhelf-3uDlkTQ-rDxot7b23bQ7F4saTrzS67SnFSeOpoX_iVbQsJcqrE98xYlswFw92LyzW6L1AGKQRAGmpzjWt_3OeIWTnpFZuwrexRz75i6MN0gN4Y8J/s1600/RD_plot.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="723" data-original-width="839" height="344" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWzeoizzI0ChKwFQg37B2YtDAhelf-3uDlkTQ-rDxot7b23bQ7F4saTrzS67SnFSeOpoX_iVbQsJcqrE98xYlswFw92LyzW6L1AGKQRAGmpzjWt_3OeIWTnpFZuwrexRz75i6MN0gN4Y8J/s400/RD_plot.png" width="400" /></a></div>
<br /></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
This graph does not show the real relationship between grades and earnings. I generated it artificially to prove a point. When such a discontinuity does exist between the control and the treatment group we can conclude that there is a causal effect of grades on earnings because we are comparing statistically similar individuals within a very narrow interval around the threshold. In this made-up example a person that gets a distinction would have about 30% higher earnings than a person that just barely failed to get a distinction.<br />
<br /></div>
</div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">However the actual data shows no such jump. The relationship really is linear (as suggested by the first graph). </span>How do we interpret this? We simply say that the same things that make students perform well in school (like ability) make them get higher salaries later in life. There is therefore no implicit and causal impact of grades on higher earnings, but it is suggestive that the same thing that's driving you to perform well in school will be driving you to perform well later in life. Encouraging, isn't it?<br />
<br />
Finally, the point of this exercise was not to infer causality between grades and earnings, but to emphasize how one should think about conducting natural experiments in social sciences. To think about issues in this way does not require too much technical skills nor a particularly profound methodological breakthrough. It simply requires a change in the paradigm of drawing explicit conclusions from correlations and trends, something that economists in particular love to do. </div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-68223140548742320642017-10-09T22:32:00.004+01:002017-10-09T22:32:58.961+01:002017 Nobel prize in Economics goes to Richard Thaler<div style="text-align: justify;">
A well-deserved <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2017/thaler-facts.html">Nobel prize</a> for a <a href="https://www.chicagobooth.edu/faculty/directory/t/richard-h-thaler">man</a> that helped establish a new field of <a href="https://www.behavioraleconomics.com/">behavioral economics</a>, disrupted the academic milieu in the rigid field of finance, and successfully started implementing his ideas as actual policies in a number of countries (most famously through the Nudge Unit in the UK - officially <a href="http://www.behaviouralinsights.co.uk/">Behavioural Insights Team</a> - set up under Cameron's administration, and the <a href="https://sbst.gov/">White House Social and Behavioral Science Team</a>, set up under Obama's administration). It wouldn't be exaggerating to say that Thaler's scientific contributions were among the most applicable of all Nobel prize winning contributions in economics thus far (even more than <a href="http://im-an-economist.blogspot.hr/2012/10/nobel-prize-in-economics-to-alvin-roth.html">Roth's</a> kidney markets, <a href="http://im-an-economist.blogspot.hr/2013/10/fama-hansen-and-shiller-winners-of-2013.html">Fama's EHM and Shiller's</a> Irrational Exhuberance, or <a href="http://im-an-economist.blogspot.hr/2015/10/angus-deaton-wins-2015-nobel-prize-in.html">Deaton's</a> measurements of poverty and inequality, to name just a few most recent notable laureates). </div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhfas6oT9yOYpTWNhyphenhyphenBl7mWBU2OxyH__NRl6gD1hBK3pFtvBCWToWQkX56DhCOb3eCCzUhyy4F-Mx1YPi78GeZP_Ch6IHi4XzCqfLJqG3Z3XxU2wm6RYK5_sH_SAgUpFbjOkITeIhyphenhyphenWyTJd/s1600/Thaler.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="960" data-original-width="960" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhfas6oT9yOYpTWNhyphenhyphenBl7mWBU2OxyH__NRl6gD1hBK3pFtvBCWToWQkX56DhCOb3eCCzUhyy4F-Mx1YPi78GeZP_Ch6IHi4XzCqfLJqG3Z3XxU2wm6RYK5_sH_SAgUpFbjOkITeIhyphenhyphenWyTJd/s320/Thaler.jpg" width="320" /></a></div>
<div>
<br /></div>
<div>
<div style="text-align: justify;">
It's been 15 years since behavioral economics has been recognized for the first time by the Nobel Committee, awarding it to <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2002/">Daniel Kahneman</a> (together with Vernon Smith for advances in experimental economics). After Kahneman and Tversky, psychologists who founded the field, Thaler is definitely its most notable contributor, having performed many experiments and having seen his recommendations become actual policy prescriptions designated at making the system a bit more efficient (or as he would put it, more suitable for imperfect Humans, rather than perfect Econs). And precisely because Humans are imperfect, because they lack self-control, because they suffer from asymmetric information, because they tend to rely on System 1 (quick thinking) rather than System 2 (analytical thinking), even when making important life decisions that would benefit from some deeper thinking, they should be "nudged" in the right direction that helps them make the optimal choice, rather than an inefficient (irrational) one. By exploiting our inertia and our propensity to fall victims to availability heuristics, hindsight bias, anchoring, illusions of validity, and a whole range of other biases, we should think about mechanism design and how to present choices to people. </div>
</div>
<br /><div style="text-align: justify;">
For example, the decision to become an organ donor after an accident. Making this the default option significantly increases the amount of people who agree to become donors. Asking the people to tick a box in order to become a donor is not the same as asking them to tick a box to remove them from the potential donor list. The same thing is with savings (for retirement) decisions - having the default option a given savings rate (say 6%) which can be changed and abandoned if anyone wants is not the same as asking the people to choose their own savings plan. In the first case someone (the employer) has made the choice for you, which you are free to alter, while in the second you have to choose for yourself from scratch, which results in the fact that most people simply choose not to. For example, the opt-in scheme (where you have to tick a box to enroll) has savings participation rates around 60%, whereas the identical opt-out (where you have to tick a box to withdraw) has participation rates between 90 and 95%. A huge and important difference.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
From the words of the <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2017/">Nobel Committee</a>: </div>
<blockquote class="tr_bq">
<div style="text-align: justify;">
<i>"Richard H. Thaler has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes."</i></div>
<div style="text-align: justify;">
<i><br /></i></div>
<div style="text-align: justify;">
<i><b>Limited rationality</b>: Thaler developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual decision rather than its overall effect. He also showed how aversion to losses can explain why people value the same item more highly when they own it than when they don't, a phenomenon called the endowment effect. Thaler was one of the founders of the field of behavioural finance, which studies how cognitive limitations influence financial markets. </i></div>
</blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<i><b>Social preferences</b>: Thaler's theoretical and experimental research on fairness has been influential. He showed how consumers' fairness concerns may stop firms from raising prices in periods of high demand, but not in times of rising costs. Thaler and his colleagues devised the dictator game, an experimental tool that has been used in numerous studies to measure attitudes to fairness in different groups of people around the world. </i></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<i><b>Lack of self-control</b>: Thaler has also shed new light on the old observation that New Year's resolutions can be hard to keep. He showed how to analyse self-control problems using a planner-doer model, which is similar to the frameworks psychologists and neuroscientists now use to describe the internal tension between long-term planning and short-term doing. Succumbing to shortterm temptation is an important reason why our plans to save for old age, or make healthier lifestyle choices, often fail. In his applied work, Thaler demonstrated how nudging – a term he coined – may help people exercise better self-control when saving for a pension, as well in other contexts." </i></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<i>In total, Richard Thaler's contributions have built a bridge between the economic and psychological analyses of individual decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioural economics, which has had a profound impact on many areas of economic research and policy.</i></blockquote>
<div style="text-align: justify;">
Read a layman-friendly description of his work <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2017/popular-economicsciences2017.pdf">here</a>, and a more technical description <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2017/advanced-economicsciences2017.pdf">here</a>. </div>
<div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I covered Thaler's work on <a href="http://im-an-economist.blogspot.hr/2016/03/behavioral-economics-or-what-ive-been.html">this blog</a> before. I wrote a review of two of his most popular books, "<i><a href="https://www.amazon.com/Nudge-Improving-Decisions-Health-Happiness/dp/014311526X">Nudge</a></i>" (co-written with Cass Sunstein), a book about how to apply the main findings of behavioral econ to economic policies (introducing the concept of liberatrian paternalism - giving people a choice, but still nudging them in the right direction), and "<i><a href="https://www.amazon.co.uk/Misbehaving-Behavioural-Economics-Richard-Thaler/dp/1846144035">Misbehaving</a></i>", his autobiographical portrayal of how the field of behavioral economics came to exist. I absolutely recommend both books to any avid reader, particularly those with a keen interest in this fascinating field, and in general to anyone interested in how the bounded human rationality affects a lot of economic outcomes, both individual and collective. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I'll finish by repeating what I said about behavioral econ when I wrote those reviews:</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
"...the success of the field, from its infancy during the long working hours in Stanford in early 1970s, to its profound impact on policy in the current decade, is impressive, to say the least. I don't recall any scientific field developing so quickly in terms of having an immediate impact on "the real world". And particularly a field that went against the dominant assumptions of its science at the time (the Samuelson mathematical economics revolution of the 50s, the origination of the efficient market hypothesis in the 60s, and the emergence of new classical macroeconomics in the 70s and the 80s, to mention only a few obstacles). To withheld such powerful opposition means that behavioral econ really is that good. All it takes for it now is to penetrate the principles of economics textbooks (a bold endeavor), and to finally improve decision-making in macroeconomics (something that Thaler predicts/hopes to be the next step). This will be its most difficult task. Unlike health or education economics, or savings and taxation, or finance for that matter, fiscal and monetary policy are difficult to test, and, as Thaler correctly pointed out, its theories/hypotheses are difficult to falsify (in many cases since they appear too vague, plus there's not enough data to begin with). If behavioral economics does to macro what it did to finance, it will be its ultimate triumph."</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Start reading behavioral econ books and papers (there's a few suggestions at the <a href="http://im-an-economist.blogspot.hr/2016/03/behavioral-economics-or-what-ive-been.html">end of this text</a>). It will be worth it. </div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-57562322284953420382017-09-07T23:28:00.003+01:002017-09-07T23:40:48.012+01:00Is economics getting better? Yes. It is. <div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-US">I attended two great conferences last week. The first one was an <a href="http://exelconference.eu/">econ conference</a> I co-organized </span><span lang="EN-US">with my </span>friends and colleagues <a href="https://sites.google.com/site/dejankovacecon/">Dr Dejan Kovac</a> and <a href="http://www.phy.pmf.unizg.hr/~bp/">Dr Boris Podobnik</a><span lang="EN-US">, which featured </span>three world-class economists from Princeton and MIT: professors <a href="https://economics.mit.edu/faculty/angrist">Josh Angrist</a>, <a href="https://krueger.princeton.edu/">Alan Krueger</a>, and <a href="http://irs.princeton.edu/people/henry-farber">Henry Farber</a>. The second was the annual <a href="http://web.apsanet.org/apsa2017/">American Political Science Association conference</a> in San Francisco. I am full of good impressions from both conferences, but instead of talking about my experiences I will devote this post to one thing in particular that caught my attention over the past week. A common denominator, so to speak. Listening to participants present their excellent research in a wide range of fields, from economics to network theory (in the first conference), from political economy to international relations (in the second), I noticed an exciting trend of increasing usage of scientific methods in the social sciences. Methods like randomized control trials or natural experiments are slowly becoming the standard to emulate. I feel we are at the beginning of embracing the <i>science</i> into social science. </div>
<br />
<div style="text-align: justify;">
The emergence of the scientific method in the social sciences is not a new thing. I've been aware of it for quite some time now (ever since my Masters at LSE to be exact). However I am happy to see that many social scientists are now realizing the importance of making causal inference in their research. Especially among the young generation. It is becoming the standard. The new normal. Seldom can a paper get published in a top journal without conditioning on some kind of randomization in its research. This is not to say there aren't problems. Many young researchers still tend to overestimate the actual randomization in their research design, but the mere fact that they are thinking in this direction is a breakthrough. <b>Economics has entered its own causal inference revolution</b>. </div>
<br />
<div style="text-align: justify;">
It will take time before the social sciences fully embrace this revolution. We have to accept that some areas of economic research will never be able to make any causal claims. For example, a lot of research in macroeconomics is unfortunate to suffer from this problem, even though there is progress there as well. Also, the social sciences will never be as precise as physics or as useful as engineering. But in my opinion these are the wrong targets. Our goal should simply be to replicate the methods used in psychology, or even better - medicine. I feel that the economics profession is at the same stage today where medicine was about a hundred years ago, or psychology some fifty years ago. You still have a bunch of quacks using leeches and electric shocks, but more and more people are accepting the new causal inference standard in social sciences. </div>
</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b>The experimental ideal in social sciences</b></div>
<div class="MsoNormal">
<br />
<div style="text-align: justify;">
How does one make causal inferences in economics? Imagine that we have to evaluate whether or not a given policy works. In other words we want to see whether action A will <i>cause</i> outcome B. I've already written about <a href="http://im-an-economist.blogspot.hr/2014/02/graph-of-week-vine-consumption-and.html">mistaking correlation for causality</a> before. The danger is in the classical cognitive illusion: we see action A preceding outcome B and we immediately tend to conclude that action A caused outcome B (when explaining this to students I use the classic examples of <a href="https://futurism.com/correlation-vs-causation-2/">internet explorer usage and US murder rates</a>, average temperatures and pirates, vaccines and autism, <a href="http://im-an-economist.blogspot.hr/2014/05/graph-of-week-correlation-doesnt-imply.html">money and sports performance</a>, or wine consumption and student performance). However there could be a whole number of <i>unobserved</i> factors that could have caused both action A and outcome B. Translating this into the field, when we use simple OLS regressions of A on B we are basically only proving correlations, and cannot say anything about the causal effect of A on B.</div>
<br /></div>
<div class="MsoNormal">
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">In order to rid ourselves of any unobservable variable that can mess up our estimates we need to <b>impose randomization </b>in our sample. We need to </span>ensure there is random assignment into treated and control units, where treated units represent the group that gets or does action A, while the control unit is a (statistically) identical group that does not get or do action A. And then we observe differences in outcomes. If outcomes significantly differ across the treatment and control groups, then we can say that action A causes outcome B. Take the example from medicine. You are giving a drug (i.e. treatment) to one group, the treatment group, and you are giving the placebo to the control group. Then you observe their health outcomes to figure out whether the drug worked. The same can be done in economics. </div>
<br />
<div style="text-align: justify;">
It is very important to have the observed units randomly assigned. Why? Because randomization implies statistical independence. When we randomly pick who will be in the treatment and who will be in the control group, we make sure that the people in each group are statistically indistinguishable one from another. The greater the number of participants, the better. Any difference in outcomes between the two similar groups should be a result of the treatment itself, nothing more and nothing less.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Positive trends</b></div>
</div>
<div>
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">Social sciences now possess the tools to do precisely these kinds of experimental tests. On one hand you can run actual randomized control trials (i.e. <b>field experiments</b>) where you actually assign a policy to one group of people and not to the next (e.g. health insurance coverage) and then observe how people react to it, and how it affects their outcomes (whatever we want to observe, their health, their income, etc.). A similar experiment is being conducted to examine the effectiveness of basic income to lower unemployment and inequality. There are plenty other examples. </span></div>
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;"><br /></span></div>
<div style="text-align: justify;">
<span lang="EN-GB" style="line-height: 18.4px;">In addition to field experiments, we can do <b>natural experiments</b>. You do this when you're not running the experiment yourself, but when you have good data that allows you to </span>exploit some kind of random assignment of participants into treatment and control units (in the next post I'll describe the basic idea behind regression discontinuity design and how it can be used to answer the question of whether grades cause higher salaries). Whatever method you use, you need to justify why the assignment into treatment and control units was random, or at least <i>as-if random</i> (more on that next time). </div>
<br />
<div style="text-align: justify;">
As I said in the intro, this is becoming the new standard. Long gone is the time where you can do theory and when empirical work was limited to kitchen-sink regressions (throw in as many variables as you can). Have a look at the following figure from <a href="https://www.bloomberg.com/view/articles/2017-07-14/so-many-critics-of-economics-miss-what-it-gets-right">Bloomberg</a> (data taken from a recent <a href="https://www.aeaweb.org/articles?id=10.1257/jel.51.1.162">JEL paper</a> by Daniel Hamermesh): </div>
</div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEgMq6Fkz3AoZHZrcGbmKheLquACluQBQsJacKdexbO4ythP4PegoNCyftC9Gp5MWosWdPDSUy8SHp59BRTuwmbeHxduZuDAydkQ0tNd1vKQatNvsELNMLhRTlHwAOAFZ46xr7WQutDDm-/s1600/Economic_research.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="437" data-original-width="557" height="313" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEgMq6Fkz3AoZHZrcGbmKheLquACluQBQsJacKdexbO4ythP4PegoNCyftC9Gp5MWosWdPDSUy8SHp59BRTuwmbeHxduZuDAydkQ0tNd1vKQatNvsELNMLhRTlHwAOAFZ46xr7WQutDDm-/s400/Economic_research.png" width="400" /></a></div>
<br />
<div style="text-align: justify;">
The trend is clear. There is a rapid decline of papers doing pure theory (from 57% at its 1980s peak, to 19% today), a huge increase in empirical papers using their own data (from 2.4% to 34% today), and an even bigger increase of papers doing experiments (from 0.8% to 8.2%). This positive trend will only pick up over time. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Here's another graph from <a href="http://www.economist.com/news/finance-and-economics/21710800-big-data-have-led-latest-craze-economic-research-economists-are-prone">the Economist</a> that paints a similar picture. This one disentangles the empirical part in greater detail. There is a big jump in the usage of quasi-experimental methods (or natural experiments) such as regression discontinuity and difference-in-difference methods ever since the late 90s. The attractiveness and usefulness of DSGE models has also seen a jump in DSGE papers in the same period, but this trend has slightly declined in the recent decade. Even more encouraging, since the 2000s randomized control trials have picked up, and in the last few years there has even been a jump in big data and machine learning papers in the field of economics. That alone is fascinating enough. </div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjWwkC-fUWI-qmPGB5jvfX_WBtciEWdtZtRDZUS63Q4EZuv4dJ5822NplMtc4WSlNB3HJ6BbeKOxC0QDJrisLzLng7hmafCzEhAo02QjTm9VzFsNPATp6RKn-Zl01Z305vjjg5txGrlIH2O/s1600/Methods+in+economics.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="207" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjWwkC-fUWI-qmPGB5jvfX_WBtciEWdtZtRDZUS63Q4EZuv4dJ5822NplMtc4WSlNB3HJ6BbeKOxC0QDJrisLzLng7hmafCzEhAo02QjTm9VzFsNPATp6RKn-Zl01Z305vjjg5txGrlIH2O/s400/Methods+in+economics.png" width="400" /></a></div>
<div class="separator" style="clear: both; text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
There are still problems however. The critics of such approaches begin to worry about the trickling down of the type of questions economists are starting to ask. Instead of the big macro issues such as 'what causes crises', we are focusing on a narrow policy within a subset of the population. There have been debates questioning the external validity of every single randomized control trial, which is a legitimate concern. If a given policy worked on one group of people in one area at one point in time, why would we expect it to work in an institutionally, historically or culturally completely different environment? Natural experiments are criticized in the same way, even when randomization is fully justified. Furthermore, due to an ever-increasing pressure to publish many young academics tend to overemphasize the importance of their findings or tend to overestimate their causal inference. There are still a lot of caveats that need to be held in mind while reading even the best randomized trials or natural experiments. This doesn't mean I wish to undermine anyone's efforts, far from it. Every single one of these "new methods" papers is a huge improvement over the multivariate regressions of the old, and a breath of fresh air from the mostly useless theoretical papers enslaved by their own rigid assumptions. Learning how to think like a real scientist is itself a steep learning curve. It will take time for all of us to design even better experiments and even better identification strategies to get us to the level of modern medicine or psychology. But we're getting there, that's for sure! </div>
