Sunday, 14 September 2014

Corruption and re-election: the curious case of Croatia

First of all apologies to my regular readers as there hasn't been a lot of blogging activity during the past two weeks. The reason for that is primarily my busy schedule as the academic year has started, in addition to a few papers I have in the review process, but mostly it was the media attention that has caught up with me lately. 

The reason for that was a research paper I did for the Croatian Banking Association on the topic of corruption in public procurement in Croatia and the relationship between local corruption and re-election (the research paper will be available soon on their website, and I'll post it on the blog as it happens; note: the paper is in Croatian - I do intend to translate it though). 

Almost all domestic media outlets (even the local ones) covered the story. After the main results of the study were presented in the monthly financial/business magazine Banka (where I tend to have more or less regular columns), all the major newspapers (Jutarnji list - the biggest domestic newspaper where the story made the cover last week, Vecernji list, Novi listSlobodna Dalmacija, Poslovni dnevnik), the most popular internet news portals (index, tportal), and even the national television (HRT) reported the story. Apparently corruption in Croatia is always a hot topic. 

The theory behind the idea

So what was the research all about? It was an empirical verification of a part of a model from my earlier paper Persistent electoral success with endogenous rents, where I theoretically made the case for long-lasting politicians in power. In addition I used the main findings of the selectorate theory by Bueno De Mesquita, Smith, Siverson and Morrow, to clarify my argument and turn it into a testable hypothesis. The basic idea is that politicians tend to create a stable, small coalition of supporters which enable them easy electoral victories and leave them virtually unaccountable to the general public. In that case the politicians in power no longer use public goods to satisfy the voters that brought them to power, but private goods they distribute to their cronies (coalition members) that keep them in power and who are simultaneously dependent of the politician for their continued rent-seeking. Even though this scenario more likely resembles a dictatorship rather than a democracy (where the small winning coalition of the dictator are usually the army generals), on a local level in democracies politicians can stay in power for decades without ever having any real accountability towards their voters. Bueno De Mesquita and Smith in the popular version of their argument (the book "The Dictator's Handbook") mention numerous examples of both autocracies and democracies where as soon as accountability and scrutiny are missing politicians get complacent and turn dishonest, regardless of the institutional setting surrounding them. This can happen in the United States (recall gerrymandering) as well as in any African dictatorship. After all the logic of political survival is always the same: stay in power! 

The methodology and results 

Using Croatian data on local level public procurement I was able to generate a testable hypothesis out of the theory, as I created eight proxy measures for corruption based on identifying suspicious and fraudulent procurement cases. I linked them across Croatia's local municipalities and cities and designed a measure of corruption as a ratio of suspicious procurement cases over total procurement cases. The term 'suspicious' was defined in many categories (companies with no employees getting vast sums of money in legal tenders, companies with profits from public procurement 10 times as much as their annual revenues, companies in losses getting indirectly financed by the government, etc.). 

The source of data are official government reports on procurement cases and companies involved in them. However they weren't openly available on any of the official government institutions, but had to be collected by independent activists aiming to increase transparency of the public procurement process (some of them received funding from the EU to support this cause). The years observed in the paper were 2009 and 2010, and the sample contained data on around 4600 cases across 300 municipalities and cities. This amounted to a total of 26bn kunas being observed (around $5bn), which is a quarter of all public procurement being done in those two years. There was a problem in creating the sample as a lot of the data wasn't suitable for linking the company with the procurement case they were involved in, since in many cases the key numbers (the financial ID of the company that needs to be reported in the procurement) were missing. This could imply that the sample actually underestimated corruption in public procurement, as the missing numbers could have been removed deliberately. 

Even in that case the results were outstanding. They even surprised me. I managed to show that the higher the level of corruption (the proxy for corruption at least), the higher the probability the politician gets re-elected (see figure below). However only up until a certain point where further corruption decreases the probability of winning. From eight measures of corruption that I made, six of them confirmed my hypothesis (the other two showed the same direction but weren't statistically significant). 

Basically this implies that voters do punish corruption but only if its exaggerated. According to the graph above (fitted values predicted from a logit model), after around a quarter of public procurement allocated in a suspicious way, the probability of re-election goes down. The politician gets thrown out of office only when he/she allocates more than half of the public funds in a suspicious manner (other things held constant). This suggests that the tolerance level the voters have for corruption is still way too high. 

The remedies 

Being able to calculate precisely how much a politician needs to steal in order to stay in power, I was risking of being accused to having provided the politicians a framework upon which they may operate. However they knew this without my research - after all that's how they managed to stay in power for all these years. 

