Tuesday, 11 November 2014

Graph of the week: A country divided

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

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

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

For example consider the following two maps:

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

Saturday, 8 November 2014

In memoriam: Gordon Tullock

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

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

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

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

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

Sunday, 2 November 2014

The ECB stress test: same old, same old

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

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

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

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

Sunday, 26 October 2014

Railway links: or how does one solve the problem of monopoly in infrastructure?

Here is a map showing the service of Amtrak train company, America's government subsidized passenger railroad company.

The map depicts Amtrak's stations across the US, where the size of the circle corresponds to the number of passengers circulating on the given station. This was taken from a summer blog at the Economist (they got it from here) where they questioned the justifiably of some of Amtrak's regular lines across the country when almost a third of their passengers use the service across only three cities (New York, Washington and Philadelphia). 

The Economist concludes:
"...Amtrak's long-haul routes (you can see them on the map as the tiny blue dots stretching across most of the country) are money pits. But America's bizarre constitutional structure, which gives outsized influence to states with small populations, creates an incentive for Amtrak to maintain unprofitable services that keep influential senators happy. 
If its long-haul trains were cancelled, Amtrak would serve just 23 states, down from the current 46. That would make it more profitable, allowing it to improve services in areas where it actually has riders—Mr Hicks suggests increasing train frequency between major midwestern cities. But an Amtrak that served just 23 states would likely be politically unsustainable—and that's exactly the problem."
This is the classical problem with any state-owned service that offers some sort of a public good. The public post service faces the same issue - because they have to offer the service even in the remote parts of the country they face high loses in such areas. A publicly owned train company is similar. Amtrak has to travel across all these routes to perform its public good function, in addition to making a few senators and congressmen happy. If it were to close down some of its unprofitable routes it would perhaps eliminate the need for such high government subsidies, but it would cause distress to local residents where the train lines have been cancelled. In economic terms the issue is pure cost-benefit, where the benefits for the many (lower subsidies and hence lower public spending, or perhaps better targeted public spending) outweigh the costs for the few. 

But politics doesn't work this way unfortunately. Very often for precisely such local issues the benefits to the few outweigh the costs for the many. That's essentially the reason why in many countries small, well organized groups, usually of a local origin, get what they want from the state budget, even though such decisions usually come at a high cost for the taxpayers. They successfully solve the collective action problem, whereas the taxpayers as a dispersed group cannot do anything about it. This is in fact one of the biggest problematic features of democracy, that needs to be solved on a constitutional level.

But I digress. The point was that in many countries large public sector companies are maintained (and by that I mean heavily subsidized) because they offer a unique service even to those areas and customers to which the 'market' wouldn't  offer the same service, or would offer it at a very high price. This is an example of the classical market failure argument

However the argument doesn't make a compelling case that by closing some of the inefficient routes there would be no market participant to provide the alternative. The costs are high, sure, however on a local level if the demand for some means of transportation is high, there will be a subsequent supply. Some entrepreneur will design a way to surpass the lack of supply and offer an alternative. Perhaps the trains across country are unpopular due to the length of travel which is why the people choose planes instead? Perhaps the primary mode of transportation in local areas are cars and buses? Perhaps the demand for taking the train in some areas is low, so the supply must simply adjust. If this means no more train services in a certain areas, this is purely the decision of the customers. The customers probably don't take trains because other modes of transportation are better and more efficient. If the company doesn't adjust to the needs of the consumers, it fails, or in a publicly-owned company scenario, it gets heavy subsidies. 

Another factor we should control for is the role of technology. Why aren't Amtrak's trains super-fast Maglev trains like in Japan? If they were, if it were possible to get from New York to LA in 8 and a half hours (2700 miles for a train traveling at 320 mph) instead of 2 and a half days, then perhaps many would take this opportunity. There is talk of magnetic technology that can make transportation even more efficient and even faster. If this ever becomes true than this type of a technological breakthrough in the railway system would be a huge disruptive technology for the airline industry. And then the airline companies will have to be subsidized as the less efficient mode of transportation.