<br />
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<div style="text-align: justify;">
P.S. <b>For those who want more</b>. Coincidentally the two keynotes we had at our conference, <a href="https://web.stanford.edu/group/scspi/_media/pdf/Reference%20Media/Angrist_Krueger_1999_Measurment%20and%20Methodology.pdf">Angrist and Krueger</a>, wrote a great book chapter back in 1999 talking about all the available empirical strategies in labour economics. They set the standards for the profession by emphasizing the importance of identification strategies for causal relationships. I encourage you to <a href="https://web.stanford.edu/group/scspi/_media/pdf/Reference%20Media/Angrist_Krueger_1999_Measurment%20and%20Methodology.pdf">read their chapter</a>. It's long but it's very good. Also, you can find this handout from <a href="http://web.mit.edu/14.771/www/emp_handout.pdf">Esther Duflo</a> particularly helpful. She teaches methods at Harvard and MIT, and she is one of the heroes of the causal inference revolution (<a href="https://economics.mit.edu/files/800">here</a> is another one of her handouts on how to do field experiments; see all of her work <a href="https://economics.mit.edu/faculty/eduflo">here</a>). Finally, if you really want to dig deep in the subject there is no better textbook on the market than Angrist and Pischke's <a href="http://press.princeton.edu/titles/8769.html">Mostly Harmless Econometrics</a>. Except maybe their newer and less technical book, <a href="http://press.princeton.edu/titles/10363.html">Mastering Metrics</a>. As a layman, I would start with Metrics, and then move to Mostly Harmless. Also to recommend (these are the last ones), Thad Dunning's <a href="http://www.cambridge.org/gb/academic/subjects/social-science-research-methods/qualitative-methods/natural-experiments-social-sciences-design-based-approach">Natural Experiments in the Social Sciences</a>, and Gerber and Green's <a href="http://books.wwnorton.com/books/webad.aspx?id=24003">Field Experiments</a>. A bit more technical, but great for graduate students and beyond.</div>
<div style="text-align: justify;">
P.P.S. This might come as a complete surprise given the topic of this post, but I will be teaching causal inference to PhD students next semester at Oxford. Drop by if you're around.</div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com1tag:blogger.com,1999:blog-3448927642739850334.post-28980346538740137472017-02-23T12:59:00.000+00:002017-02-23T13:00:20.663+00:00Vote buying with intergovernmental grants (my paper published in Public Choice)<div style="text-align: justify;">
When I started working in the academia a few years back, my friend and co-author Josip Glaurdić asked me which journal would I like to be published in the most? Without hesitation I said: <a href="http://link.springer.com/journal/11127">Public Choice</a>! </div>
<br />
<div style="text-align: justify;">
Well, that goal has now been accomplished. I have a publication in one of my all time favorite political economy journals! You can <a href="http://link.springer.com/article/10.1007%2Fs11127-017-0435-y">read the paper on this link</a>, it's been published online first. Next big goal: Quarterly Journal of Economics (I will also accept American Economic Review, Journal of Political Economy or American Political Science Review). </div>
<div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<a href="http://link.springer.com/article/10.1007%2Fs11127-017-0435-y">Our paper</a> is on the political bias in the allocation of intergovernmental grants in Croatia. Here's the abstract: </div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>"Instead of alleviating fiscal inequalities, intergovernmental grants are often used to fulfill the grantors’ political goals. This study uses a unique panel dataset on more than 500 Croatian municipalities over a 12-year period to uncover the extent to which grant distribution is biased owing to grantors’ electoral concerns. Instead of the default fixed effects approach to modelling panel data, we apply a novel within-between specification aimed at uncovering the contextual source of variation, focusing on the effects of electoral concerns on grant allocation within and between municipalities. We find evidence of a substantial political bias in grant allocations both within and between municipalities, particularly when it comes to local-level electoral concerns. The paper offers researchers a new perspective when tackling the issue of politically biased grant allocation using panel data, particularly when they wish to uncover the simultaneous impact of time-variant and time-invariant factors, or when they cannot apply a quasi-experimental approach because of specific institutional contexts."</i></blockquote>
<div style="text-align: justify;">
Basically, we have taken a new spin on a well-researched topic in the field of political economy: does central government allocate local government grants based on selective political criteria? There is a multitude of papers on this for various countries (just check out <a href="http://link.springer.com/article/10.1007%2Fs11127-017-0435-y#Bib1">our references</a>), with the overreaching conclusion being: yes, there is a political bias in the allocation of intergovernmental grants (intergovernmental meaning the flow of funds from the central to the local government). It happens for two main reasons: 1) central government helps its local co-partisans (mayors from the same party as the national government) retain office by giving them more money to buy votes in local election years, and 2) the central government helps itself (increases its own chances of re-election) by giving more money to important districts in national election years. An important district can be either a swing district, where voters often switch from one party to the other, or a core district, where voters always vote for the same party. The literature has found evidence of both. We find that money mostly goes to core districts. Politicians thus want to get as many votes as possible in districts where they are already strong. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So what makes our paper special? The standard literature approach was mainly to uncover the within unit variation of grant allocation over time. This means that they wanted to see which factors' changes over time affect how much money does a local unit of government get. When uncovering the effect this way the literature usually discards any between-unit variation, i.e. it cannot make any inferences between local units. To clarify here is a sentence from the paper: <i>"For example, finding that larger vote shares for the government within counties result in more allocated grants over time—clearly a within effect—often is misinterpreted as the between effect and generalized into a cross-sectional conclusion that counties received more grants because the government garnered a larger share of the votes in a previous election."</i></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>A few clarifications before moving on</b>: A panel dataset means having observations on multiple units over time. This is opposed to a cross-section where you just have observations on multiple units in one fixed time period. Having panel data is great because it allows you to eliminate any changes across units that stay fixed over time (like gender, geography, demographics, or any slow-changing variable like institutions), and focus only on estimating the effect of the changing independent variables on your outcome of interest. It is a very neat way of making correct inferences in the social sciences. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
What we wanted to do is to use our panel dataset to explore the variation both within and between our units of interest. So not only the standard within effect in a municipality over time, but also the cross-sectional effect of the differences between units to see which non-changing factors also could affect our outcome. In our own words:</div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>"We test how the effects of political considerations on grant allocation change over time within each entity and how they vary across them. The within-between approach thus allows for the inclusion of potentially influential time-invariant variables, which the fixed effects approach eliminates, as a separate between-entity effect, in addition to keeping all the benefits of the fixed effects estimation. Disentangling the within- and between-entity effects is important as it not only provides a more substantive interpretation, but also enables the researcher to correctly identify the source of variation by not confusing which of the two effects is driving the estimated relationship. By utilizing this particular approach our goal is to offer researchers a new perspective on tackling the issue of grant allocation when one wishes to test for the simultaneous impact of time-invariant and time-variant variables, and when a quasi-experimental setting is unfeasible owing to specific circumstances of the observed political system."</i></blockquote>
</div>
<div>
The within-between approach is a new method referenced to a great paper by <a href="https://www.cambridge.org/core/services/aop-cambridge-core/content/view/S2049847014000077">Bell and Jones (2015)</a>. </div>
<div>
<b><br /></b></div>
<div>
<b>Results</b></div>
<div>
<br /></div>
<div style="text-align: justify;">
What do we find? As I've said before, there is a clear conclusion that there is a significant political bias in the allocation of intergovernmental grants. The national government favors municipalities that support them in the national elections, and those that were won over by their co-partisan mayors. They give more money during election years (both national and local), and they support core municipalities rather than swing municipalities. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The within-between approach was most helpful in examining the interaction effect of votes for government and turnout. This is best seen on the figures below:</div>
<div>
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgivd2Rbnoq7DyYBh4obLhJZVEsSe-tUEF_zpsISjZgHxkx9Bkg0mcA9QBCGMRhqZ7xgzxbKo8yCDHPvrKUaN6V78lGgyYrpK_4HSiGrBFRbWnEWj0gY6X8jBR2OKu_TF6fsSNr_lr8LM4N/s1600/HR_grants_figure+1.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="140" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgivd2Rbnoq7DyYBh4obLhJZVEsSe-tUEF_zpsISjZgHxkx9Bkg0mcA9QBCGMRhqZ7xgzxbKo8yCDHPvrKUaN6V78lGgyYrpK_4HSiGrBFRbWnEWj0gY6X8jBR2OKu_TF6fsSNr_lr8LM4N/s400/HR_grants_figure+1.jpg" width="400" /></a></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjhVyxjYhDhBdr21XJYZEqKhI1i0SlKJ3rgItSZJOYrI4UEZV-PEViqFC1sxNVonkH3v6VLYRKLi4z7WLAf19Gg3RWsblKI75oHEBN7IH_HG-9q3HnViOw83Ivdt1xU_vZ-wethiCTsd5Y/s1600/HR_grants_figure+2.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="140" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjhVyxjYhDhBdr21XJYZEqKhI1i0SlKJ3rgItSZJOYrI4UEZV-PEViqFC1sxNVonkH3v6VLYRKLi4z7WLAf19Gg3RWsblKI75oHEBN7IH_HG-9q3HnViOw83Ivdt1xU_vZ-wethiCTsd5Y/s400/HR_grants_figure+2.jpg" width="400" /></a></div>
<div>
<br /></div>
<div>
In our own words: </div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>"...in Fig. 1 it is obvious that higher national turnout is conditioning only the within-municipality changes in grants in a positive way, whereas the between effect goes in completely the opposite direction (and also is insignificant). In other words, the government rewards only those municipalities wherein they gain support through higher voter turnout rates across time.</i> </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<i>In Fig. 2, representing local level estimates, the conditionality of turnout on a between-municipality level is shown to be crucial for concluding that mayors who win on higher voter turnouts are likely to receive larger grants. The within effect plays no role here, so the conclusion regarding the effect of mayoral alignment and turnout on grant allocation is valid only on a between-municipality level. In other words, aligned mayors who win their posts with high voter turnout rates do not get more intergovernmental grants (they do get more such funds, but not conditioned on turnout), while aligned mayors already holding power do get more money if they can increase voter turnout. Both findings make sense, since winning over a new municipality is good for the national party regardless of turnout, while for existing incumbents establishing their dominance with even more support is likely to be rewarded. None of these conclusions would have been possible without the use of the WB approach."</i></blockquote>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-14103038605633735922017-01-31T21:00:00.000+00:002017-02-01T11:05:43.257+00:00This Trumpian neomercantilism is ridiculous!<div style="text-align: justify;">
Protectionism never helped anyone. Particularly among the developed nations. I have yet to encounter a case of a rich country becoming even richer after imposing tariffs and trade restrictions. Even when looking at firm-level data over the long run, protectionism never helped. In many cases it arguably made them even less efficient (I provide a real-life example below). The notion that tariffs (taxes on imports) and quotas (limits on import quantities) are in general bad for the economy that imposes them could even be called a <i>stylized fact</i> of the profession. And it is one of those rare 'facts' a vast majority of economists would agree with; even those who like to emphasize that free trade has both winners and losers, and even those who cite the successes of South Korea or China in using state protectionism of infant industries to gain a competitive advantage abroad (although there are a <i>lot </i>more factors explaining their success - plus I have yet to see a good piece of research defending this argument). </div>
<br />
<div style="text-align: justify;">
So why then, if the experts are practically unanimous, are calls for protectionism so attractive and can become so politically salient? One reason is because people don't trust experts anymore, but even when they did, they still had a misunderstanding of trade. Trade is just one of those topics everyone seems to have an opinion on, usually the wrong one. I've written before on the ills of the so-called <a href="http://im-an-economist.blogspot.co.uk/2013/12/economic-history-mercantilism-and.html">mercantilist fallacy</a>. This fallacy usually attracts anyone who suffers from a zero-sum game mentality. Your gain must imply my loss. If we trade with China and have a trade deficit (we import more than we export), we're "losing to China". This is the same variant of the classic saying that "<a href="http://im-an-economist.blogspot.co.uk/2014/10/imports-and-exports-two-sides-of-same.html">exports are good while imports are bad</a>". If I export then I get money, if I import I lose money. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Let me emphasize just how ridiculous this argument is. Saying that imports are bad and exports are good is like saying that selling is good (cause we get money when we sell something) while buying is bad (cause we lose money when we buy something). Far from it! Both transactions are good, because when you buy/import you do it either to resell it at a higher price or consume it. If the transaction is voluntary it is by definition beneficial, both for the seller and the buyer, regardless if the seller/buyer is a foreigner. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Also, governments, i.e. countries <i><b>do not</b></i> import nor export. Companies do. They sell (export) and buy (import) on the international market. In fact, the determinant of the demand for imports comes directly from the consumers themselves. Or companies buying intermediary products that are cheaper abroad. If we as customers have a greater benefit from consuming foreign rather than domestic goods, then there will be a company that will offer them to us. It will import foreign goods knowing someone back home will buy them. We as consumers therefore determine the demand for imported goods. Whether it's clothes or food, that almost any country can produce on its own, or cars and IT goods that most countries cannot.</div>
<b><br /></b>
<b>How the import tariff affects US consumers</b><br />
<br />
<div style="text-align: justify;">
So how does all this link to the new US President? Well, it's got to do with the most recent set of ideas on trade policy coming from the <i>experts</i> in the Trump administration <i>(btw, should we trust these experts over all the others? I guess we should, they <b>do</b> work for the President, right?).</i></div>
<br />
<div style="text-align: justify;">
Take for instance their idea for imposing a tariff of 20% on all imports coming from Mexico. Guess who will pay the ultimate price of that 20% tariff? Yes, you've guessed it - US consumers! How? Let me explain it in very simple, Trumpian terms. </div>
<br />
<div style="text-align: justify;">
I am a distribution company (let's call me 'the Middleman') which sells electric equipment (let's call it 'Stuff') all across the US. I don't make them myself, I just sell them. So when I buy the Stuff I want to sell, my main motivation for purchase will be a good (i.e. low) price. I buy most of the Stuff from Mexico, from a firm called Mexico Stuff Manufacturer (MSM) and then sell it to local shops across the country. MSM gives me a good quality product and at a lower cost than if I were to buy domestically.</div>
<br />
<div style="text-align: justify;">
Now the tariff is implemented at 20% on all imports from Mexico. If I want to buy the Stuff from MSM again I have to pay 20% more. That's not very good news for me given that this would eat up almost my entire profit margin. In other words if I buy the Stuff at a higher price I have to increase my selling price to the shops to stay in business. </div>
<div>
<br /></div>
<div>
<div style="text-align: justify;">
Or, if I don't want to do that I can always find a new supplier, perhaps someone in the US - call it US Stuff Manufacturer (USSM). The thing is, the reason I didn't go there in the first place was because USSM was charging me more than MSM for the same quality Stuff. Now that their prices are, let's assume, equal, I am basically at a standstill since whoever I buy from I still have to charge a higher price to the shops. So I decide to stick with the devil/supplier I know. In each case, whatever I choose to do, my prices will have to go up. </div>
</div>
<div>
<br /></div>
<div>
<div style="text-align: justify;">
So I go to the shops and sell them the Stuff at a 20% higher price. What do they do? They push that same price increase on the final consumer and charge them the extra 20% they had to pay me. They're in the same business I'm in - they buy the Stuff from me, and resell it at a higher price to the final consumer. </div>
</div>
<div>
<br /></div>
<div>
<div style="text-align: justify;">
But why would the shops pay the higher price? Why would they be the price-taker in this case? Because they are in the exact same position I'm in - they have no choice. In either case, if they buy from me or if they decide to switch and get the Stuff from USSM directly they still need to pay a higher price than before - a price that will always be shifted to the final consumer. The example holds even if the price of Mexican Stuff is now higher than the price of US Stuff, because the price at which we buy the US Stuff for will still be higher than the old pre-tariff price of Mexican Stuff. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is why <b>a tariff on imports has the equivalence of a tax on domestic consumers buying foreign goods</b>. This might sound like an attractive way to nudge consumers towards buying more stuff produced domestically, but we're talking about individual preferences here. If I like a foreign car, if I think it's more fuel efficient, I will buy a foreign car, regardless of what my government wants me to do. I would hate to have the government limiting my free choice and telling me what to buy! <i>(Wasn't this the biggest issue some Americans had with Obamacare?)</i></div>
<div style="text-align: justify;">
<i></i></div>
<div>
<br />
<div style="text-align: justify;">
<b>What if the goods being traded are perfect substitutes?</b> </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In other words what if I can easily switch between domestic and foreign brands, so that by imposing a higher price on Mexican Stuff, consumers will just switch to US Stuff as it will now be more price competitive? In theory yes, in reality - no. Why? Just look at the <a href="https://ustr.gov/countries-regions/americas/mexico">composition and current prices of the goods the US imports from Mexico</a>: </div>
<div style="text-align: justify;">
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtYSRDAvgjL46JDx3eoH0zK4seH-w85ll8je1m9AmT4LiC4cCwHAhfxD8DkWKOXr_fOMKPbVvh0wAUgAuT6iURnKDusW9pXQ4TqLo6B28qIadBXCt22vMFbaTwbcMj1fCcW_iDKBUmFWmJ/s1600/US+mexican+imports.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="225" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtYSRDAvgjL46JDx3eoH0zK4seH-w85ll8je1m9AmT4LiC4cCwHAhfxD8DkWKOXr_fOMKPbVvh0wAUgAuT6iURnKDusW9pXQ4TqLo6B28qIadBXCt22vMFbaTwbcMj1fCcW_iDKBUmFWmJ/s400/US+mexican+imports.jpg" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="font-size: 12.8px;">Source: <a href="http://money.cnn.com/2017/01/09/news/economy/us-mexico-trump-cars-imports-trade-deficit/">CNN Money</a></td></tr>
</tbody></table>
</div>
<div style="text-align: justify;">
Can the US produce all this stuff? Sure it can. In fact, it does, and it exports the same stuff to Mexico (<a href="https://ustr.gov/countries-regions/americas/mexico">see for yourself</a>). Why is there then a demand for these products to come from Mexico? Price competitiveness due to lower wage costs in Mexico could be only one reason (the example above explained how that works). Another very important one are individual preferences. </div>
<br />
<div style="text-align: justify;">
Of the top of my head I can remember a very similar protectionist policy applied by the US back in the 1980s against Japanese imported cars. There was a <b>voluntary export restriction</b> imposed by the US government in 1981 limiting the number of Japanese cars to be imported in the States to 1,68 million per year. It was later raised to 1.85 million and to 2.3 million by 1985. It was finally lifted in 1994 (read more <a href="http://www.nytimes.com/1988/01/30/business/japan-confirms-it-will-continue-us-quota-of-2.3-million-cars.html">here</a> or <a href="http://www.heritage.org/research/reports/1985/02/the-costly-truth-about-auto-import-quotas">here</a>). What happened? The policy directly lowered the supply of Japanese cars on the market. With demand remaining high what was the effect? Prices went up. US consumers did not stop buying Japanese cars despite their higher price. They were simply better than US cars. More fuel efficient to be exact. Who profited from this policy? Only one group: Japanese car companies. That's right, the end effect of a protectionist policy aimed to protect the US car industry made Japanese car companies richer. <i>(This is, mind you, an example from the classical textbook by <a href="http://course.sdu.edu.cn/G2S/eWebEditor/uploadfile/20120417191243_590081573385.pdf">Krugman and Obsfeld on International trade</a>)</i></div>
<br />
<div style="text-align: justify;">
Finally, I don't see why Mexico is complaining. Or China. A 20% tax on imports from Mexico and an alleged 40% tax on imports from China is only going to benefit the companies in these countries. Sure, they might sell lower quantities of their products, but they will more than compensate this with higher prices. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Who will pay the price for this? US consumers. Protectionism is a tax on them. So when Trump says he will force Mexico to pay for 'the Wall' by imposing a tariff on their imports, I hope these examples helped illustrate what this means - it means that US consumers will ultimately pay for the Wall through a tax they won't even realize hit them. </div>