Nonetheless I needed to make a series of normative implications and reform proposals aimed at reducing the scope of local corruption in Croatia. My first immediate reform was to introduce a term limit for local politicians (a maximum of two terms in office, i.e. 8 years). This way we can immediately get rid of all those politicians who are in power for over a decade and have created a corrupt, crony system centered around them. Simultaneously with the term limit electoral rule, the number of local municipalities has to be reduced, or more precisely we need to increase the number of voters necessary for electing the politician into office. This goes directly in line with the selectorate theory and increasing the minimum winning coalition. In many local municipalities in Croatia it takes a few hundred voters to get re-elected. By increasing the size of the municipality, we put the politicians in a completely new environment thus destabilizing their currently held concessions. 

However implementing the two reforms won't necessarily solve the problem. Eight years can be more than enough to build a corrupt system and a cronyist network of supporters (after all the term limit political economy literature suggests that when politicians are facing their final term in office they tend to steal more; see Besley, 2006 and Ferraz and Finan, 2011), while operating in a new environment is only a temporary setback to which the politicians can quickly adjust. This is why a third reform is crucial, and should also be applied simultaneously. In the next phase of the research I intend to construct an index of local corruption in Croatia ranking the cities and municipalities from the most corrupt to the least corrupt. This way it could be easy to adjust the flow of funds from the central government budget to the local budgets on the basis of their corruption rankings. Those on the bottom of the list get no money from the central budget (these funds contribute to around a fifth of the local budget). This will then send a clear signal to the voters that because of their local politician being corrupt they couldn't afford to solve some of the local problems they tend to encounter on a daily basis (garbage disposal, schools, kindergartens, hospitals, basic infrastructure, etc.). By having this information the voters will react and vote the politician out of office. 

All three reforms must be applied simultaneously. Exposing the corrupt practices of current local politicians may not yield them out of office as they still have a strong support group backing them in their municipality. However after throwing them out via a term limit, the new politicians won't have this luxury. They will immediately be prevented from engaging into similar corrupt actions. Such reforms, if implemented correctly, will become irreversible as the voters would possess more knowledge and demand more accountability and transparency. It will be impossible to remove this right from them in a democratic society. 

Friday, 29 August 2014

Gerrymandering explained

What is gerrymandering? The simplest explanation would be: instead of voters choosing their politicians, politicians choose their voters. 

Confused? Take a look at the following video from Ezra Klein.

Basically, politicians redraw the electoral district boundaries so as to maximize their support in the newly created district. They split the state into as many districts as possible, each tailored based on the voter support they receive at the particular territory. The obvious outcome is that you can get more seats for less votes (a typical quirk of the first-past-the-post electoral system - just ask the LibDems in the UK). To get a better sense of what it is take a look at the following few maps of the US Congressional Districts:
California, District 38
Florida, District 5
Illinois, District 4
Top three: North Carolina, D-12, Florida, D-5 (again), Pennsylvania, D-7
Bottom three: Maryland D-3, North Carolina D-1, Texas D-33
There's many more, less obvious, examples but one thing is clear - in these districts politicians literally choose their voters. And, as said, the outcome is getting more seats with less votes. For example in the 2012 US House elections, Democratic candidates won 1.4 million more votes, but Republicans got more seats (234 to 201). Don't confuse this with the electoral college system for US Presidential elections, which gave Bush the Presidential victory over Gore even though Gore won the popular vote. (Btw, on that subject, take a look at a very interesting paper on the so-called butterfly ballot which might have swayed Florida, and hence the Presidency, towards Bush. Another example of "creativity" in designing electoral rules.) 

Another consequence of gerrymandering is lack of accountability of Congressmen who are pretty much safe in their seats in a rigged electoral system. Without proper accountability, and after having to rely on a small group of essential supporters for re-election, democrats quickly turn into autocrats. Not by oppression or committing mass murders, but by corruption and theft. This is the central argument of the so-called selectorate theory, devised by four political scientists, Bueno De Mesquita, Smith, Morrow and Siverson. When the incentives to be accountable with the taxpayers' money are lacking, then politicians (regardless of which system they come from) have a tendency to act in a more corrupt manner. I recommend the book "The Logic of Political Survival" by the four authors, or even a popular version of the argument - "The Dictator's Handbook". I briefly covered part of their theory back in 2012

So how does one prevent gerrymandering? The most obvious solution is to take the gerrymandering decisions out of the politicians' hands and assign it to courts or some nonpartisan commission. California has done some progress on that area with their California Citizens Redistricting Commission. Canada did it back in the 1960s, appointing an independent commission to redraw district boundaries. Down at the Vox webpage (from where the video was linked), they have presented a map of the US without gerrymandering, made by the Center for Range Voting. Nonpartisan initiatives such as these are exactly the sort of thing needed to prevent the electoral frauds and altogether the unfairness of the first-past-the-post system. And most importantly they increase the accountability of politicians in democracies, preventing them from turning into a certain Bell, CA city manager

Wednesday, 20 August 2014

What happens if the "right" people don't hold power?