</div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com6tag:blogger.com,1999:blog-3448927642739850334.post-84894455753706761832016-12-27T22:22:00.000+00:002016-12-27T22:36:19.899+00:002016: a bad year for predictions<div style="text-align: justify;">
Talk about <a href="http://im-an-economist.blogspot.hr/2016/02/what-ive-been-reading-vol-2.html">Black Swans</a>, 2016 was full of them! From elections to markets, from hacking to terrorist attacks, it was one unexpected event after another. Each a complete shocker in its own way. Especially in sports and politics. <a href="https://www.quora.com/How-did-Portugal-win-the-Euros">Portugal winning the Euro</a> football tournament, <a href="http://www.espn.com/espn/feature/story/_/id/15386257/the-leicester-city-heroes-won-premier-league">Leicester winning the Premier League</a>, Britain coming in second at the <a href="http://www.bbc.com/sport/olympics/rio-2016/medals/countries">Olympic game medal count</a>, or the <a href="http://m.mlb.com/news/article/207938228/chicago-cubs-win-2016-world-series/">Chicago Cubs winning the World Series</a> were as big as Black Swans as Brexit or Trump. </div>
<div style="text-align: justify;">
<br /></div>
<div>
<div style="text-align: justify;">
It goes without saying that a year of Black Swans was a terrible year for forecasters. Even the biggest names of the 'industry' have stumbled and failed to predict the biggest disruptive events of the year: Brexit and Trump. Not <a href="http://www.oraclum.co.uk/">my company</a>. <a href="http://oraclum.eu/election-2016-final-prediction/">We got Trump spot on</a>. Just to remind my readers, we called 47 states including the most important swing states like PA, FL, NC, and OH for Trump. Our <a href="http://oraclum.eu/will-next-us-president-forecasting-election2016/">unique prediction method</a>, that was further perfected since Brexit, has hit bull's-eye!</div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYkYsols2PuH3nsWo-jWDYs7n-BVC2s0SKld8qqcABEljN4xaekEENedO-H6XFjqw0ObZ-pXm-v4djwPz_KZTeMurpGjw2aC-QOXbq7qQEduCkyy4EMCJhr-1KJop3YYl-QWWjdqf9-dPI/s1600/FinalMap_large.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="303" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYkYsols2PuH3nsWo-jWDYs7n-BVC2s0SKld8qqcABEljN4xaekEENedO-H6XFjqw0ObZ-pXm-v4djwPz_KZTeMurpGjw2aC-QOXbq7qQEduCkyy4EMCJhr-1KJop3YYl-QWWjdqf9-dPI/s400/FinalMap_large.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Our almost perfect prediction for Trump<br />
<a href="http://oraclum.eu/election-2016-final-prediction/">Oraclum Intelligence Systems</a></td></tr>
</tbody></table>
<div style="text-align: justify;">
I cannot say the same for myself however. I usually make my prediction at the beginning of each year. So far I boasted some big hits like the <a href="http://im-an-economist.blogspot.hr/2015/12/hits-and-misses-evaluating-last-years.html">UK general election of 2015</a>, the <a href="http://im-an-economist.blogspot.hr/2014/12/hits-and-misses-evaluation-of-last.html">success of anti-establishment parties in the EU 2014 elections</a>, the Scottish referendum, oil prices, interest rates, year-on-year economic growth projections, and even <a href="http://im-an-economist.blogspot.hr/2014/12/hits-and-misses-evaluation-of-last.html">Germany as the winner of the 2014 World Cup</a>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But this year it's been quite a few misses for <a href="http://im-an-economist.blogspot.hr/2016/01/2016-predictions-women-in-charge.html">my beginning-of-the-year predictions</a>. The very title of my <a href="http://im-an-economist.blogspot.hr/2016/01/2016-predictions-women-in-charge.html">January 1st blog</a> signifies the extent of the miss - <i>"women in charge"</i>. I predicted that by the end of the year Hillary Clinton is expected to join Angela Merkel, Janet Yellen, and Christine Lagarde (and Irina Bokova as the UN secretary general) to have five out of ten most powerful political positions be held by women. That was a big miss. Hillary lost, Bokova lost, Yellen will most likely be replaced by Donald Trump, and Merkel is facing a tough election next year (although she will probably hold on). The woman I did not see coming was Theresa May, the new UK PM. Even if I had predicted Brexit back then I would have said that Cameron would have been replaced by Boris Johnson, not Theresa May. Again, a true Black Swan. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Brexit was another big miss. I was categorical in saying that Britain won't leave the EU. I wasn't even sure the referendum would be held this year (this wasn't decided until February, as Cameron wanted to move quickly to capitalize on his general election victory). I had a bunch of rational explanations on why the Brits will not vote Leave. All of which apparently biased by my liberal worldview. I <a href="http://im-an-economist.blogspot.hr/2016/06/brexit-reaction-democratic-deficit.html">wrote a comment</a> on this after the event, making a couple of other bold predictions on the way. I just can't get enough of predictions, apparently. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In the US not only was I very bullish on Hillary, I didn't even predict Sanders to give her a run for her money. I did give Trump the biggest probability to win the Republican presidential nomination (I had Rubio second), but I still gave Hillary 55% to clinch the Presidency in November. Interestingly enough I didn't change my mind on Hillary's chances until the last few days of the campaign when I saw our model estimating a Trump victory. It was a shocker, but we did get it right. The lesson was to trust my data, not my guts. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The second lesson from this was that with election forecasting I should wait for the last few weeks before the elections to figure out how the voters feel. After all I now possess a powerful method to do just that, so I will refrain from making any more election predictions a year in advance. Plus, I'll rather sell this info to our clients rather than boasting on my blog. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Oh, and I also missed my sports predictions. I said that either Germany or Belgium will win the Euro, but in the end it was a final between Portugal and France, won by - surprise, surprise - Portugal. For the Olympics I was right that the US will win the most medals but I never even dreamed that the UK will come in second. In front of China! Now that was a surprise. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>The hits</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It wasn't all misses. I had some <a href="http://im-an-economist.blogspot.hr/2016/01/2016-predictions-women-in-charge.html">good wins</a>. Such as the economy, which unlike politics was rather predictable last year. Ireland was, as predicted, the best performer of the year in the EU, while Greece was the worst. The developed world grew more robustly, although the recovery is still slow, particularly in Europe. The US continued a steady growth trajectory and unemployment fell below 5%. <a href="https://www.theatlantic.com/business/archive/2016/12/fed-dec-meeting/510674/">The Fed raised interest rates </a>only slightly in December, while other central banks (ECB, BoE) went for the opposite following the massive political uncertainty in Europe.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Oil prices did not go above $60, China did not go into recession as many were screaming early this year, and Putin came out of the year stronger than ever. Japan is still stagnating, and India overtook China as the fastest growing economy. All of these were good predictions, the kind that were slightly easier to make. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Oh and here's one big hit - I predicted no terrorist attacks during the Olympics in Brazil or the Euro in France. This was a bold prediction but I was confident nothing would happen given the level of security usually associated with these events. Terrorists will not get away with it if everyone is paying extra careful attention to spot them out. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Interestingly, with all the Black Swans that happened this year none of them went 'under the radar'. In other words Brexit or Trump had a realistic chance of happening, even if many estimated those chances to be low. Leicester or the Cubs on the other hand - those were the true under-the-radar Black Swans.<br />
<br />
Anyway, if you think this year was hard to predict, think of how difficult the next one will be. No one has an idea of what a Trump presidency will look like. No one has an idea how Brexit will turn out (I'm sure Britain will Leave, the question is under which circumstances). Politically it could be another shocker with elections coming up in Germany, France, and the Netherlands. The last two could bring leaders that could spell and end to the EU itself. What about Syria and the EU refugee problem? Will Putin and Trump solve these issues? What about the potential US trade war with China? We're in for quite a ride! </div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-36884198702003227922016-11-29T01:26:00.001+00:002016-11-29T01:26:46.719+00:00Is technological progress at the heart of stagnation?<div style="text-align: justify;">
In the <a href="http://im-an-economist.blogspot.co.uk/2016/11/explaining-our-current-stagnation.html">previous text</a> I presented several economic hypotheses explaining why the developed world has entered what could possibly be a prolonged period of economic stagnation. In today's text (<i>note: long read</i>) I will present my own opinion, arguing that what we are experiencing is a temporary slowdown which could last for several decades, but one that could also provide the greatest opportunity for the next huge boost in living standards. I hypothesize that the underlying factor behind both the current temporary stagnation (particularly in productivity and real wages) and the upcoming rise in living standards is - <b>technology</b>. </div>
<br />
<div style="text-align: justify;">
As I've emphasized several times on the blog before, I believe we are currently, for the past 30 years, in the period of the <a href="http://im-an-economist.blogspot.hr/2012/12/cps-technology-friend-or-foe.html">Third Industrial Revolution</a>. And in our times, it's only heating up, with the potential to bring to some <a href="http://im-an-economist.blogspot.hr/2013/06/disruptive-technologies.html">new disruptive innovations</a> that could change our world as much as the previous two industrial revolutions had. The technological progress we are currently undergoing will, without doubt, be disruptive. As it always is. But in its disruptive nature it will bring greater benefits for the future generations. Automated work being replaced by robots will surely lead to job losses. But in a new economy, the job losses could be offset by a series of new opportunities and entirely new careers. Which ones in particular, we can't really tell at this moment. But just like the first two industrial revolutions brought completely new jobs and changed the world as we know it (more than 95% of jobs that exist today didn't exist before the 18th century), so will the Third bring in new jobs and new possibilities we can't even imagine. Social networks have already introduced new types of occupations (social network experts being the most dubious one). Various bloggers and youtubers have managed to turn their hobby into a money making venture. Firms are just beginning to exploit the Internet, and its users are just uncovering the various ways they can make money on it. None of this was even conceivable back in the 1990s when our remote Internet usage was often wrapped around in frustration with our dial-up connection (<a href="https://www.youtube.com/watch?v=gsNaR6FRuO0">remind yourself of that glorious sound</a>, I know you want to!). Today so much more opportunities await. </div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7LwU_pp7Kwrx5knzv6ItkurK2H571JB7D2QqIMjFLDaZbwut_ZjtxnUqAPSKvhvbBehmt3xW95x-p_1kCM40VffpzLJePPQp-bDNM52KQz1dbTdtaMvNitoB_gsy3zOnRZN042ZczwhBz/s1600/autopilot.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="231" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7LwU_pp7Kwrx5knzv6ItkurK2H571JB7D2QqIMjFLDaZbwut_ZjtxnUqAPSKvhvbBehmt3xW95x-p_1kCM40VffpzLJePPQp-bDNM52KQz1dbTdtaMvNitoB_gsy3zOnRZN042ZczwhBz/s400/autopilot.jpg" width="400" /></a></div>
<br />
<div style="text-align: justify;">
The good thing about this <b>inevitable change is that it tends to be gradual</b>. This meaning that even if robots and automated work start replacing low-skilled jobs, this will all still happen during a prolonged period where it will be possible to maintain a generational switch.<br />
<br />
What does this mean in particular? Let's take the example of the taxi market and the driverless car (or if you want - Uber, which is the intermediate step). Naturally if driverless cars all start hitting the streets they will almost immediately take away all the jobs from the taxi drivers. Which is likely to cause them to rebel, quite legitimately so. One always has an incentive to protect their job and their immediate interest. A good way to achieve a peaceful transition would be to allow the technological breakthrough to enter gradually by having the taxi drivers operating and overseeing the driverless cars at first. This would, on one hand, correspond to a permanent barrier to entry for any new driver, however all the current drivers would keep their jobs. Until retirement or until they find another job, whichever comes first. Each current driver would therefore still be driving/riding the driverless car and providing for example local advice to tourists. This would then be a perfect way to tell whether or not the passengers really enjoy the conversation and demand for the actual person to be in the car, or do they just prefer the robot to take them where they need to go without speaking to it. It's all about having choices! And in this way to minimize the despair of potential job losses imposed by the new technology. But I digress. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjmrYCa9wticE10vOH9HQKWpDwPuDMVIzNFlquLDZcXLxoJTx4vPU_as9LBSmBywCYb4AVLeeEAQKoBhxr0SHQuEjt580ZYEL1lvvPtfHf90jGbAEOJztHJMFCiPLafxInRiuYGHaHNqZYn/s1600/SunHouse.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="208" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjmrYCa9wticE10vOH9HQKWpDwPuDMVIzNFlquLDZcXLxoJTx4vPU_as9LBSmBywCYb4AVLeeEAQKoBhxr0SHQuEjt580ZYEL1lvvPtfHf90jGbAEOJztHJMFCiPLafxInRiuYGHaHNqZYn/s320/SunHouse.jpg" width="320" /></a>The current slowdown is essentially of temporary effect as <b>we're currently in a transitional period from the old industry-driven economy (including the service industry) to the new digitally-driven economy</b>. The industry-driven economy still rests upon the old industrial classification paradigm: the primary sector (agriculture, fishing, and mining), the secondary sector (manufacturing, production), and the tertiary sector (services). So far in the history of the West we have witnessed the transition from an agricultural-dominant economy to a manufacturing-driven economy (the First Industrial Revolution in the 18th century), a shift from manufacturing to rapid industrialization in the 19th and beginning of the 20th century (the Second Industrial Revolution driven by mass innovation), and a shift from industrialization to services in the final part of the 20th century following a period of rapid globalization.<br />
<br />
Now we are facing something different - <b>a shift beyond the standard paradigm</b>. Disruptive technological progress will rapidly change our patterns of production and of specialization. It will be nothing like the world we knew so far. Just like the first two industrial revolutions brought us to a state of the economy not known to us before. In the 16th and 17th century having a locomotion and machines was unimaginable. In the 18th century having electricity, cars, airplanes, and modern medicine was unimaginable. After WWI having computers and traveling to space was unimaginable. 40 years ago a cell phone was unimaginable, while a mere 15 years ago a smartphone was unimaginable. True, there were always visionaries who offered their overly enthusiastic views of the future by simply extrapolating the current levels of technological progress. In the 1960s visions of the future included flying cars, intergalactic travel, jet-packs, and personal robots, all by the year of 2000 (check out <a href="http://gizmodo.com/42-visions-for-tomorrow-from-the-golden-age-of-futurism-1683553063">some of the futurist visions from that time</a> - some of them actually did come to existence; also <a href="http://www.scientificamerican.com/article/pogue-what-the-1960s-got-rightand-wrongabout-todays-tech/">read this piece</a> to see which predictions came true).</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhYDHrl_ToAXSlvoqN__09PI7-K6Sp9jooVsuXzUKBGkBUuju055ZU1oggVIFULntYfhVjc-NlwScb522vrDulfG4iDDfrin_kcHhbs3AyTMawCxrUafhPms9LN_0-PhUkZGRX4w4L3uuWo/s1600/Motopia.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="182" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhYDHrl_ToAXSlvoqN__09PI7-K6Sp9jooVsuXzUKBGkBUuju055ZU1oggVIFULntYfhVjc-NlwScb522vrDulfG4iDDfrin_kcHhbs3AyTMawCxrUafhPms9LN_0-PhUkZGRX4w4L3uuWo/s400/Motopia.jpg" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<b>How the Internet has changed things - for the better</b><br />
<br />
<div style="text-align: justify;">
Why don't many people see this obvious advantage of the technological progress so far? A famous quotation from Nobel prize winner Robert Sollow: <i>"You can see the computer age everywhere except in the productivity statistics"</i> is actually true. There is a<b> productivity paradox where the advances in computing power haven't really made workers more productive</b>. This is contrary to the idea that automation of work should increase total factor productivity. Essentially the idea is that despite all the benefits the Internet has brought to us (instant global communication, entirely new business and marketing models, different consumer behavior patterns, social networking, even spontaneous mass gatherings), it has made only marginal improvements in well-being, at least compared to the non-internet age of the 1980s. The technology skeptics cite similar examples where modern technologies only offered marginal improvements over the products we enjoy today. For example, whereas the first invention of the car was a huge advantage over a horse, its further improvements, after reaching a certain level of speed and safety, were marginal. Airplanes are a similar example. Yes, today they tend to be much safer, but flight times are still similar to what they were 50 years ago. The smartphone was an improvement over the regular cell phone, but not as much as the cell phone was an improvement over the landline, and both not as much as the regular landline was an improvement over letters and telegrams.</div>
<br />
<div style="text-align: justify;">
However all these examples are missing the point. We are still at the very early stages of the Third Industrial Revolution - the Digital Revolution. We are slowly entering the Information age. The Internet has made much bigger changes than standard economic indicators would suggest. Particularly since most of them were indirect. <b>The Internet has, without doubt, changed the patterns of firm specialization and has increased the rate of trial and error as well as innovation</b>. The vast availability of information online can improve business strategies and force businesses to adapt to the Internet revolution. Those that don't, lose customers. No matter what industry they are in. In the upcoming decades this will become even more obvious. Furthermore, the Internet has had a key role in promoting economic opportunity for all, particularly for the underprivileged. To start a business all you need is a laptop and an internet connection (of course, this varies from country to country depending on the scope of regulations). Most importantly the Internet and the increasing socialization it has brought with it can be used to foster democracy and the empowerment of the middle classes. That is one of its, by far, biggest advantages. Social networks and the Internet can do more in overthrowing dictators and holding politicians accountable in democracies than the media ever could. (Obviously they can also be used in an opposite capacity - by distributing fake news and encouraging bubble behavior; but to be fair, fake news and living in bubbles happened way before the Internet). </div>
<br />
<div style="text-align: justify;">
For all these reasons, in the upcoming Information Age, the Internet should be free for all - a global public good. Free access to the Internet should be a human right (the <a href="https://www.wired.com/2011/06/internet-a-human-right/">UN</a> has done a lot in promoting this idea, there is even an <a href="http://ahumanright.org/">initiative to implement the Internet as a basic human right</a>, but some <a href="https://en.wikipedia.org/wiki/Right_to_Internet_access#Critiques_of_the_human_right_to_Internet_access">disagreements still remain</a>). Nevertheless, its creation of economic opportunity, its role in fostering democracy by empowering the middle classes, its ease of access to education (online courses can do wonders!) are more than enough to declare it a human right and offer it as a global public good. This is something that the future might hold for us - free Internet, worldwide. (Although, don't be so sure on the "free" part. We have access to electricity and clean water, but both still come at a cost).</div>
<br />
<b>Learning from Japan</b><br />
<br />
<div style="text-align: justify;">
Even with all those advantages at hand, we have currently reached a ceiling with our pre-IT revolution models of economic growth. Japan is perhaps the best example. A huge booming economy for 30 years following the recovery after WWII, it was hit by a housing bubble burst in 1990 and has experienced very low to zero economic growth ever since. In the past 26 years Japan grew, on average, by 0.7%. Its lost decade of the 90s has turned into two lost decades and is now in the middle of a third. Its public debt is <a href="https://en.wikipedia.org/wiki/List_of_countries_by_public_debt">the largest in the world</a>, and by a long shot (public debt to GDP is 230%, higher than even Greece, with debt to GDP at 170%). For the entire 26-year period inflation has been close to 0, borderline deflation, as have their interest rates. Needless to say Japan has done a series of <a href="http://im-an-economist.blogspot.co.uk/2014/04/assessing-abenomics.html">monetary and fiscal stimuli</a> to prompt up their economy throughout this period, but nothing has worked. The consequences of both are highly visible in their over-expanded monetary base and huge debt.</div>
<br />
<div style="text-align: justify;">
But in reality, there is nothing wrong with Japan. Yes its economic indicators are terrible, yes the population is ageing which is always a problem in countries with high debt levels, but Japan remains one of the richest countries in the world. Their <a href="https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)_per_capita">GDP per capita (PPP)</a> is around $38,000 which is quite a lot for a country with 127 million people. The only comparable in population size is the US with a GDP per capita (PPP) of $55,000. But beyond GDP, Japan ranks highest in many of the measures of living standards and well-being. By <a href="https://en.wikipedia.org/wiki/List_of_countries_by_life_expectancy">life expectancy</a> they are no.1 in the world (84 years on average!), their human development index, prosperity index, happiness index all put them among the top performers. Their health care and education system are flourishing, they have low crime rates, and decreasing inequality. One conventional economic indicator - unemployment - always managed to stay low, at around 4%. And their levels of innovation and technological adaptation are arguably among the world's highest if not <i>the</i> highest. The vast majority of the population is therefore enjoying really good living standards. It seems that low GDP growth, ongoing deflation, and high public debt (as long as it is <a href="http://im-an-economist.blogspot.co.uk/2013/01/graph-of-week-sovereign-debt.html">held by the domestic population</a> in a country stable and rich enough to have a huge demand for its debt, particularly domestic in this case), don't really hamper living standards. The two and a half decades of stagnation have not apparently taken their toll on well-being.</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1cbwu6ykHwsq8W4mncRaT0lpYjRKqgtOYZH7gyZDl8DBAQLymnpJR0DCAA7Qg92Q4S-D6RRtI1XCt74zhwZe3PhPK3YQuRnMaCHs4leFBwjludASUJ6hjbp2TVh9rEIenn9b7J5siNaoM/s1600/japan_HDI.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="139" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1cbwu6ykHwsq8W4mncRaT0lpYjRKqgtOYZH7gyZDl8DBAQLymnpJR0DCAA7Qg92Q4S-D6RRtI1XCt74zhwZe3PhPK3YQuRnMaCHs4leFBwjludASUJ6hjbp2TVh9rEIenn9b7J5siNaoM/s400/japan_HDI.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So what's the story here? Japan has simply reached a level of very high living standards combined with a strive for technological innovation that has perhaps even worsened some productivity numbers and possibly GDP growth as well (although there are a number of reasons why GDP growth was low in Japan). The IT revolution took huge proportions in Japan. Anyone who's ever been there speaks of its technological superiority and a number of "cool gadgets". Few of these gadgets have raised GDP, but they have contributed to the well-being of the population, and more importantly, they have opened vast new opportunities for its population. It takes time for these to be seized in order to produce a high magnitude well-being effect. </div>
<b><br /></b>
<b>The Third Industrial Revolution IS at the heart of the current stagnation...</b><br />
<br />
<div style="text-align: justify;">
The point is that we are currently experiencing a stagnation caused by a series of factors, one of which is certainly the technological revolution. I've <a href="http://im-an-economist.blogspot.hr/search/label/Technology">written on that before</a> on multiple occasions. Essentially, technological progress began by shifting jobs and changing the patterns of specialization and production. This will go on for several more decades. But the further it unfolds, the more benefits it will bring that will be immediately noticeable to us. In other words, <b>think of the current stagnation in wages and productivity (and hence economic growth) as an indirect consequence of the upcoming and ongoing technological progress</b>. It takes time for the people to recognize the <a href="https://static1.squarespace.com/static/56eddde762cd9413e151ac92/t/573db457f85082ef2c9390ed/1463661656761/PSST.pdf">new patterns of specialization</a> and to exploit the opportunities for new jobs. With the start of the IT revolution in the 80s we've already noticed a series of new jobs being created. It all started with companies like IBM, Dell, HP, and Apple to provide the hardware. Then came Microsoft and revolutionized the software (Apple made it even cooler later on in the second coming of Steve Jobs). Then the Internet giants started emerging: Google, Facebook, Amazon, YouTube, eBay and many others. (The criticism these companies get is that while they replaced many old jobs in manufacturing, it wasn't actually a one-for-one replacement. They created much less jobs than what manufacturing companies created.)</div>
<br />
<div style="text-align: justify;">
All these new companies emerged in the very beginning of the IT revolution (some even before like IBM). Expect many more of these to come in the following decades. Don't necessarily expect new search engines, software manufactures, online retailers, or social networks. <b>No, the new high tech companies will be about something completely different. </b>They will most likely strive on the benefits provided by all these companies before them (we all have laptops, running on either Windows or Mac, and we all use Google, Facebook, YouTube, etc.).</div>
<br />
<b>...but it will also set the stage for the next big boost in living standards</b><br />
<br />
<div style="text-align: justify;">
The current level of technological development set the stage for the Next Big Thing. They didn't replace all the lost jobs, and were on that front mostly disruptive innovations. For now. However the foundations have been laid. These foundations are supported by the current (temporary) industry giants. And most importantly <b>they provide the nurturing environment for growth, for new companies that one day will be even greater and will perhaps not only change the jobs market, they could profoundly change our way of life</b> (e.g. robot manufacturing companies, or nanotech companies, or AI producers, or fusion energy companies - a bit too much? <a href="https://en.wikipedia.org/wiki/Physics_of_the_Future">Or is it?</a>). In 50 or 100 years from now we may look down on manual labor and automated work as relics of the past. And no one will complain as everyone will find such jobs meaningless and will have the time to pursue their most desired careers. It might sound a bit idealistic from today's point of view but who knows. Cars, trains, and airplanes sounded idealistic back when the First Industrial Revolution was underway, but today we know of no better form of transportation. At this point, we can only imagine.</div>
<br />
<div style="text-align: justify;">
Now, all this is just a theory. I can devise a multitude of examples and arguments in support of it, but I cannot really test it. Yet. Time will tell basically whether or not this thinking has any merit at all. I do however carry a slightly optimistic bias in believing that we live in awesome times and are on the verge of a breakthrough that most of us simply aren't aware of. My optimistic bias makes me a bit subjective towards the impact of technological progress on future living standards, but drawing simply from historical patterns and the possibilities being uncovered to us, the IT revolution is nothing to be feared.</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPwjbd8PbaH7vlMyacD7yWcgq9Mkg1F9GzrWs6xwdxXIX2o1GaAw7XLTYZ63ZX0cQGrpBljFAEjwjSsTq8o25OJFbLr2qrqEgcslnRlgXE85EeZignpej9w-EoCvRmerU1cl2Cob74MDXM/s1600/FutureCities.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="301" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPwjbd8PbaH7vlMyacD7yWcgq9Mkg1F9GzrWs6xwdxXIX2o1GaAw7XLTYZ63ZX0cQGrpBljFAEjwjSsTq8o25OJFbLr2qrqEgcslnRlgXE85EeZignpej9w-EoCvRmerU1cl2Cob74MDXM/s400/FutureCities.jpg" width="400" /></a></div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com3tag:blogger.com,1999:blog-3448927642739850334.post-70175483147682178472016-11-20T13:15:00.002+00:002016-11-20T13:17:06.916+00:00Explaining our current stagnation<div style="text-align: justify;">
Ever since the <a href="http://im-an-economist.blogspot.co.uk/p/financial-crisis-2007-2009.html">financial crisis of 2007-2009</a> and its subsequent (slow and modest) <a href="http://im-an-economist.blogspot.co.uk/search/label/Recovery">recovery</a> many have claimed the world has entered into a state of prolonged stagnation. In addition to economic growth being relatively low (and therefore not enough to close the potential GDP gap caused by the crisis), real wages are also stagnating, unemployment is still high (although in relative decline), inflation is close to zero, while productivity growth is sending troublesome signals for some time now. This is particularly true of Europe, as it bears the <a href="http://im-an-economist.blogspot.co.uk/2013/07/the-perplexity-that-is-japan.html">strongest resemblance to Japan</a>, and is on a good course to repeat Japan's (still ongoing) two decades of stagnation (more on emulating Japan in my next text). </div>
<br />
<div style="text-align: justify;">
We all know the story. I, for one, have told it many times on the blog (see <a href="http://im-an-economist.blogspot.co.uk/2012/03/stimulus-debate-revisited.html">here</a>, <a href="http://im-an-economist.blogspot.co.uk/2013/01/huge-budget-deficits-are-result-of.html">here</a>, <a href="http://im-an-economist.blogspot.co.uk/2012/09/recovery-paradigms-fiscal-consolidation.html">here</a>, <a href="http://im-an-economist.blogspot.co.uk/2012/07/britains-productivity-conundrum.html">here</a>, <a href="http://im-an-economist.blogspot.co.uk/2012/12/igniting-recovery-fiscal-policy-and.html">here</a>, <a href="http://im-an-economist.blogspot.co.uk/2013/09/five-years-after-crisis-legacy.html">here</a> or <a href="http://im-an-economist.blogspot.co.uk/2014/05/why-no-inflation.html">here</a>). After the financial crisis, which usually tends to cause prolonged and slow recoveries, many governments adopted stimulus and bailout programs in 2009 that <a href="http://im-an-economist.blogspot.co.uk/2013/01/huge-budget-deficits-are-result-of.html">all but destroyed their public finances</a> at the time. In retrospect this was a <b>textbook Keynesian solution in times of crisis</b> - in order to restore confidence and replace the lack of private sector investment the government should step in and provide as much liquidity and stimulus as possible. And most of them did. The US, the UK, almost all European countries, even some Asian countries (like China) were forced to adopt stimulus packages as an immediate response to boost confidence. In addition central banks did their part and lowered interest rates to <a href="http://im-an-economist.blogspot.co.uk/2015/12/graph-of-year-fed-increases-interest.html">historical lows</a> to provide the <a href="http://im-an-economist.blogspot.co.uk/2012/09/more-on-monetary-stimuli.html">much needed liquidity</a> to the banking sector (whose reaction was mainly to <a href="http://im-an-economist.blogspot.co.uk/2011/10/restoring-confidence.html">hoard this cash</a>, not let it flow in the system). But this doesn't work, the conventional wisdom teaches us, since you can only lower rates so much, forcing you to fall into a liquidity trap. And the only thing that can get you out of a liquidity trap is more government spending.</div>
<br />
<div style="text-align: justify;">
This solution was applied throughout. And its main consequence, in only a single year, was that debt levels have risen sharply (to be fair <a href="http://im-an-economist.blogspot.co.uk/2013/01/huge-budget-deficits-are-result-of.html">bank bailouts contributed to rising debt levels</a> even more). They almost doubled in the US and in the UK, as in many European countries, while in countries like Ireland and Iceland they quadrupled. Budget deficits also went haywire. The UK in 2010 had the <a href="http://im-an-economist.blogspot.co.uk/2013/04/graph-of-week-british-austerity-three.html">third biggest deficit in the world</a>: -10% of GDP (behind only the revolution-undergoing Egypt and the shambolic Greece). Even for rich and usually fiscally responsible countries like the US or the UK, this was too much. The textbook Keynesian solution might have prevented a deeper slump as some economists claim (this we will never know as we cannot prove it), but it also dramatically increased budget deficits and public debt levels (this we can prove - see my discussion <a href="http://im-an-economist.blogspot.hr/2013/10/yes-economics-is-science-but-many.html?showComment=1458652139649#c1381559914586065623">here</a>). Austerity was imposed only after the stimulus and bailout packages (starting in 2010/11), it was not the initial reaction. Many argue that austerity was applied too quickly, before the economies actually recovered, but that too is a discussion for another time. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>The slow recovery is only part of a longer trend of stagnation? </b></div>
<br />
<div style="text-align: justify;">
In order to understand the big picture of why the recovery was so slow, we must look at the trends that have occurred before the crisis. Many claim the stagnation (particularly in productivity and real wages) started long before. The first graph looks at the <b>decline in the growth rate of total factor productivity (TFP) in the US</b>, relative to its 1947-1973 trend. Natural logs are used to emphasize the relative stagnation of TFP. (Btw, the <a href="http://ftalphaville.ft.com/2016/03/11/2155269/productivity-and-innovation-stagnation-past-and-future-an-epic-compendium-of-recent-views/">FT Alphaville blog</a> has assembled in one place all the different hypotheses and ideas on why TFP growth started to decline since the 70s).</div>
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh0dR2n4XPKAF0edZMzGsHWLgjQ4IdM2i7qZuhCPgHJHaXKJdx_2ELTr5GxP1IpLAKmwrLYtZRlMec8Ee5VUBLPlJtyWuEcyWiZyCRnqvA03GIi89Ym3Krg1HygrFLnG7jv-fkTzZ_VzV1c/s1600/TFP_US.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh0dR2n4XPKAF0edZMzGsHWLgjQ4IdM2i7qZuhCPgHJHaXKJdx_2ELTr5GxP1IpLAKmwrLYtZRlMec8Ee5VUBLPlJtyWuEcyWiZyCRnqvA03GIi89Ym3Krg1HygrFLnG7jv-fkTzZ_VzV1c/s400/TFP_US.jpg" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">The quarterly TFP rates for the US from 1947 till 2010. <br />
Graph taken from <a href="http://macromarketmusings.blogspot.co.uk/2011/02/great-stagnation-and-total-factor.html">David Beckworth's blog</a></td></tr>
</tbody></table>
<div style="text-align: justify;">
The second figure depicts a very modest, almost nonexistent, growth of real wages compared to productivity which has, as shown in the previous graph, experienced its own relative slowdown (the reason the graphs are not comparable is that the upper one uses natural logs, whereas in the lower one the second part of the picture only shows the rate of change from 1979 to 2009). Knowing that productivity rise fell short of its trend-based expectations, it is all the more <b>striking to see the relative stagnation of real wages in the past 30-40 years</b>. </div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_xQz8-h7h4ypCthUFmNj3bTH_dlCaztM02qdVdwRtvx8DJivwY0vlFhqp26EsBsqaG3ozrorRghtB1rXSk42bYUhIHTaJcEEVqCYzdKc4rxVnVCi8oFXWUWjFVA8ERAV9GvbK_03LbNvT/s1600/Productivity+and+wages.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="336" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi_xQz8-h7h4ypCthUFmNj3bTH_dlCaztM02qdVdwRtvx8DJivwY0vlFhqp26EsBsqaG3ozrorRghtB1rXSk42bYUhIHTaJcEEVqCYzdKc4rxVnVCi8oFXWUWjFVA8ERAV9GvbK_03LbNvT/s400/Productivity+and+wages.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><a href="http://blog.leyerle.com/2012/03/milking.html">Source</a></td></tr>
</tbody></table>
<div style="text-align: justify;">
In addition, the <b>wage growth was distributed unequally</b>, where the trend for the bottom 90% of income earners was even worse throughout the observed period, not only for the US but for some other developed countries as well (shown here are Australia, Canada, France, Sweden and the UK): </div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiiZz7KUFUjViUw9Ll3oM-9sxZnJHqyj6EULrviei13LWxixFbXJxDYy1wQvsbwBy9W03eENmrZq6BvMrIf4PZplT_MSNrO5C0KIOSSfcewB_LZrc_m0npvs7lgyOu7fXCSpehbSntuLWrU/s1600/productivity-and-income-growth-jpeg.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="191" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiiZz7KUFUjViUw9Ll3oM-9sxZnJHqyj6EULrviei13LWxixFbXJxDYy1wQvsbwBy9W03eENmrZq6BvMrIf4PZplT_MSNrO5C0KIOSSfcewB_LZrc_m0npvs7lgyOu7fXCSpehbSntuLWrU/s400/productivity-and-income-growth-jpeg.jpg" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><a href="https://therationalpessimist.com/2015/01/21/chart-of-the-day-21-jan-2015-summers-secular-stagnation/">Source</a></td></tr>
</tbody></table>
<div style="text-align: justify;">
So what are the structural factors responsible for this 30-year long era of relative stagnation in productivity and real wages? Are these structural factors the same ones disabling our economies from fully recovering from the recent crisis? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Economists came up with several competing hypotheses, each very interesting in its own way. I will present five of them briefly. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>1) The secular stagnation hypothesis</b></div>
<br />
<div style="text-align: justify;">
The first in line is the so-called secular stagnation theory. Its main proponent is <a href="http://larrysummers.com/category/secular-stagnation/">Larry Summers</a>. According to this theory, <i>"economies suffer when higher propensity to save is coupled with a decreasing propensity to invest"</i>. Excessive savings will therefore lower aggregate demand which puts a downward pressure on inflation and on real interest rates (hence the low inflation and low interest rates we are experiencing) and lower economic growth. Furthermore even when high growth is achieved within this several-decade-long stagnation, it was usually a result of excessive borrowing that translates savings into unsustainable investments and causes bubbles.</div>
<br />
<div style="text-align: justify;">
I'm having difficulty in buying this argument given that the data shows a clear trend of <a href="https://fred.stlouisfed.org/series/PSAVERT">declining savings rate</a> in the US for the past 30-40 years before the crisis (see graph below). Besides, a bubble could not have lasted that long. It is true that higher savings was a response to the crisis (as you can also see in the graph), and it's also true that the immediate post-crisis consequence was massive deleveraging of a population overburdened with debt, but it certainly isn't a long term trend.</div>
<br />
<div class="separator" style="clear: both; text-align: center;">
</div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJsVtzpzCAUeWhXaeYOHcd02kBYrDSurOoh_GjNs8YWaUcXj5DLKmTIAhE3EJItBVgml2nUpyFv9dotYRBwH4OFZbabv91n20J_6xiWD-8cQPr4w0kkMvUzg3rsWYjQ_-Jf0y8kP1aE6gD/s1600/US+savings+rate.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="154" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJsVtzpzCAUeWhXaeYOHcd02kBYrDSurOoh_GjNs8YWaUcXj5DLKmTIAhE3EJItBVgml2nUpyFv9dotYRBwH4OFZbabv91n20J_6xiWD-8cQPr4w0kkMvUzg3rsWYjQ_-Jf0y8kP1aE6gD/s400/US+savings+rate.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><a href="https://fred.stlouisfed.org/series/PSAVERT">Source</a></td></tr>
</tbody></table>
<div class="separator" style="clear: both; text-align: center;">
</div>
<div style="text-align: justify;">
Perhaps Summers is referring to <a href="https://fred.stlouisfed.org/series/GSAVE">total gross savings</a>, which has indeed been steadily increasing in the past 40 years, but in this case looking at the absolute value is wrong. Even <a href="https://fred.stlouisfed.org/series/W206RC1A156NBEA">gross savings as percentage of national income</a> have been in a steady decline since the 1980s. To be fair, Summers is perhaps more preoccupied with the <a href="http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/">last couple of years</a> (given that only in the last 7 years have we had historically low real interest rates):</div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>"Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth. This picture fits with much of what we have seen in recent years. Real interest rates are very low, demand has been sluggish, and inflation is low, just as one would expect in the presence of excess saving. Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation."</i></blockquote>
<div style="text-align: justify;">
However, hasn't China had a massive imbalance between savings and investments for the past 30 years? In times when its economic growth rates were in double digits for decades? It was this circumstance in particular that turned <a href="http://im-an-economist.blogspot.co.uk/2011/11/eurozone-crisis-analysis-of-causes-and_12.html">China into the greatest creditor nation in the world</a> (S>I, meaning that EX>IM), while the US became the greatest debtor nation in the world. The US had a much higher propensity to invest than to save, and this imbalance led to a huge current account deficit (just the opposite of above; I>S, mean that IM>EX). The story of trade, unlike what the politicians make you believe, revolves around the relationship between savings and investments; here I fully agree with Summers.<br />
<span agree="" and="" between="" boils="" domestic="" down="" ex="" fully="" here="" i="" imply="" investments="" nbsp="" p="" politicians="" relationship="" savings="" story="" summers.="" that="" the="" think="" to="" trade="" unlike="" what="" with=""><span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words=""><br />
<b>2) The debt accumulation hypothesis </b></span><br />
</span><br />
<div style="text-align: justify;">
<span agree="" and="" between="" boils="" domestic="" down="" ex="" fully="" here="" i="" imply="" investments="" nbsp="" p="" politicians="" relationship="" savings="" story="" summers.="" that="" the="" think="" to="" trade="" unlike="" what="" with=""><span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words="">The next one comes from <a href="http://im-an-economist.blogspot.co.uk/2012/11/reinhart-and-rogoff-on-crisis-and.html">Reinhart and Rogoff</a>. They tend to blame massive debt accumulation. In other words, a period of sustained and bold optimism in which asset prices kept on rising, meaning that both the public and the private sector may borrow indefinitely. This happened not only in the US, but across the spectrum, as many countries ran large current account deficits prior to the crisis. This was particularly problematic in Europe as the desire to eliminate risk through the introduction of the common currency <a href="http://im-an-economist.blogspot.co.uk/p/eurozone-sovereign-debt-crisis.html">encouraged borrowing from abroad</a> where high CA deficits were channeled into consumption rather than investment. What explains the slow recovery is deleveraging - a typical reaction to financial crises caused by an excessive accumulation of debt. In fact, in their excellent book "<i>This Time Is Different</i>" the authors point out that banking crises that arose due to an excessive accumulation of debt <a href="http://im-an-economist.blogspot.co.uk/2011/11/eurozone-crisis-intermezzo.html">always imply a very slow and prolonged recovery</a>, not only for the financial centers but also for the periphery. </span></span><br />
<br />
However this is still a theory focused only on the explanation of the post-crisis stagnation; it doesn't stretch long enough to explain the puzzling decline in productivity and real wages for the past 30 years. So we move on to the next one. <br />
<br />
<b>3) The global savings glut hypothesis </b><br /><br />This famous hypothesis was proposed by Ben Bernanke, the former Fed chairmen, <a href="http://www.federalreserve.gov/boardDocs/Speeches/2005/200503102/default.htm">back in 2005</a>. According to Bernanke reducing a financial surplus (households pushing savings) or running large deficits (governments or households financing consumption) will result in a (potentially decade-long) boom on the asset market. Bringing this up on an international level, financial surpluses from Asian households and governments were translated into investments and consumption in the West. The analogous story can be told in <a href="http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html">Europe</a>: the 'interaction' between the savings in the "core" and the deficits in the "periphery". </div>
<span agree="" and="" between="" boils="" domestic="" down="" ex="" fully="" here="" i="" imply="" investments="" nbsp="" p="" politicians="" relationship="" savings="" story="" summers.="" that="" the="" think="" to="" trade="" unlike="" what="" with=""><span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words="">
</span></span>
<div style="font-style: italic; text-align: justify;">
<span agree="" and="" between="" boils="" domestic="" down="" ex="" fully="" here="" i="" imply="" investments="" nbsp="" p="" politicians="" relationship="" savings="" story="" summers.="" that="" the="" think="" to="" trade="" unlike="" what="" with=""><span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words=""><br /></span></span></div>
<span agree="" and="" between="" boils="" domestic="" down="" ex="" fully="" here="" i="" imply="" investments="" nbsp="" p="" politicians="" relationship="" savings="" story="" summers.="" that="" the="" think="" to="" trade="" unlike="" what="" with=""><span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words="">
<div style="text-align: justify;">
In essence this hypothesis also begins with the period of low interest rates that reflected higher world savings. I wrote about it in my 2011 paper <a href="http://www.ijf.hr/eng/FTP/2011/1/vukovic.pdf">"The Political Economy of the US Financial Crisis"</a>: "There was strong demand for
safe assets from Asian and oil exporting countries that contributed to depress the
yield on long term government securities issued by advanced economies, the US
in particular. A low US savings rate also contributed in steering assets from current
account surplus countries into financing US investments and consumption.