A bit of bureaucratic wisdom by Sir Humphrey Appleby (Yes Minister TV series).

If the video doesn't work, see it on this link.

Wednesday, 13 August 2014

Argentina's default - what's it all about?

Two weeks ago Argentina has once again declared default on its debt (the last time being 13 years ago during the infamous Corralito in 2001). This makes it their 9th default since they got their independence almost 200 years ago (Reinhart and Rogoff have the numbers: Argentina defaulted on its debt in 1827, 1890, 1951, 1956, 1982, 1989, 2001). In the slow summer months this is obviously the top story: New York Times organized a debate questioning the justice behind the default (since after all it was the New York federal court which ruled that Argentina must pay a small group of bondholders $1.5bn by the end of July), Kenneth Rogoff and Joseph Stiglitz propose solutions on Project Syndicate, coupled with the usual reports from The EconomistForbesWSJThe Economist (2), Financial Times, etc. 

What happened? 

After last minute talks being held in New York with a small group of its bond holders, colloquially referred to as "vulture fund" investors (see definition here) but usually called "holdout" investors, who demanded, by the order of the New York federal court, that the Argentine government pays them its $1.5bn debt obligation, the government refused to do so and was consequentially in default over its debt. 

The story gets more convoluted. The relentless group of holdout investors, led by US investor and hedge fund owner Paul Singer, represent only a small portion of Argentina's debt holders who didn't agree to a debt restructuring scheme after the 2001 default. Yes, the story originates in 2001. Back then Argentina defaulted on its debt during a major financial and fiscal crisis (the Argentine great depression, it was called). They simply stopped paying off their obligations to thousands of investors worldwide who were attracted to Argentine government bonds offering relatively high yields at the time (in the 90s). After facing an immediate credit halt, the government faced an enormous challenge in trying to refinance its debt and stand back on its feet. In 2005 they reached an agreement with the bondholders and began the process of debt restructuring. They exchanged 76% of their defaulted bonds for new ones with only 25% to 33% of face value of the old ones (investors had to agree to a huge cut). There was a second debt restructuring in 2010 which took the total to 93% of all defaulted bonds being restructured. The only ones who remained were the investors that were persistent enough in getting their money by court. 

So where do the "vulture funds" come in? In 2002 when Argentina stopped paying back their debts, many bondholders realized they were holding worthless assets and were trying to quickly get rid of them in order to cut their losses. Paul Singer, owner and founder of Elliott Management hedge fund bought off most of these bonds at only a fraction of their initial value, for $48 million. Today, they're worth over $800 million, provided that the Argentine government repays them in full. A hefty profit, isn't it? That's how the so-called "vulture funds" make their money - they buy worthless junk bonds for a cheep price from panicking investors and then get their money in court from the government who sooner or later has to repay them. It's standard practice actually. 

Which brings us back to July 2014 and the decision of the New York federal court for Argentina to meat its obligation to these investors. The problem was that the ruling of the judge Thomas Griesa forbade Argentina from paying its obligations to those creditors which accepted the debt restructuring of 2005 and 2010, until they meet their obligations to those who did not accept the restructuring (the holdouts and the "vulture funds"). The logic behind the decision is the "equal treatment" clause called pari passu, implying that borrowers need to treat all bondholders the same. It's not that Argentina didn't have the money to pay - they did, they've deposited $540 million in Bank New York Mellon which was supposed to transfer the money to the creditors. But the court ruled that Argentina could not pay the creditors which accepted the restructuring until it pays off those who rejected it. The court gave them a deadline of July 30th 2014 to arrange a way to repay these creditors. The Argentine government refused. 

Why did Argentina do this? It's not as if they don't have the $1.5bn to pay out to Paul Singer. The story is much more complicated. If they had repayed the money, thus respecting the court's decision, this would have encouraged other holdout creditors to demand full payment on their investment, which raises the price to $15bn. Furthermore other creditors who accepted the initial restructuring could do the same thing, and this raises the bill to over $140bn (30% of their GDP). It's easy to imagine if you're a holder of Argentine debt, and you see others being successful in getting paid in full via a court order, you might as well try it yourself. 

Now its easy to see why the Argentine government had no choice but to declare an unusual default.


This creates problems for other countries in debt restructuring schemes. Namely Greece and certain other European countries. Who is to say that Greek creditors wouldn't follow the example of Paul Singer and bring the whole thing to court. When it comes to your money, vast sums of it, you hardly care of the problems you're imposing on the economy of the debtor country. Just ask George Soros and does he care about the pains he caused Britain in 1992 (one can say that he does, he's into philanthropy now, isn't he?).