However, capital inflows were used to finance current consumption rather than
investment into productive assets. The US current account deficit started to grow
uncontrollably by the end of 1998 and reached its highest level around 2006, while
at the same time oil exporting countries and emerging Asian countries experienced
high surpluses in their current accounts. This period is matched by
the likewise high growth in the US housing market. There is no proof that the
current account deficit itself caused the housing boom, but there is evidence that
the inflow of foreign capital was mainly used at the time being for the purchase of
real-estate, adding to the housing bubble. Excess savings in Asia were being invested
into safe assets such as US government securities, which contributed to a
high level of capital inflows into the US. High inflows into the US brought about
excessive risk taking and exposed domestic financial institutions, companies and
households to exchange rate risk. Pushing excess savings towards assets increases
the demand for these assets which resulted in an appreciation of asset prices. This
put additional pressure on demand as well as on total output. An inflow of foreign
savings, combined with low interest rates and expectations of constantly increasing
asset prices resulted in the creation of an asset bubble in both houses and
securities. An increasing demand for assets motivated the financial market in developing
new instruments and securities (derivatives) whose main purpose was to
diversify risks." </div>
<br />
<b>4) The long-run decline in growth hypothesis </b><br />
<br />
<div style="text-align: justify;">
The most recent hypothesis, attributed to economist <a href="https://www.ted.com/talks/robert_gordon_the_death_of_innovation_the_end_of_growth">Robert Gordon</a>, does go back long enough to explain the fundamental decline in the total factor productivity growth. In fact, that's what the theory is all about. In his bestselling new book <a href="http://press.princeton.edu/titles/10544.html">"The Rise and Fall of American Growth"</a>, Gordon paints a very pessimistic picture of an exhausted american growth model. He claims that all the life-altering innovations of the past (in particular from 1870 to 1970) will not be repeated in the future, meaning that our TFP as well as our economic growth rates may go down even more (he makes a prediction of long-run economic growth to fall down to only 0.2% - see graph below). Some of reasons of why this could be so (the so called 'headwinds' the economy is facing) are the rising inequality, an ageing population, poor education, and rising debt levels. In brief, Gordon's view is that the technological revolution will not increase our living standards. I personally disagree with this assessment, as I find it unnecessarily pessimistic. I will challenge it thoroughly in my next blog post.<br />
<div style="font-style: italic;">
<br /></div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="font-style: italic; margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgK6QJ0doitSfO7UhA_lSOmXMLph91sN_qdoIUdAVuawGC0TZ7Lk9VcYmO14kLlO7qP7zlU3B3ix-G239VnJqDSJlfE-rstW-DXgdnsbYYdx7JMg2TV0JP26V-DDl6xdGIpgGJ3tVMXEjY5/s1600/Gordon_graph.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgK6QJ0doitSfO7UhA_lSOmXMLph91sN_qdoIUdAVuawGC0TZ7Lk9VcYmO14kLlO7qP7zlU3B3ix-G239VnJqDSJlfE-rstW-DXgdnsbYYdx7JMg2TV0JP26V-DDl6xdGIpgGJ3tVMXEjY5/s400/Gordon_graph.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><span style="font-style: normal;"><a href="https://itdoesnotaddup.com/category/robert-gordon/">Robert Gordon's</a> projection of average growth until 2100.</span></td></tr>
</tbody></table>
</div>
<div style="text-align: justify;">
What about the origin of the current stagnation? According to Gordon it was a mere exhaustion of innovation. None of the stuff produced in the late 20th and at the beginning of the 21st century (like the Internet, or iPhones, or Google and Facebook) can match themselves to the benefits given to our societies during the late 19th and 20th century - things like electricity, cars, penicillin, running water in homes, the telephone, etc. Many of the 'headwinds' such as the rise of inequality, the ageing of the baby boomers, or rising debt levels are attributed to this very problematic feature and are, according to Gordon, responsible for the relative decline as well as for the even worse future rates of growth. So the current stagnation is a mere beginning of a long trend of close to zero economic growth given that we will fail to emulate the technological breakthroughs of the 20th century. A truly depressing outlook. </div>
<div style="text-align: justify;">
<br /></div>
<b>5) The 'low-hanging fruit' hypothesis</b><br />
<br />
Finally, Tyler Cowen in his great book <a href="https://en.wikipedia.org/wiki/The_Great_Stagnation">"The Great Stagnation"</a> argues that the US simply ran out of low-hanging fruits which fueled american growth from the late 19th century onward. He makes an interesting claim that these low-hanging fruits brought the country to its current technological plateau and now it's stuck here for a while before a next major revolution happens. </span></span></div>
<div style="text-align: justify;">
<span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words=""><br /></span></div>
<div style="text-align: justify;">
<span ex="" exactly="" hypothesis.="" in="" nbsp="" of="" opposite="" other="" p="" secular="" stagnation="" the="" therefore="" words="">So w</span>hat are these low-hanging fruits the US had and has by now exhausted? Cowen cites the three most important ones: free land and abundant resources (particularly in the late 19th and early 20th century as it attracted many talented Europeans to enjoy the relative abundance); technological breakthroughs from the 1880s to the 1970s (the same ones Gordon mentions: electricity, motors, cars, planes, telephone, plumbing, pharmaceuticals, mass production, radio,TV, etc.), and last but not least smart, uneducated kids (a vast amount of people that educated themselves and massively contributed to economic growth).</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
All of this is gone now. Moving a student from high school to college today will only reap marginal returns at high costs. Moving a child from a farm to high school back then significantly increased its skill-set and thus opened up room for innovation. This innovation came in the form of massive technological improvements which all greatly increased our living standards; not only in terms of faster transportation or handy appliances - it also significantly improved our health and increased life expectancy. No modern-day innovation can improve our living standards that significantly nor can it expand our life expectancy to a 100 years. The Internet, social networks, search engines and smartphones are all cool and useful stuff, but their impact on our living standards is not even comparable to that of electricity, engines, conveyor belt production, or pharmaceuticals. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Yet! We have no idea how the Internet will change our life in the future and what opportunities the current technological plateau will open up for us. Remember, we are in the midst of the Third Industrial Revolution - the IT Revolution. It's benefits won't be obvious to us quite yet. My hypothesis is that the IT Revolution is at the heart of the current stagnation. I will defend this argument in more depth in the next post. </div>
<div style="text-align: justify;">
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-44824112077294644182016-11-10T18:00:00.000+00:002016-11-11T17:24:58.490+00:00We called it! How we predicted a Trump victory with amazing precision<div style="text-align: justify;">
First of all apologies to my regular readers for not presenting our results here sooner. It's been overwhelming in the past two days - first with the prediction, then with the results, and then with the post-election frenzy. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Anyway, we gave an <a href="http://oraclum.eu/election-2016-final-prediction/">almost perfect prediction</a>! Not just a Trump victory, but also all the key swing states (PA, FL, NC, OH), and even that Hillary could get more votes but lose the electoral college vote.<br />
<br />
Here are our results as I presented them in a Facebook post on the eve of the election:</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<iframe allowtransparency="true" frameborder="0" height="727" scrolling="no" src="https://www.facebook.com/plugins/post.php?href=https%3A%2F%2Fwww.facebook.com%2Fvuk.vukovic.msc%2Fposts%2F10153899593592601&width=500" style="border: none; overflow: hidden;" width="500"></iframe></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For a more detailed explanation <a href="http://oraclum.eu/election-2016-final-prediction/">read our blog</a>. The method is described there in greater detail, plus we call all the states.<br />
<br />
The story got covered first by the academic sources. My own University of Oxford published it as part of their <a href="https://medium.com/@Oxford_University/us-election-2016-views-from-oxford-6e3c1387086c#.k5bz437gv">main election coverage</a>, as did my alma mater, LSE on their <a href="http://blogs.lse.ac.uk/europpblog/2016/11/11/how-a-small-cambridge-based-startup-correctly-predicted-a-trump-victory/">EUROPP blog</a>.<br />
<br />
<iframe allowtransparency="true" frameborder="0" height="502" scrolling="no" src="https://www.facebook.com/plugins/post.php?href=https%3A%2F%2Fwww.facebook.com%2Fpermalink.php%3Fstory_fbid%3D1165932226776036%26id%3D150984984937437&width=500" style="border: none; overflow: hidden;" width="500"></iframe><br />
<br />
<iframe allowtransparency="true" frameborder="0" height="559" scrolling="no" src="https://www.facebook.com/plugins/post.php?href=https%3A%2F%2Fwww.facebook.com%2Feuroppblog%2Fposts%2F1013786098750342&width=500" style="border: none; overflow: hidden;" width="500"></iframe><br />
<br />
More news coverage soon to come!</div>
<div style="text-align: justify;">
<br />
<br /></div>
<div style="text-align: justify;">
<b>Details of our prediction </b><br />
<br /></div>
<div style="text-align: justify;">
The results nevertheless came as an absolute shock to many, but it was the pollsters that took the biggest hit. All the major poll-based forecasts, a lot of models, the prediction markets, even the superforecaster crowd all got it wrong (we have summarized their predictions <a href="http://oraclum.eu/election-2016-others-saying/">here</a>). They estimated high probabilities for a Clinton victory, even though <a href="http://fivethirtyeight.com/features/final-election-update-theres-a-wide-range-of-outcomes-and-most-of-them-come-up-clinton/">some were more careful</a> than others in claiming that the race will be very tight. </div>
<div style="text-align: justify;">
<br />
Our prediction survey, on the other hand, was <a href="http://oraclum.eu/election-2016-final-prediction/">spot on</a>! We (by that I mean <a href="http://www.oraclum.co.uk/">Oraclum Intelligence Systems</a>) <b>predicted a Trump victory, and we called all the major swing states in his favour</b>: Pennsylvania (which no single pollster gave to him), Florida, North Carolina, and Ohio. We gave Virginia, Nevada, Colorado, and New Mexico to Clinton, along with the usual Red states and Blue states to each. We only missed three – New Hampshire, Michigan, and Wisconsin (although for Wisconsin we didn’t have enough survey respondents to make our own prediction so we had to use the average of polls instead). Therefore the only misses of our method were actually Michigan, where it gave Clinton a 0.5 point lead, and New Hampshire where it gave Trump a 1 point lead. Every other state, although close, we called right. For example in Florida we estimated 49.9% to Trump vs. 47.3% to Clinton. In the end it was 49.1 to 47.7. In Pennsylvania we have 48.2% to Trump vs. 46.7 for Clinton (it was 48.8. to 47.6. in the end). In North Carolina our method said 51% to Trump vs. 43.5% for Clinton (Clinton got a bit more, 46.7, but Trump was spot on at 50.5%). <b>Our model even gave Clinton a higher chance to win the overall vote share than the electoral vote</b>, which also proved to be correct. Overall for each state, on average, we were right within a single percentage point margin. Read the full prediction <a href="http://oraclum.eu/election-2016-final-prediction/">here</a>.</div>
<div style="text-align: justify;">
<br />
<div style="text-align: justify;">
It was a big risk to ‘swim against the current’ with our prediction, particularly in the US where the major predictors and pollsters were always so good at making correct forecasts. But we were convinced that the method was correct even though it offered, at first glance, very surprising results.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Read more about the method <a href="http://oraclum.eu/will-next-us-president-forecasting-election2016/">here</a>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>The graphics</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Here is our final map:</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_h9K8T-Ko9Ea3MjmCneIXFZkRlUk1zR-4gCchrL_W6Xj04a1oG806iecjbCuXQmBd58tlmlWKamxtyCXEg1hI-Q4tY_mrgrZojFtRg_5qc9agqDk8s_7lFk_E2j1vqLzDITWAUmt6zRaV/s1600/FinalMap_large.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="302" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_h9K8T-Ko9Ea3MjmCneIXFZkRlUk1zR-4gCchrL_W6Xj04a1oG806iecjbCuXQmBd58tlmlWKamxtyCXEg1hI-Q4tY_mrgrZojFtRg_5qc9agqDk8s_7lFk_E2j1vqLzDITWAUmt6zRaV/s400/FinalMap_large.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For the swing states:</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOeIJTi0zSDGc46oupKfym2JyHa7zb6P0uSDrSaI3yxol-ko_ff46kyrsYEtVgcBwrgLeGWGjekopd2dbfVhlJ6O6YGuYl-_PNHsCgnfyBWShVsrvb9wS-TR4c6wGeVLLtIeqG3ZFjcRAI/s1600/Final-result-swing-states+%25281%2529.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="126" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOeIJTi0zSDGc46oupKfym2JyHa7zb6P0uSDrSaI3yxol-ko_ff46kyrsYEtVgcBwrgLeGWGjekopd2dbfVhlJ6O6YGuYl-_PNHsCgnfyBWShVsrvb9wS-TR4c6wGeVLLtIeqG3ZFjcRAI/s400/Final-result-swing-states+%25281%2529.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And here are the actual results (courtesy of <a href="http://270towin.com/">270towin.com</a>):</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglxVwy7yLvEC46gQghRyeb5mALN3UwKEQ7shx6TbiKhRKhda_VcVqKzAwyOSHyVER31RiAOLE_P7mongmCI9pmOMJvs25f2XUvzZasyXbwaEkMYRLoS-vbsza7DbYtyZR92MkLzBx4Tx-o/s1600/USelection16_results+map.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="255" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglxVwy7yLvEC46gQghRyeb5mALN3UwKEQ7shx6TbiKhRKhda_VcVqKzAwyOSHyVER31RiAOLE_P7mongmCI9pmOMJvs25f2XUvzZasyXbwaEkMYRLoS-vbsza7DbYtyZR92MkLzBx4Tx-o/s400/USelection16_results+map.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Pretty good, right? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Here is, btw, what the other poll-based forecasters were saying (more on that <a href="http://oraclum.eu/election-2016-others-saying/">here</a>):</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimfFr-mKZqXzXJlouVYe3cBuX0_ptixwt5xBoeIizDa-JSjSGvSmkQGIQ7Vd2VkVyeal4wlVKgeADl46hyphenhyphenY6BzknNis0tB_FDezrKcOudovPR7YH-sigaxf0BAaQF-DKM9VBCpQmrGJv6w/s1600/Chances+table_0811.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="156" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimfFr-mKZqXzXJlouVYe3cBuX0_ptixwt5xBoeIizDa-JSjSGvSmkQGIQ7Vd2VkVyeal4wlVKgeADl46hyphenhyphenY6BzknNis0tB_FDezrKcOudovPR7YH-sigaxf0BAaQF-DKM9VBCpQmrGJv6w/s400/Chances+table_0811.png" width="400" /></a></div>
<div class="separator" style="clear: both; text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: justify;">
In addition to these <a href="http://oraclum.eu/election-2016-others-saying/">other forecasters we were tracking</a> were even more confident in Hillary taking all the key states. As you can see no one gave PA to Trump, some were more careful about FL and NC, although they too were mostly expected to go to Hillary. However the reason I think PA was key in this election is because everyone thought Hillary's victory was certain there. Not to mention the shocks of losing MI and WI as well. If Hillary got these three states, even by losing the toss-up FL and NC, she would have won (278 EV). This is why, I believe, all the forecasters were so certain (some more than others) that Hillary will pull it off. Holding on to what was supposed to be her strongholds (all three states were last Red under Reagan in 1984) was to be enough for victory. Trump dominated the Rust Belt. Which is why I think this election was a good example of an economic vote. But more on that in another post. </div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-78805991389557897662016-11-03T23:50:00.003+00:002016-11-03T23:50:53.112+00:00New Scientist: "As US election looms, time is ripe for a new science of polling"My article got <a href="https://www.newscientist.com/article/2111298-as-us-election-looms-time-is-ripe-for-a-new-science-of-polling/">published today</a> at the <a href="https://www.newscientist.com/">New Scientist</a>! One of the biggest science magazines in the world.<br />
<br />
See the text <a href="https://www.newscientist.com/article/2111298-as-us-election-looms-time-is-ripe-for-a-new-science-of-polling/">here</a> (<i>there is no paywall, you just register and read it for free</i>). It was even on the front page:<br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7Ip5_oi6wpnwWm_h3US9elR6xbi8wVvwou6VfDZx5wOsMTa2NZCin44QsRGM5SbTaPCXTG5kbgKEvMFHtHLM6dCM130PFKr0W22iy1xU7AsFbgUlTkCe4gV4UlsxB-Jin2Mh5bhvD6Q0u/s1600/newscientistcoveer.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="265" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7Ip5_oi6wpnwWm_h3US9elR6xbi8wVvwou6VfDZx5wOsMTa2NZCin44QsRGM5SbTaPCXTG5kbgKEvMFHtHLM6dCM130PFKr0W22iy1xU7AsFbgUlTkCe4gV4UlsxB-Jin2Mh5bhvD6Q0u/s400/newscientistcoveer.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><a href="https://www.newscientist.com/">New Scientist website front page 03 Nov 2106</a></td></tr>
</tbody></table>
<div style="text-align: justify;">
The text is about the scientific experiment behind <a href="http://im-an-economist.blogspot.co.uk/2016/10/predicting-2016-us-presidential-election.html">our prediction survey</a>. It starts by examining why the pollsters are getting it wrong lately and whether or not there is any science at all behind polling. Then it introduces our prediction survey idea and how we're doing an experiment on US elections to see whether or not science can actually improve polling. </div>
<br />
For those who don't bother to register in order to read it on the New Scientist webpage, I have copied the text here (enjoy!):<br />
<br /><h2>
<b>As US election looms, time is ripe for a new science of polling</b></h2>
<br /><b>"Growing scepticism about traditional methods for predicting election outcomes is fuelling a search for a more scientific approach to polling, says Vuk Vukovic</b><br /><br /><div style="text-align: justify;">
As the US prepares to vote for its new president next week, narrowing political polls have suggested that this crucial election may be too close to call.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Although such polls are hugely influential – affecting <a href="http://www.bbc.co.uk/news/live/election-us-2016-37825671">financial markets, for example</a> – it is becoming clear that we should not set too much store by them. Their reliability is increasingly doubted in the wake of polls that got it wrong on big occasions, such as those relating to the <a href="https://www.theguardian.com/politics/2016/jan/19/general-election-opinion-poll-failure-down-to-not-reaching-tory-voters">UK’s 2015 general election</a> and <a href="https://www.theguardian.com/politics/2016/jun/24/how-eu-referendum-pollsters-wrong-opinion-predict-close">Brexit vote</a>, and <a href="http://fivethirtyeight.com/features/how-i-acted-like-a-pundit-and-screwed-up-on-donald-trump/">Donald Trump</a> securing the Republican party nomination in the US.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Why might that be? These days, pollsters find it harder to get responses by calling voters on their home phones. A typical telephone survey now has a response rate of <a href="http://www.people-press.org/2012/05/15/assessing-the-representativeness-of-public-opinion-surveys/">below 9 per cent</a>, with fewer willing interviewees making the polls less likely to be representative of the wider voter population and, hence, less precise and reliable.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Telephone polls are usually carried out during the day, biasing the results towards stay-at-home parents, retirees and the unemployed. Most people, for some reason, do not respond to cellphone surveys as eagerly as they once did to those by landline.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<a href="https://www.washingtonpost.com/news/the-fix/wp/2016/05/02/has-someone-cracked-the-code-on-making-internet-polls-more-accurate/">Online polls</a> have their own weaknesses: they tend to be <a href="http://whatukthinks.org/eu/are-phone-polls-more-accurate-than-internet-polls-in-the-eu-referendum/">biased</a> towards particular voter groups, such as the young, better-educated and urban dwellers.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In both types of survey, pollsters try to <a href="http://ukpollingreport.co.uk/blog/archives/9738">compensate for biases</a>, but the results of doing so can be dubious – <a href="http://www.nytimes.com/glogin?URI=http%3A%2F%2Fwww.nytimes.com%2Finteractive%2F2016%2F09%2F20%2Fupshot%2Fthe-error-the-polling-world-rarely-talks-about.html%3F_r%3D3">as shown</a>when four different pollsters gave four different results for the key swing state of Florida in the current US campaign based on the same data set. Furthermore, a <a href="http://www.nytimes.com/glogin?URI=http%3A%2F%2Fwww.nytimes.com%2F2016%2F10%2F06%2Fupshot%2Fwhen-you-hear-the-margin-of-error-is-plus-or-minus-3-percent-think-7-instead.html%3F_r%3D3">recent study showed</a> that the actual margin of error of a poll’s finding is about 7 per cent, instead of the typically reported 3 per cent. Not surprisingly, <a href="http://www.acsh.org/news/2016/10/19/polls-are-not-rigged-they-also-arent-scientific-10329">some critics argue</a> that opinion polls are more art than science.</div>
<div style="text-align: justify;">
Turning to science</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Putting polling back on a scientific footing will require experiments in the coming years, combining insights from various branches of sociology, economics, mathematics of networks and statistics.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I am one of a group of researchers at Oraclum, a <a href="http://oraclum.eu/">start-up based</a> in Cambridge, UK, involved in <a href="https://election2016.oraclum.co.uk/">conducting precisely this type of experiment</a>. Our new kind of poll is conducted online, meaning we have to make election predictions from unrepresentative and biased samples of voters.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
However, <a href="http://oraclum.eu/will-next-us-president-forecasting-election2016/">we have added a twist</a> that we hope will improve its power to predict an election outcome, in that we go beyond asking people who they will vote for. We also ask who they think will win and their view on who other people think will win. The idea is to incorporate wider influences, including peer groups, that shape an individual’s choice on voting day.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Why might this work? When people make choices, such as in elections, they usually succumb to their standard ideological preference. However, they also weigh up the chance that their favoured choice has. In other words, they think about <a href="http://www.huffingtonpost.ca/ali-kashani/strategic-voting-justin-trudeau_b_8351796.html">how other people will vote</a>. This is why people sometimes vote strategically and do not always pick their first choice, but can opt for the second or third to prevent their least-preferred option from winning.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It is going to take a fair few experiments to answer the question of whether contemporary polling can be considered scientific.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And though the current US election is widely condemned for its negative atmosphere, it provides a good chance for a new science of polling to begin to take shape.</div>
<i><br />If you are a US voter, you can help Oraclum test its polling method by <a href="https://election2016.oraclum.co.uk/">participating in its survey</a> and sharing it with your friends."</i><br /><br /><b>Vuk Vukovic is a researcher at Oraclum and a PhD student at the University of Oxford</b>Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-38856326015852420032016-10-27T22:06:00.001+01:002016-10-27T22:06:30.875+01:00Predicting the 2016 US Presidential election<div style="text-align: justify;">
<b>Is it possible to have a more accurate prediction by asking people how confident they are that their preferred choice will win?</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
One consequence of this hectic election season has been that people have stopped trusting the polls as much as they did before. Which is surprising given that in the US, unlike the rest of Europe, pollsters and particularly polling aggregation sites (like <a href="http://fivethirtyeight.com/">FiveThirtyEight</a>) have on aggregate been quite accurate in their predictions thus far. Still, one cannot escape the overall feeling that pollsters are losing their reputation, as they are often being accused of complacency, sampling errors, and even deliberate manipulations.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
There are legitimate reasons for this however. With the rise of <a href="https://www.washingtonpost.com/news/the-fix/wp/2016/05/02/has-someone-cracked-the-code-on-making-internet-polls-more-accurate/">online polls</a>, proper sampling can be extremely difficult. Online polls are based on self-selection of the respondents, making them non-random and hence <a href="http://whatukthinks.org/eu/are-phone-polls-more-accurate-than-internet-polls-in-the-eu-referendum/">biased</a> towards a particular voter group (young, better educated, urban population, etc.), despite the efforts of those behind these polls to adjust them for various socio-demographic biases. On the other hand, the potential sample for <a href="http://www.nytimes.com/2015/11/28/upshot/online-polls-are-rising-so-are-concerns-about-their-results.html">traditional telephone</a> (live interview) polls is in sharp decline, making them less and less reliable. Telephone interviews are usually done during the day biasing the results towards stay-at-home moms, retirees, and the unemployed, while most people, for some reason, do not respond to mobile phone surveys as eagerly as they once did to landline surveys. With all this uncertainty it is hard to gauge which poll(ster) should we trust and to judge the quality of different prediction methods.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
However, what if the answer to ‘what is the best prediction method’ lies in asking people not only who they will vote for, but also who they think will win (as ‘citizen forecasters’) and more importantly, how they feel about who other people think will win? Sounds convoluted? It is actually quite simple.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
There are a number of scientific methods out there that aim to uncover how people form opinions and make choices. Elections are just one of the many choices people make. When deciding who to vote for, people usually succumb to their standard ideological or otherwise embedded preferences. However, they also carry an internal signal which tells them how much chance their preferred choice has. In other words, they think about how other people will vote. This is why people tend to vote strategically and do not always pick their first choice, but opt for the second or third, only to prevent their least preferred option from winning.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
When pollsters make surveys they are only interested in figuring out the present state of the people’s ideological preferences. They have no idea on why someone made the choice they made. And if the polling results are close, the standard saying is: “the undecided will decide the election”. What if we could figure out how the undecided will vote, even if we do not know their ideological preferences?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
One such method, focused on uncovering how people think about elections, is the <a href="https://election2016.oraclum.co.uk/">Bayesian Adjusted Social Network (BASON) Survey</a>. The BASON method is first and foremost an Internet poll. It uses the social networks between friends on Facebook and followers and followees on Twitter to conduct a survey among them. The survey asks the participants to express: 1) their vote preference (e.g. Trump or Clinton); 2) how much do they think their preferred candidate will get (in percentages); and 3) how they think other people will estimate that Trump or Clinton will get.</div>
<div style="text-align: justify;">
<br /></div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiNf0SFjs35wzRYTdwXqCNVMb7M3E15c-Bhyphenhyphen8kWUsp4pFc83H0ETXLbM14xH_-P1PY3IPe5mYjIS5ZQcdNkdZMXita7hepgz_ZJre6Uenp2oClteHDjRtk-60WVeHbP7A5cShyphenhyphenjRln9usKy/s1600/Map+of+current+predictions.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="251" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiNf0SFjs35wzRYTdwXqCNVMb7M3E15c-Bhyphenhyphen8kWUsp4pFc83H0ETXLbM14xH_-P1PY3IPe5mYjIS5ZQcdNkdZMXita7hepgz_ZJre6Uenp2oClteHDjRtk-60WVeHbP7A5cShyphenhyphenjRln9usKy/s400/Map+of+current+predictions.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><a href="https://election2016.oraclum.co.uk/" style="font-size: 12.8px;">BASON Survey for the 2016 US Presidential elections</a><br />(temporary results for states in which predictions have been made by our users)</td></tr>
</tbody></table>
<div style="text-align: justify;">
Let’s clarify the logic behind this. Each individual holds some prior knowledge as to what he or she thinks the final outcome will be. This knowledge can be based on current polls, or drawn from the information held by their friends and people they find more informed about politics. Based on this it is possible to draw upon the wisdom of crowds where one searches for informed individuals thus bypassing the necessity of having to compile a representative sample.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
However, what if the crowd is systematically biased? For example, many in the UK believed that the 2015 election would yield a hung parliament. In other words, information from the polls is creating a distorted perception of reality which is returned back to the crowd biasing their internal perception. To overcome this, we need to see how much individuals within the crowd are diverging from the opinion polls, but also from their internal networks of friends.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Depending on how well they estimate the prediction possibilities of their preferred choices (compared to what the polls are saying), the BASON formulates their predictive power and gives a higher weight to the better predictors. For example, if the polls are predicting a 52%-48% outcome in a given state, a person estimating that one candidate will get, say, 90% is given an insignificant weight. Group predictions can be completely wrong of course, as closed groups tend to suffer from confirmation bias. On the aggregate however, there is a way to get the most out of people’s individual opinions, no matter how internally biased they are. The Internet makes all of them easily accessible for these kinds of experiments, even if the sampling is non-random. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<a href="http://www.oraclum.co.uk/">Oraclum</a> is currently <a href="https://election2016.oraclum.co.uk/">conducting the survey</a> across the United States. Forecasts are updated daily with the final one being shown on Election Day. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>So if you think you know politics, and that you do not live in a bubble where everyone around you thinks the same way, <a href="https://election2016.oraclum.co.uk/">log into our app</a> through Facebook or Twitter, give your prediction, and attain bragging rights among your friends on November 8th. Don’t forget to share and remember: if it’s not on Facebook or Twitter, it didn’t happen!</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<div>
<blockquote class="twitter-tweet" data-lang="en">
<div dir="ltr" lang="en">
Our <a href="https://twitter.com/hashtag/BASONsurvey?src=hash">#BASONsurvey</a> is up and running <a href="https://t.co/nmYCRS0RFF">https://t.co/nmYCRS0RFF</a> Make your prediction now, attain bragging rights later! <a href="https://twitter.com/hashtag/Election2016?src=hash">#Election2016</a></div>
— Oraclum (@Oraclum_UK) <a href="https://twitter.com/Oraclum_UK/status/789179717341421569">October 20, 2016</a></blockquote>
</div>
<div>
<script async="" charset="utf-8" src="//platform.twitter.com/widgets.js"></script></div>
<div>
<br /></div>
<div>
<iframe allowtransparency="true" frameborder="0" height="577" scrolling="no" src="https://www.facebook.com/plugins/post.php?href=https%3A%2F%2Fwww.facebook.com%2Foraclumintelligencesystems%2Fposts%2F272511659810347&width=500" style="border: none; overflow: hidden;" width="500"></iframe></div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-64436345709581418992016-10-20T22:04:00.001+01:002016-10-20T22:04:49.148+01:00The trade-off between equality and efficiency reexamined<div style="text-align: justify;">
After having read and reviewed Stiglitz's book <a href="http://im-an-economist.blogspot.co.uk/2016/10/what-ive-been-reading-vol-11-aktinson.html">earlier this week</a>, and after having written the following paragraph...</div>
<div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<div style="text-align: justify;">
<i>"I too have long considered the relationship between equality and efficiency to be non-linear, instead of just a simple trade-off. Too much equality isn’t good since it reduces incentives, but neither is too much inequality. I would say the relationship is of an inverted-U type where moving to both extremes – too much and too little equality is bad for the economy. The trick is to find an optimal point which reduces the level of inequality where it offers more opportunities for everyone, but also just enough for it to continue to drive incentives. More on that in my next blog post."</i></div>
</blockquote>
<div style="text-align: justify;">
...I just had to dig deeper into the whole <b>equality-efficiency trade-off</b>. So I picked up a seminal book from a man who specialized in economic trade-offs, none other than - <a href="http://www.econlib.org/library/Enc/bios/Okun.html">Arthur Okun</a>! Okun is more famous for his <a href="https://en.wikipedia.org/wiki/Okun%27s_law">"law"</a> stipulating the linear relationship (read: trade-off) between GDP and unemployment, where every 1% increase in the rate of unemployment corresponds to a 2% decline of GDP. But today I will not be examining this supposed relationship from the 60s, but a more contemporary one (proposed in the 1970s), claiming that there is a similar linear relationship between equality and efficiency, all summarized in the following book:</div>
</div>
<br />
<div style="text-align: justify;">
<b>Okun, Arthur (1975) <i>Equality and Efficiency. The Big Tradeoff</i>. Brookings Institution, Washington, DC. </b><i>(this would now be vol. 12 of the <a href="http://im-an-economist.blogspot.co.uk/search/label/Book%20review">What I've been reading</a> section)</i></div>
<div style="text-align: justify;">
<i><br /></i></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<span lang="EN-US">Okun's book, published
in 1975, testifies of this relationship where greater economic equality
necessarily to some extent implies lower efficiency of the economy. In other
words, <b>lowering inequality comes at a cost of lowering efficiency</b>. He develops
a very interesting argument in which he acknowledges this trade-off, but
also proposes a set of policy interventions that would increase both efficiency
and equality – such as policies aimed at attacking inequality of opportunity,
like racial and sexual discrimination in the workplace (which were arguably
even greater back in the 1970s than today) and barriers of access to capital.
So in a way even though he implies a linear relationship between equality and
efficiency, where one is necessarily sacrificed in terms of another, he clearly
sees that when inequality is too high, it can also act as an impediment on efficiency.
Okun emphasizes on several occasions that he is a stern believer in the market
system, but also that some rights (like the right to vote) should not be bought
and sold for money. In other words, he believes in the enormous efficiency of
the market system (he devotes an entire chapter emphasizing the benefits of the
“mixed” economy model vs the socialist economic model), but is also concerned with the moral implications of why some of our basic human rights cannot have a price tag
attached to them. The reason why is very
eloquently summarized in following sentences: <i>“Everyone
but an economist knows without asking why money shouldn’t buy some things. But
an economist has to ask that question”</i>. Hence the first chapter. <o:p></o:p></span></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<br /></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<span lang="EN-US">It is in this book that
he also uses his famous <b>“leaky bucket” metaphor</b> to emphasize the inequality-efficiency
trade-off. Here’s a brief explanation: say you want to tax the richest families
for a certain amount of money (e.g. $4000 per family) and then redistribute this
money to the poor so that each poor family gets $1000 (the ratio of poor to
rich is assumed to be 4:1). Now imagine you are carrying all this money you
took from the rich in a leaky bucket, so that each poor family will necessarily
receive less than a $1000. What’s the cutoff value of money the poor would
receive for you to consider the transfer efficient? There is basically no wrong
answer here – it depends on your preferences for redistribution. Some people
would accept 10 or 20%, some 60% (like the author), some almost 99%. The point
that the leaky bucket experiment is trying to make is that each redistributive
action will necessarily come at some cost in efficiency. But we as a society
must accept this in order to lower economic deprivation that not only hurts the
economy, but it can also infringe on our principles of democracy. <o:p></o:p></span></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<br /></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<span lang="EN-US">Okun devotes a
considerable amount of attention to the problem of <b>too much power in the hands
of certain interest groups</b> and how they might use it to bias the budget (and much more) in
their direction. He cites oil producers, farmers, teachers, union workers, gun lobbies,
you name it. Specifying the intensity of their preferences through money is a perfectly
legitimate manifestation of their democratic right to fight for their interests.
However by doing so they necessarily channel public resources to the hands of the
few, at the expense of an unorganized majority which lacks enough interest to engage
(just as <a href="http://im-an-economist.blogspot.co.uk/2013/09/why-politicians-dont-cut-spending.html">Mancur Olson</a> taught us). <o:p></o:p></span></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<br /></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<span lang="EN-US">What fascinates me is
that this discussion seems so contemporary, yet Okun wrote it back in 1975!