Argentina PD From 5Y CDS Spread Updated

But the moral hazard issue is much, much deeper. On one hand you're breaking an essential commitment in the debtor-creditor relationship - an obligation to pay the money back. If someone takes someone else's money and doesn't pay him back, that's called theft. This was what the "vulture" investors are counting on and this is why legally they're 100% right. No doubt about it. 

But on the other hand, if the government does pay to this small fraction of investors it creates a whole plethora of unwanted effects. Payment to them implies paying money to all other holdout investors and possibly those who already accepted the cut on their investment. And after all the "vultures" themselves didn't actually borrow the money to Argentina, they just bought highly undervalued bonds of those who did borrow money to Argentina. But legally, the obligation to pay is mandatory.

The "vulture" investors know this, the Argentine government knows this, all other investors are standing by, so we enter a very interesting bargaining game between the first two. And in this case it's fair to say there is no winner. The holdout "vultures" aren't happy as they're still not getting paid. The rest of the bondholders are being prevented by court to get their money. And as for Argentina, yet another default only pushes their country into further problems.

So what next? More negotiations between Argentina and the holdout investors where some settlement must be reached. In the meantime, the bonds are earning an 8% interest on missed payments which is only to the benefit of the bondholders. Apparently, they can wait. The law is on their side, no matter how President Cristina Kirchner tries to describe it. 

Saturday, 9 August 2014

Week links (9)

Some texts that caught my attention over the past few weeks:

1. Argentina's default
As you may or may not noticed in these summer weeks, Argentina has declared a bankruptcy for the second time in 13 years. They place the blame on a US (vulture) hedge fund and its owner Paul Singer. A "vulture fund" buys cheap debt (bonds) of countries in financial distress for a discounted price and then profits by suing the debtor country, usually striping it of its assets. The coverage: The EconomistForbesWSJWashington PostNew York TimesKenneth Rogoff, etc. 

2. Inheritance flows in Sweden, 1810-2010, VoxEU
An impressive database covering a very sensitive issue of inequality based on inheritence, one of the topics emerging through the works of Atkinson, Piketty and Saez.
"Overall, our analysis of inheritance flows in Sweden since the early 19th century point out two major lessons with respect to the development of capital and its impact on inheritance. Historically, Sweden does not fit the picture of a country where, despite a long history of aristocracy, accumulated capital was large in relation to income (even though inequality and capital concentration might have been high). In more recent times, Sweden stands out as a country where the return of capital has not automatically translated into a return of inherited wealth. It remains to be seen whether this is just a delay based on new wealth being accumulated mainly among the relatively young, or whether inheritance will remain low due to aspects of how intergenerational transfers of wealth are organised in Swedish society."
3. Chris Patten: What I've learned from Vladimir Putin, Project Syndicate
Bottom line is he is not to be trusted.

4. Tyler Cowen: Political booms and financial crisesMarginal Revolution
Cowen finds a very interesting paper showing how abrupt rises of government popularity in emerging economies predict financial crises better than any other warning indicator such as a credit boom.
"We show that governments in emerging economies are more concerned about their reputation and tend to ride the short-term popularity benefits of weak credit booms rather than implementing politically costly corrective policies that would help prevent potential crises."
A sort of a political business cycle, isn't it? 

5. John Cochrane: Work and jail, The Grumpy Economist
Cochrane points out to a staggering relationship between black male high school dropouts and their risk of imprisonment: 
"Nearly 70 percent of black high school dropouts will spend time in jail. And pretty much end their hopes for conventional employment as a result."

He blames the war on drugs for this. An interesting read.

6. Scott Sumner: Economics: Truer than it seems, EconLog
"One thing that economists and non-economists have in common is that they underestimate the power of economic theory. More specifically, they aren't able to accurately connect the predictions of economic theory with the behavior that they (wrongly) think they observe in the people around them. There are many examples of this. For instance, most people (economists and non-economists) underestimate elasticities. They underestimate how strongly people respond to changing incentives, such as tax changes, wage changes, price changes or interest rate changes."
A recommended read to a prospective economist. He offers a very good explanation of the logic behind the Ricardian equivalence. 

7. Acemoglu and Robinson: "Why Lebanon has a very ineffective state" and "The will to make legible" - both on the problems of state formation, Why Nations Fail blog

8. How the year you were born influences your political preferences, NY Times
This one is from the beginning of July, but it's still very amusing - the authors (of the paper not the article) claim that you form your political preferences between the ages of 14 and 24. These are the most formative years, whereas events that happen after you turn 40 don't change your opinion by much. Apparently if you were born in the 1940s your preferences were formed during the Eisenhower administration making you relatively more pro-Republican, while the baby boomers born in the 1950s were influenced by administrations of Kennedy, Johnson and Nixon making them relatively more pro-Democratic. Makes sense.

Well, would you look at that, if I was born in America, I would have been (on average) a Democrat by now, with my political views forged mostly by the Bush and Obama administrations. Interesting...