Furthermore, he lays out other facts about 1975, where he complains about the
“unacceptably” high levels of wealth and income inequality: <i>“The richest 1 percent of American families
have about one-third of the wealth, while they receive about 6 percent of
after-tax income.”</i> Today that figure is much higher – it is about 18% of
total income. In the books on inequality <a href="http://im-an-economist.blogspot.co.uk/2016/10/what-ive-been-reading-vol-11-aktinson.html">I’ve read so far</a>, the 1970s were the
golden age! But according to Okun, it was still too high. Even in the decade when top income tax rates were
75%, America still had the inequality problem. <o:p></o:p></span></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<br /></div>
<div style="margin-bottom: .0001pt; margin: 0cm; text-align: justify;">
<span lang="EN-US">This can only confirm
Okun’s hypothesis that the US has always sacrificed equality for efficiency.
Inequality in the US has been and probably always will be higher than in Europe
– but that is precisely because of the innovation-driven, trial-and-error,
cut-throat capitalism of the US versus the welfare-state, cuddly capitalism of
Europe. And that's fine. But the fact is that inequality in neither of these
has to be this high. Hence the final chapter where he proposes a set of
standard policy measures (some of them quite good, focusing equality of
opportunity) designed to combat the “alarmingly” high inequality of the 1970s
(sic!), without sacrificing efficiency. </span></div>
<br />
<b>Building up on Okun: The trade-off reexamined</b><br />
<br />
<div style="text-align: justify;">
Following in that direction, I consider the given relationship to be an <b>inverted U-shaped curve, with higher levels of inequality corresponding to lower levels of efficiency</b> (and hence GDP/income per capita growth), <b>and vice versa - too much equality implies a lack of incentives for the people to create wealth</b>. In other words there will (and should) always be some acceptable level of inequality, which in itself is not necessarily bad given that it is combined with <a href="http://im-an-economist.blogspot.co.uk/2013/06/graph-of-week-great-gatsby-curve.html">high social mobility</a>. However if the levels of inequality are too high they will negatively impact economic growth. The goal is then to find a balance of lower inequality combined with high social mobility, in order to maximize economic efficiency, i.e. to maximize the productive capabilities of the economy. In other words, there is no linear trade-off between equality and efficiency - there is a need to strike a balance between them. I summarize it in the graph below:</div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjW91DoTo4xskNaljMcI4aF1T-cJVo8M60W3WRhgIAUNT93ja2yFnED-7fkJiD56cWwdMdBcKI86RqOPOwCVRQsmoTVZiLpS8Rk9AO7PlRnalrctiebMuxZVFqJCk8HoebFBxYpJNyctC_q/s1600/Equality-efficiency-tradeoff-blog.png" imageanchor="1"><img border="0" height="296" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjW91DoTo4xskNaljMcI4aF1T-cJVo8M60W3WRhgIAUNT93ja2yFnED-7fkJiD56cWwdMdBcKI86RqOPOwCVRQsmoTVZiLpS8Rk9AO7PlRnalrctiebMuxZVFqJCk8HoebFBxYpJNyctC_q/s400/Equality-efficiency-tradeoff-blog.png" width="400" /></a></div>
<br />
<div style="text-align: justify;">
We start from the bottom-left corner with the Gini index at its theoretical 0 level, implying perfect equality (each person having the same income). Clearly for that level of equality efficiency (measured as either total factor productivity (TFP) or GDP p/c growth) is also around 0, since no one has any incentives to produce and to innovate given that all rewards are equal. Even at slightly lower levels of equality (after introducing some inequality), efficiency does not increase, assuming that it takes time for agents to pick up the signal that there is now a possibility to work more in order to get more. Then <b>as inequality stats to increase, the level of economic efficiency increases even more as the relationship becomes reinforcing </b>- more people see that their innovation, talent or extra effort will be significantly rewarded so they expand their activities which creates upward pressure on both inequality and efficiency. Until it reaches a point of maximum economic efficiency for a given level of inequality. As I've pointed out in the graph this is not necessarily at the Gini=0.3, it could be either higher or lower than that - this needs to be verified empirically. After that global maximum of the curve, the relationship turns negative - <b>more inequality beyond the efficiency-maximizing level slowly but steadily decreases economic efficiency</b> until society descends into close to perfect inequality (a Gini=1 means one person has all the income), where again there are no incentives to produce, innovate or create new value, given that all of this new wealth will just fall into the hands of the selected few (like in a stationary bandit dictatorship).</div>
<br />
<div style="text-align: justify;">
The question to ask is why does this relationship between efficiency and inequality suddenly turn from positive to negative? Which are the forces at work that turn inequality not only into a social, but also an economic problem for society, in a sense that greater wealth accumulation into the hands of fewer and fewer individuals undermines productivity and the desire to innovate? The answer is exactly that - <b>as more and more people start realizing that the value they produce is, within a crony system, ending up in the hands of the few, rather than being distributed among the many, their productivity will necessarily decline</b>. It is exactly like living in a communist dictatorship. Most people rationally choose not to innovate because they realize that any wealth they create will be extracted by the state. So a communist dictatorship will always, ironically, resemble a society with high levels of inequality, given that the elite around the dictator will hold not only full political power, but also a vast majority of economic power (if you want examples just take a look <a href="https://en.wikipedia.org/wiki/List_of_countries_by_income_equality">at this list</a> to see which kinds of countries score highest in their Gini levels). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Now, I've deliberately put the US on the right side of the curve suggesting that it is currently beyond the peak of an efficient level of inequality, and that it certainly does have room to lower its current high inequality which would not hurt its economic efficiency. On the contrary - it would most likely improve it. Remember that the total factor productivity in the US has been in a stage of relative stagnation since the 1970s, which I think can be explained by the simultaneous origination of the Third Industrial Revolution and the technological progress that has lowered productivity and kept low and middle-class wages relatively stagnant. Combined with globalization and a <a href="http://im-an-economist.blogspot.co.uk/2014/02/inequality-in-democracies-interest.html">host of other factors </a>(read about all of them <a href="http://im-an-economist.blogspot.co.uk/2016/10/what-ive-been-reading-vol-11-aktinson.html">here</a>) all of them have affected the rise of inequality combined with a decrease of efficiency. An experienced researcher is likely to conclude that perhaps there is an omitted variable bias in this story, meaning that there is one common factor that is affecting both the rise in inequality and the decline of efficiency - technological growth is the perfect example. I agree, the relationship is far from proven to be a causal one. Nevertheless, some levels of income inequality are obviously bad for growth. If the majority of the population is experiencing declining living standards this affects their purchasing power and their consumer choices, which on the other hand puts a lot of businesses in danger of having declining sales. A consumerist society is only efficient if the people can get a decent salary for a decent job. The prosperous cycle is an amazing thing, but it needs to be in motion. If it stops or it slows down (and we can actually measure this by an indicator called the <a href="http://im-an-economist.blogspot.co.uk/2012/02/graphs-of-week.html">velocity of money</a>, which is dancing at <a href="https://fred.stlouisfed.org/series/M2V">historical lows</a> right now!) then the economy is likely to undergo a period of prolonged stagnation. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Finally, given that my graph above is a mere theoretical construct, one should really consult the actual data to see whether or not it holds. I intend to do just that in the next few years.</div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-4675015114278829052016-10-17T22:43:00.001+01:002016-10-20T19:04:41.025+01:00What I've been reading (vol. 11): Atkinson & Stiglitz<div style="text-align: justify;">
<b>Atkinson, Anthony (2015) Inequality. What Can Be Done? Harvard University Press</b></div>
<div style="text-align: justify;">
<b>&</b></div>
<div style="text-align: justify;">
<b>Atkinson, Anthony (2008) The Changing Distribution of Earnings in OECD Countries. Oxford University Press</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The first two books, both written by the same author, Oxford economics professor <a href="http://www.tony-atkinson.com/">Sir Tony Atkinson</a>, will be reviewed jointly. The reason is that the earlier book, <i>The Changing Distribution of Earnings in OECD Countries</i> is more a case study summary of the empirical facts behind the rise of inequality in the West in the past century, the point of which is again summarized in the first few chapters of the author’s latest book <i>Inequality</i>. Basically the earlier book is a very detailed portrayal of the worrying inequality trend in the case of 20 OECD economies. It has two main parts – the first which depicts both the theoretical arguments and the summary of the historical trends for all the given countries, and the second which (on over 200 pages) details all the data, the graphs and the individual explanations of the causes of inequality for each of the 20 observed countries. The second book is a popular version of the same argument intended for “the masses”, but in particular aimed at the policymakers. After setting the diagnosis, describing the historical trends, and the economics behind inequality, the author dives into a very ambitious task of setting out a series of 15 concrete policy proposals that countries (but mostly the UK) can apply in order to reduce income and wealth inequality. The final part of the book then discusses the potential objections – are the proposals shrinking the pie, can they be done, will globalization hinder their effect, and finally will they be sustainable within the budgetary restrictions? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Let’s start with the general conclusions of <b>the</b> <b>first book</b> in order to ease into the policy proposals of the second book. The first book is not intended for the average layman; it’s more <b>an empirical economist’s companion on the vast data on inequality</b>. The true gems of the book for the average researcher are precisely the 200 pages of data and graphs on inequality for each of the 20 countries. It’s a wonderful dataset above all (<a href="http://www.wid.world/">accessible here</a>), and Atkinson goes to great lengths to describe all the faults and the benefits of the dataset, emphasizing on several occasions how the data is not comparable across countries (and to some extent it is even difficult to compare it within countries given the different methodologies for income reporting).<br />
<br /></div>
<div style="text-align: justify;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgGkHdoxMCsPK6LHwAbDLmT1vZtcuI3KMYZZ5MGOSWOKqFblr4mx6JQ1W6ilpiehyphenhyphenznZL0Raua2K2DvJNPvBfYlOjgECZRUCTd5wwDo1E-WvXQLe3gz0i6STU3s4J0SEsYuhQ0M7mKdJUuX/s1600/Atkinson_2008.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgGkHdoxMCsPK6LHwAbDLmT1vZtcuI3KMYZZ5MGOSWOKqFblr4mx6JQ1W6ilpiehyphenhyphenznZL0Raua2K2DvJNPvBfYlOjgECZRUCTd5wwDo1E-WvXQLe3gz0i6STU3s4J0SEsYuhQ0M7mKdJUuX/s200/Atkinson_2008.jpg" width="136" /></a>But before descending into the data he summarizes the trends. And they are in most cases bad. It is the story most people worried about inequality are by now quite familiar with. It has followed a trajectory of a decline after WWII which continued during the 50s, 60s and the 70s, but since the 80s it began to rise reaching its current unprecedented levels – well, at least that’s how the story goes for the US and the UK, Portugal, and the three transitional economies he has in the sample – Hungary, Czech Republic, and Poland, whereas the rest of Western Europe did not see such a high divergence between top and bottom income levels (the main comparison are the income levels of the top 10% vs the bottom 10% of income earners). After presenting these trends Atkinson delivers his own critique of the economic textbook model of inequality, in that <a href="http://im-an-economist.blogspot.co.uk/2012/11/technological-shocks-and-unemployment.html">technology</a> and varying skills (attained through education) are not enough of an explanation. He adds to them an important role of the capital market (think of interest rates on <a href="http://im-an-economist.blogspot.co.uk/2012/05/graph-of-week-student-loans.html">student loans</a>) but also explains in a bit more detail the so-called superstar model (people with extremely scarce skill for which there is a huge demand) and pay norms. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In his more recent book, <b><i>Inequality: What Can Be Done?</i></b>, he does go a bit deeper into examining some of the causes of the rise in inequality. And he does it by first examining the factors that have lowered inequality in the post-WWII period, only to see most of them reversed in the 1980s making inequality rise again. One of biggest reasons in the post-war decline of inequality was<b> the rise in the share of wages in total national income</b> (reaching 80% of national income in the 1970s in the US and UK). In the subsequent decades the share of capital in income increased whereas the share of wages decreased. Furthermore the <b>welfare state expanded significantly in the post-war era, as did redistributive social transfers</b>. Unemployment was much lower, wage dispersion was reduced as the consequence of collective bargaining and government intervention in the labour market, while the concentration of capital income among the top income earners was in decline. Let’s also not forget the <b>much higher income taxes on top incomes</b> from that period. All of this basically went into reverse since the 1980s (on average higher unemployment, fall in share of wages and rise in share of capital in total income, declining power of unions, a cut in top income taxes and a scaling back of the welfare state). To this I would still <b>add the forces of globalization </b>(unskilled workers are mostly losers from trade) <b>and technological change</b>, as well as the effect of the capital market, changing pay norms and superstars (increasing demand for global talent). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Although Atkinson here provides a very good overview of the facts, he gets carried away from time to time. For example, I didn’t buy into the argument that high income taxes in the period from 1950 to 1979 (when they averaged 75%!) were necessarily the reason why economic growth was high in the 50s and the 60s. The main reason as to why growth was high in those decades was probably the post-war reconstruction (the <a href="http://im-an-economist.blogspot.co.uk/2012/03/stimulus-debate-revisited.html">broken window hypothesis</a>), plus the post-war baby boom which certainly encouraged greater consumption and hence significantly increased economic growth. When these two forces halted relative stagnation ensured in the 1970s. <b>High taxes had absolutely nothing to do with growth at the time; if anything they could have contributed to the 1970s stagnation</b>, since their relative decline in the 1980s did bring back growth. However, none of this has been empirically verified by anyone to my knowledge.<br />
<br /></div>
<div style="text-align: justify;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUa3-XUUoVhoH3zwvat8W-YjdtxD3I53UC43jqRM0MoPou8Qq5GGaVVjssUDhiqEC2V4O-xTH746BNClUTp6WzWAEjHdNus7Mf2eoaU0I4hzreX11T-riVeUHz7ibNrVL3uuT1w0XgLuMH/s1600/Atkinson_2015.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUa3-XUUoVhoH3zwvat8W-YjdtxD3I53UC43jqRM0MoPou8Qq5GGaVVjssUDhiqEC2V4O-xTH746BNClUTp6WzWAEjHdNus7Mf2eoaU0I4hzreX11T-riVeUHz7ibNrVL3uuT1w0XgLuMH/s200/Atkinson_2015.jpg" width="132" /></a>Let’s move to the proposals. They are exactly what one would imagine in a book like this – popular, to some extent utopist, very bold, to some extent controversial (the author even acknowledges this several times, but stresses that such bold proposals are necessary to make the public discourse move in the “right” direction). What disappoints me is that there is a lack of convincing evidence of the full effect some of these proposals will entail. <b>There seems to be a focus only on one aspect of the story – reversing the factors that caused inequality to rise, without considering how this would affect other aspects of modern societies.</b> Plus some of the ideas seem to me more like back of the envelope calculations than seriously thought-through proposals. Don’t get me wrong, I am in favor of reducing inequality, but a set of “concrete” proposals has to be more precise in how exactly would it affect inequality, and how exactly would it affect economic growth. There are three chapters in the back that are supposed to answer part of this (e.g. there is a simplified analysis of how some proposals would fit into the budget), but its not convincing. Other proposals don’t even qualify given that they are too vague. I understand this is a popular version and that the author clearly decided to avoid too much numbers and complexities not to bore the average reader. But to me, in order to even consider many of the proposals, I require much more details, first and foremost to give an answer how exactly the author thinks many of the proposals could be done (assuming even that they pass through the bi-partisan parliamentary process). Again, I fully understand his reluctance to go into greater detail, plus I understand he wanted to stir the dialogue, rather than to come up with a White Book of ready-made reforms. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<div style="text-align: justify;">
Having said all that, <b>some of the proposals are actually quite good and even easy to implement</b>. Like the capital endowment fund for children (minimum inheritance), the national savings bond to encourage savings, the child benefit to be extended to all children (and taxed as income for parents with higher incomes), the participation income proposal (similar to basic income, but different in terms of who has the right to get it, and how much), the earned income discount proposal, an interesting proposal for progressive lifetime capital recipient tax etc. However other proposals go directly against the empirical evidence the author himself cites. He does it on purpose (to create an effect of shock). E.g. he cites the <a href="http://www.ucl.ac.uk/~uctp39a/rates.pdf">paper by Brewer, Saez, and Shephard</a> where they use a natural experiment setting to calculate the <b>optimal top income tax rate</b> (the one that would maximize revenue) <b>at 40%</b>. Atkinson however purposely calls for a top rate of 65%. Then there is the guaranteed public employment proposal (without at all calculating its effects), the code of practice for determining the living wage (to be determined by something closely resembling a central planning body), the proposal for property tax which disregards its potential effect on housing prices, etc. Overall, the proposals are certainly very interesting, however I would welcome a more detailed and more empirically justifiable argumentation for each of them.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Stiglitz, Joseph (2012) The Price of Inequality. WW Norton </b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In what is essentially perceived to be a book about inequality, the Nobel-prize winner <a href="https://www8.gsb.columbia.edu/faculty/jstiglitz/bio">Joseph Stiglitz </a>presents a very interesting portrayal of everything that went wrong in the US in the past few decades, in economic but also in political terms. <b>Despite stable GDP growth, even in per capita terms, most citizens have not felt this growth</b> and have actually witnessed their living standards decline. <b>The US political system is failing as well; it is being captured by special interests which channel money towards the wealthy</b> (via direct involvement in government redistribution but mostly via prone regulation and legislation), <b>making America less and less a country of equal opportunity</b>. In fact, the decline of social mobility, emphasized several times in the book, is an even bigger problem for the US. Both the poor and the rich are becoming entrenched in their positions in the income distribution, <b>making it increasingly less likely for someone who is poor to climb the income ladder way to the top, and vice versa</b> – <b>it is very unlikely for someone who is rich to fall out of this category</b> (educational opportunities play a key role here). All of this is without doubt true and very problematic as the US model of democracy is being shaken to its core. How can the US express its moral authority over others if it too has fallen into the trap of cronyism? Stiglitz however does not explicitly define all of the above as the consequence of cronyism or even interest group state capture; he likes to present it as a market failure, but also a political failure to deal with the market failure. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
For Stiglitz there is something broken in system; <b>a system that seems to be designed to help those on the top at the expense of the rest of society</b>. His main culprit here is politics, even if some of these forces are attributed to markets. <b>The economic elites have used their money to buy political influence and hence political power in order to shape the system towards their benefit</b>. This may sound a bit like conspiracy theory, but it has some merit. There are a multitude of examples of political capture by interest groups (via campaign contributions), but even more importantly regulatory capture (when an industry directly funds the politicians responsible for overseeing their practices), or even what Stiglitz defines as ‘cognitive capture’ – how only those who “agree” with the bankers are allow to write legislation and regulation that concerns the financial industry (this includes central bankers as well). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2-Es-N7h4mcj9gVcskMRs4JRxwAoW1QN_XFpvbvkWnGOXBluL2FLnaRUqVfVg0tFC3RHglNieaZNds8M-TzAePH3LDSvspNx1KlhoA0gq8-S4Cq4GzITBMvBAgmr5g-PsfpbgZ9z83aV6/s1600/The_Price_of_Inequality.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2-Es-N7h4mcj9gVcskMRs4JRxwAoW1QN_XFpvbvkWnGOXBluL2FLnaRUqVfVg0tFC3RHglNieaZNds8M-TzAePH3LDSvspNx1KlhoA0gq8-S4Cq4GzITBMvBAgmr5g-PsfpbgZ9z83aV6/s200/The_Price_of_Inequality.jpg" width="133" /></a>An even bigger problem is how the wealthy (the top 1%) have acquired their wealth. Stiglitz attributes much of it to – <b>rent seeking</b>. An activity where one gets <i>“income not as a reward for creating wealth but by grabbing a larger share of the wealth that would have otherwise have been produced without their effort.”</i> And although this cannot be said of most of those in the 1% (<a href="http://im-an-economist.blogspot.co.uk/2012/01/percentages-and-inequality-who-is-top-1.html">I wrote about it a long time ago</a>), it certainly does seem to be true for a considerable amount of those in the top. <a href="http://im-an-economist.blogspot.co.uk/2015/05/austerity-and-inequality-in-corrupt.html">In the conference where I met Stiglitz</a>, this was the main discussion, in fact – how many of those in the top around the world acquire their wealth through political connections (rent seeking) rather than via actual wealth creation. In other words the problem is that <b>even though the pie is growing, a bigger and bigger amount of that pie is being captured by the rent seekers instead of the wealth generators</b>. And <i>that</i> is indeed a huge problem. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Another interesting part of the argument is the price we’re paying for inequality. Stiglitz goes <b>beyond the trade-off between equality and efficiency stating that too much inequality is also bad for efficiency and bad for growth</b>. He’s right, and it’s easy to see how – for one thing, having too many people left out of the benefits of economic growth derails their consumer spending power. I too have long considered the relationship between equality and efficiency to be non-linear, instead of just a simple trade-off. Too much equality isn’t good since it reduces incentives, but neither is too much inequality. I would say <b>the relationship is of an inverted-U type where moving to both extremes – too much and too little equality is bad for the economy.</b> The trick is to find an optimal point which reduces the level of inequality where it offers more opportunities for everyone, but also just enough for it to continue to drive incentives. More on that in my next blog post. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Having said all this, there is still a feeling that the book lacks clarity in certain parts, as even within chapters it tends to jump from one argument to another. It gives the impression that it was either written too fast, that it was assembled quickly using some old writings, or even that certain chapters were written by someone else (several times he uses the “I” form, but in a few chapters there is also the “we” form, as in “our argument is…”). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Plus there is often incoherency in the arguments. In the early chapters he claims that markets are not the principal driving force of the current status of the US, since all other countries are operating on the same market principals. His hypothesis is that the market forces are real but are being shaped by the political process that defines laws, regulations and institutions, all of which has some distribute consequences. Then in the closing few chapters he resorts to his usual bashing of the market forces and a cry for an omnipotent government to solve their failures. The biggest problem with this standard argument from the Left is that they expect the very same corrupt politicians, enslaved by their clientelistic relationship with powerful interest groups, be given even more power to supposedly fix the system. That’s why, in essence, redistribution is not the answer – given the issue of who is making the distributional decision. The answer is to change incentives (or “ideally” to elect someone like Stiglitz to lead us, right?). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And then we come to the <b>policy proposals</b>; his grand economic reform agenda followed by a rather disappointing political reform agenda (disappointing given his excellent recognition of all the errors of the political system). Each is to be applied simultaneously in order to, well, create a better world, what else?! Reading these agendas (summarized on about 20 pages in the final chapter of the book) felt like reading a political program for a generic social-democratic candidate for president/prime minister. It was <b>just a bunch of bullet points whose only purpose is to convey a positive message to the voters, rather than being a set of policies that can actually fix the system</b>. Particularly when comparing them to Atkinson’s proposals, with whose details I also wasn’t really satisfied, but at least Atkinson made some effort into discussing the viability and applicability of each proposal. With Stiglitz, it all sounds just too cheap. For most of the proposals there isn’t a single sentence in how they are to be implemented, not to mention what the potential effects could be. Apart from the usual – if we implement all this we’re going to have a better society! It really <i>is</i> a mediocre political program. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Now don’t get me wrong, some of the things he proposes in the book are quite good. I particularly agree with his criticism of “GDP fetishism”, given that GDP does not accurately reflect living standards, and particularly the sustainability of the economic growth model. Or the ideas to end corporate welfare (like hidden subsidies to big corporations and government giveaways in the form of procurement), to improve access to education, help Americans save (there is btw no indication as to how this is supposed to be done, but OK), expanding health insurance, improving the legal system, curb discrimination, etc. However others are just too much, or can be completely incoherent (like all of his proposals to curb the power of the financial sector – there is no indication as to how this was supposed to be done). Some are just breathtakingly shocking. For example I was bemused that a self-respecting economist can utter these words: <i>“If exports create jobs, then imports destroy jobs; and we’ve been destroying more jobs than we’ve been creating”</i> (pg. 279). Wow! A Nobel-prize winning economist succumbing to the most <a href="http://im-an-economist.blogspot.co.uk/2013/12/economic-history-mercantilism-and.html">basic mercantilist fallacy</a> by saying that <a href="http://im-an-economist.blogspot.co.uk/2014/10/imports-and-exports-two-sides-of-same.html">imports destroy jobs</a> is just unbelievable. You’re not running for President, Prof. Stiglitz, please do away with the conspiracies. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
However, I would still recommend the book even to those who usually disagree with Stiglitz, because if you can look past some of his standard ramblings, he really does deliver a decent analysis of some of the things that went wrong with the US political system.</div>
</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-28912811480435716902016-10-10T23:37:00.000+01:002016-10-11T16:02:56.956+01:002016 Nobel prize awarded to Hart and Holmstrom for contract theory<div style="text-align: justify;">
It's that time of the year again - <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/">Nobel prize awards</a>! After being awarded to a single recipient two years in a row (<a href="http://im-an-economist.blogspot.co.uk/2015/10/angus-deaton-wins-2015-nobel-prize-in.html">Deaton in 2015</a>, <a href="http://im-an-economist.blogspot.co.uk/2014/10/jean-tirole-wins-2014-nobel-prize-in.html">Tirole in 2014</a>), this year the Nobel in economics is shared by two worthy winners, both relatively unknown outside the economic arena. The reason is that both <a href="http://scholar.harvard.edu/hart">Oliver Hart</a> from Harvard, and <a href="http://economics.mit.edu/faculty/bengt">Bengt Holmstrom</a> from MIT, are theorists. What is their area of expertise? <a href="https://en.wikipedia.org/wiki/Contract_theory"><b>Contract theory</b></a>, arguably the most complex field in modern economics. Which is why this year's prize is another laudable effort to commemorate this very important branch of economic theory for the very first time. </div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPMRXmITIhoqH_9zgyk_mmv913q60G87q04Z062HCorG8r9Cfh3E-1CD99LPUD_ekybuohFmFqZCn1UqRtkeJyb7_B77QRMYvmaNI-Puvbzi8uw5HNsBsFTJ85ojum5Gh8HdkA2OQ8dRav/s1600/nobelwinners2016.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="222" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPMRXmITIhoqH_9zgyk_mmv913q60G87q04Z062HCorG8r9Cfh3E-1CD99LPUD_ekybuohFmFqZCn1UqRtkeJyb7_B77QRMYvmaNI-Puvbzi8uw5HNsBsFTJ85ojum5Gh8HdkA2OQ8dRav/s400/nobelwinners2016.jpg" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So what's contract theory all about? Or to be more precise, what was the significance in their contribution? The <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/press.html">official statement</a> says the following: <i>"Modern economies are held together by innumerable contracts. The new theoretical tools created by Hart and Holmström are valuable to the understanding of real-life contracts and institutions, as well as potential pitfalls in contract design ... </i><i>This year’s laureates have developed contract theory, a comprehensive framework for analysing many diverse issues in contractual design, like performance-based pay for top executives, deductibles and co-pays in insurance, and the privatisation of public-sector activities."</i></div>
<div>
<br /></div>
<div style="text-align: justify;">
Read a more detailed (layman) explanation <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/popular-economicsciences2016.pdf">here</a>, and a more complex, theoretical one <a href="https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/advanced-economicsciences2016.pdf">here</a>. Also, here is a <a href="https://www.bloomberg.com/view/articles/2016-10-10/economics-nobel-rewards-theories-worth-building-on">good text</a> from Tyler Cowen. </div>
<br />
<div style="text-align: justify;">
In a nutshell, contract theory studies <b>how, in the presence of asymmetric information</b> (adverse selection, moral hazard, signaling, etc.) <b>do economic agents enter into contractual obligations</b>. How do they create a mutually beneficial deal, that will incentivize both parties to keep their part of the bargain. Theorists examining contract theory try to find the optimal arrangement that will motivate agents to keep their commitment, even when entering the obligation with a veil of uncertainty. In other words, it's a utility maximization exercise, with time discounting and asymmetric information acting as the constraints. Examples of contractual relationships can vary from managers and shareholders, insurance companies and their clients, a firm and its suppliers, or between lenders and borrowers. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The crucial part in designing an optimal contract structure is the satisfaction of divergent interests. In other words the contractual relationship must be thought of as mutually beneficial, otherwise no one would enter into one. It's a <b>principal-agent game</b>, to be more precise. The issue is that the principal does not have perfect information on whether the agent is keeping to his side of the deal. A multitude of principal-agent examples have been researched in microeconomics, including labour economics, and political economy, and have mostly been modeled using game theory. One of the most famous principal-agent examples is the labour market: how does the principal (the employer) make sure that the agent (the worker) is not shirking? In a world of limited information the principal can never be too sure in whether or not the agent is performing his job as contractually obliged. In politics, the principals are the voters (the public), whereas the agents are the politicians. The voters "hire" politicians to do the job of running the country, but have very limited oversight into what the politicians are actually doing (notice that in dictatorships it is the dictator who is the principal, since he is accountable to no one). The example that Holmstrom used is the relationship between a company's shareholders (principal) and its CEO (agent) - how do the shareholders make the CEO maximize shareholder value instead of just their own compensation? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Contract theory goes one step beyond modelling the pure principal-agent game. It is concerned with designing the optimal contractual structure to make sure that both parties benefit from the relationship and that neither has an incentive to shirk. It's all a question of risks vs incentives - which incentives will you offer the agent and at what cost? Examples include everything from performance-based pay structures to the extent of bonuses and stock options given to managers. The other important part, done by Hart, was to distinguish between <b>complete and incomplete contracts</b>, where the former are a theoretical construct, while the later are applicable to realistic settings, where the parties are unable to precisely articulate all the details <i>ex ante</i>. In particular, incomplete contracts are aware of the informational asymmetry and are concerned with the optimal allocation of control rights - which party should be given the decision rights (and how to compensate the other party), or should the decision rights be given to a third party? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Needless to say the real-life application of these theoretical findings are primarily embedded in law (corporate law to be exact), particularly in the cases of property ownership, control rights, mergers and acquisitions, bankruptcy legislation, financial contracts, etc. This also means that their application is important for designing policy - the optimal bankruptcy laws, or property rights, and even privatization (how to strike a balance between cost reduction and quality). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
All in all, a welcomed award to a fascinating field of research. All the more so given that it was the recipients who designed this theoretical framework for others to build on. Congratulations to Hart and Holmstrom! </div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com0tag:blogger.com,1999:blog-3448927642739850334.post-42023670363957591792016-09-19T15:11:00.002+01:002016-09-19T15:23:41.611+01:00The John Lewis economy - a belated comment<div style="text-align: justify;">
In my <a href="http://im-an-economist.blogspot.hr/2016/09/what-ive-been-reading-vol-10-cronyism.html">last book review</a> I summarized a very interesting book called <a href="https://en.wikipedia.org/wiki/The_Spirit_Level:_Why_More_Equal_Societies_Almost_Always_Do_Better"><i>The Spirit Level</i> by Richard Wilkinson and Kate Pickett</a>. In it the authors propose a solution that would not only lower inequality and thus correct many of the negative social outcomes related to it (but not caused by it, mind you; they don't prove causality), but also change the entire system of values in society, so that people would be less profit-oriented and would increase their levels of interpersonal trust (among other things). </div>
<br />
<div style="text-align: justify;">
Their big idea is to introduce <b>democratic employee ownership</b>. Hence the title: The John Lewis economy (the <a href="http://www.johnlewispartnership.co.uk/">John Lewis Partnership</a> is the famous UK example of an <a href="http://www.johnlewispartnership.co.uk/content/dam/cws/pdfs/our%20responsibilities/our%20employees/Guide_to_Employee_Ownership.pdf">employee-owned firm</a>; it allows all of its employees to share the firm's profits and have oversight over management decisions through several democratic mechanisms of corporate governance). It's a belated comment since I wanted to write a piece about this <a href="http://www.telegraph.co.uk/news/politics/nick-clegg/9016800/Nick-Clegg-plans-a-John-Lewis-economy.html">ever since 2012, when UK deputy PM Nick Clegg</a> of the Liberal Democrats introduced the actual term "John Lewis economy". It was part of his policy proposal to introduce tax breaks to companies if they offered shares to their employees. </div>
<br />
<div style="text-align: justify;">
Although the idea of employee-ownership is certainly admirable (it is easy to get 'hooked' on it), there are several problems with this model being forced upon the entire system and applied in every company. First of all, how would one enforce it? Clegg had the idea of offering incentives in the form of tax breaks. Fair enough, but as Wilkinson and Pickett (as well as many proponents of employee ownership) clearly state this is not enough. Employees have to have a more democratic say in managing the company, not just a share that doesn't mean much to them if everything still stays the same. They need to have oversight over management decisions (like voters do in democracies). That is at least how the John Lewis Partnership works. The problem is that the John Lewis Partnership developed and perfected this model through 80 years of its existence. It had the time to adapt and adjust its employee ownership model throughout this turbulent time. </div>
<br />
<div style="text-align: justify;">
Another problem with such a proposal is the statement that <i>"participation, commitment and control would be maximized if companies were 100 per cent employee-owned"</i>. And furthermore that <i>"companies could raise capital through loans or mortgages retaining control for themselves"</i>, since only a small amount of money on stock markets makes any contribution to companies. This is very problematic on a number of levels. Removing access to various sources of finance for companies means condemning them on the mercy of commercial banks, to name only one consequence. The second is that this would severely undermine the dynamism of the economy as it would reduce their expansion capability, not to mention the ability to employ more people. Firms raise money in various ways primarily in order to expand, to service more customers, and - most importantly - hire more people! Without an ability to expand, or with this ability being seriously constrained, the economy would drastically reduce its dynamism, and especially its innovative capacity. The proposal to virtually abolish the stock exchanges is literary a reduction of modern society to <a href="http://im-an-economist.blogspot.hr/2016/08/what-ive-been-reading-vol-8-economic.html">pre-industrial revolution times</a>, where the lack of economic growth implied less belief in the future and forced the economies to remain in a <a href="http://im-an-economist.blogspot.hr/2016/08/what-ive-been-reading-vol-9-economic.html">Malthusian trap</a> for millennia. I understand there do exist a lot of successful co-ops out there, and this is perfectly fine. I encourage them to set up shop, expand and include more people in their networks. But one cannot enforce this upon the entire economic system as it would go against the <a href="http://im-an-economist.blogspot.hr/2016/08/what-ive-been-reading-vol-8-economic.html">evolutionary foundations of modern capitalism</a> (within which we fought hard to attain the human rights we today take for granted). Having a fairer system is absolutely necessary. But you do not achieve fairness by shattering the spirit of growth and progress. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Furthermore, one of the biggest arguments to impose employee-ownership is to change the for-profit mentality. This term is very often being confused with a battle for talent on a global level. You cannot compare the wages of local workers of a multinational company with its management. First and foremost because the demand and the supply for the two groups are different. Local workers are supplied and hired on the local market, whereas management is assembled from a national or even global pool of talents. Attracting the very best costs money. </div>
<br />
<div style="text-align: justify;">
The same argument is with wages for athletes. There is a huge earnings differential between athletes in a single sport, and an even bigger one for athletes across all sports. Football players (both American and European - which I refuse to call 'soccer') are much better paid than volleyball or handball players. Even an average or below average football player in a good club may have a higher salary than some of the best players in other less popular sports. And this is perfectly normal given the greater demand for watching high quality athletes compete in the most interesting sports for the majority of people (football, basketball, baseball in the US, etc.), which necessitates that they be paid the heftiest sums. This is even more obvious for individual sports and their superstars - think of the top 10 tennis players, formula 1 drivers, or legends like Usain Bolt - who is to say he is not a great performer in addition to being one of the greatest athletes of all time? People pay extreme sums of money to buy tickets for Olympic game finals only to see Usain Bolt run for 10 seconds! And none of them consider this a waste of money. </div>
<br />
<b>The bottom-up approach to solving the inequality problem</b><br />
<br />
<div style="text-align: justify;">
By far the biggest problem problem I have with many such proposals aimed at lowering inequality is the focus they tend to have on high incomes and the profit-motive mentality. The main proposals are usually aimed at increasing the top tax rates or curbing the profit motive of companies so as to make them more socially responsible. And although I agree that having more socially responsible companies would be a good thing, I don't think anyone should force companies to make choices they don't want to make. <a href="http://im-an-economist.blogspot.hr/2016/03/behavioral-economics-or-what-ive-been.html">Nudging them in the right direction</a> with smart regulation is much better. Having customers aware of the products made by socially responsible companies is another good example. There have been numerous examples where civil action against polluters or socially irresponsible companies made them change their business practice. The last thing any company wants is a bad reputation. Now they must compete in their social responsiveness in addition to their prices and product quality.</div>
<br />
<div style="text-align: justify;">
To return to my initial point, why isn't any anti-inequality advocate focused on a bottom-up approach? Why aren't many policy proposal focused on the <b>poverty side of inequality</b>. After all, the variety of health and social outcomes linked with inequality can easily be attributed to poverty, like crime and violence, poor education performance, teenage pregnancies, imprisonment, selected health and mental issues, etc. In other words, if we can make the poor richer and better off by turning more of them into the middle class, we would surely be reducing inequality and simultaneously improving a variety of health and social issues, without imposing potential damage of wealth creation at the top. In fact, having high incomes can only serve as a motivation for people to invest in their education and abilities to achieve the same high living standards. A whole different problem is if the people are <a href="http://im-an-economist.blogspot.hr/2013/07/graph-of-week-climbing-income-ladder.html">being prevented from upwards social mobility</a> if they don't belong to a particular class, gender, or race. This is an issue any anti-inequality advocate should look into since <a href="http://im-an-economist.blogspot.hr/2013/06/the-1-inequality-conundrum.html">low social mobility</a> (caused primarily by cronyism and elite entrenchment) is arguably the biggest obstacle for lowering inequality - it prevents access on the low levels of society and thus immediately discriminates those on the low end of the earnings distribution.</div>
<br />
<div style="text-align: justify;">
Fighting poverty, in my opinion, is the most effective way of fighting inequality. Primarily since there are many more poor people out there than rich people. Helping all of them get higher earnings will necessarily solve many of their social issues as well. I understand the psychological factor of anxiety by seeing someone being so much more well off, however this mentality is perhaps a greater concern that the profit-motive one. Why should one care so much about the wealth of others? Because we only value our own success compared to other people's success. Ever more so in today's dynamic era of fast information. I still feel however that the resentment towards the well-off would be contained (but not eliminated) if we eradicate poverty. This remains to be scientifically tested. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Finally, if you want to build a more egalitarian society than the first thing where to look is among existing egalitarian societies - like Scandinavia, Canada, or Japan. What makes them so successful? Mass employee ownership of private sector companies? The US and the UK have 10 times more employee-owned firms than all other countries in the world put together (don't believe me? <a href="https://en.wikipedia.org/wiki/List_of_employee-owned_companies">See for yourself</a>). So having employee ownership is not that crucial to achieve a more egalitarian society, is it? What is? Economic freedom is one thing. <a href="http://im-an-economist.blogspot.hr/2013/02/a-tribute-to-nordic-model.html">Look it up</a>.</div>
Vuk Vukovichttp://www.blogger.com/profile/01878567452492217960noreply@blogger.com1