Returning back to the initial question from the title, governments should provide only the basic, essential public goods such as the proper justice system, private property protection, enforcement of contracts, and the basic infrastructure, all of which equally benefit everyone. The basic infrastructure does not imply having large, inefficient public companies being granted a monopoly on a certain service (btw monopolies should never be classified as market failures since it is the government that offers a licence for a company to be a monopoly). It implies that the government builds the roads and railways for the market participants to take advantage of. Literary and figuratively speaking. It is up to the entrepreneurs to seize the opportunity and satisfy the specific demand for a certain service. Heavily subsidizing public companies for inefficient services is never the solution. In terms of technology (building super fast Maglev trains), because its early implementation can bring about extremely high costs (just like the initial railways and roads had enormous costs), this too can be justified as a necessary, basic public good that brings an equal benefit to all the citizens, not just the selected few. 

Tuesday, 14 October 2014

Jean Tirole wins the 2014 Nobel prize in economics

It's that time of the year again - the Nobel prize announcements. As always, the last in line is the Sveriges Riksbank Prize in Economic Sciences in Memory of Albert Nobel, or colloquially the Nobel prize in economics, awarded yesterday. This year the honorary recipient was Professor Jean Tirole from Toulouse, France, one of the most cited economists in the World. He is only the third Frenchmen to receive the prize, first one since Maurice Allais in 1988. In addition, this ended an almost 15 year domination of US-based economists (at least one recipient each year was a US-based economist - they still dominate the field, as in every other science btw). Also he's one of the rare economists who got the honor as a single recipient (which became particularly rare in the past 15-20 years).

The award was given for his contributions in the "analysis of market power and regulation". Basically Tirole studied monopolies and oligopolies (since most industries are actually dominated by a few big firms), and how to regulate them to produce more socially-optimal outcomes. 

Here's a paragraph from the Nobel committee:
His analysis of firms with market power provides a unified theory with a strong bearing on central policy questions: how should the government deal with mergers or cartels, and how should it regulate monopolies?

Before Tirole, researchers and policymakers sought general principles for all industries. They advocated simple policy rules, such as capping prices for monopolists and prohibiting cooperation between competitors, while permitting cooperation between firms with different positions in the value chain. Tirole showed theoretically that such rules may work well in certain conditions, but do more harm than good in others. Price caps can provide dominant firms with strong motives to reduce costs – a good thing for society – but may also permit excessive profits – a bad thing for society. Cooperation on price setting within a market is usually harmful, but cooperation regarding patent pools can benefit everyone. The merger of a firm and its supplier may encourage innovation, but may also distort competition.
The best regulation or competition policy should therefore be carefully adapted to every industry’s specific conditions. In a series of articles and books, Jean Tirole has presented a general framework for designing such policies and applied it to a number of industries, ranging from telecommunications to banking. Drawing on these new insights, governments can better encourage powerful firms to become more productive and, at the same time, prevent them from harming competitors and customers.

Very applicable stuff! Here is a more detailed explanation (slightly technical), and here is a very reader-friendly explanation

All in all, a well deserved prize for Professor Tirole. Personally, I'm mostly familiar with his contributions to game theory (the textbook he and Drew Fundenberg wrote on game theory is a state-of-the-art piece of work, I recommend it to any PhD student). However his biggest contributions are, obviously, in the field of market regulation (where he also has a very influential textbook: "The Theory of Industrial Organization"). Even though, as Tyler Cowen noted, his research extends to a variety of fields, and he is particularly good in formalizing propositions and assumptions, and in mechanism design. Since his papers and their results are usually very complex, he hasn't been particularly present in the media, despite his ideas significantly influencing public policy. For example, here is an old text of his from 2007 published at VoxEU called "Four principles for an effective state". Read it, it's excellent and ever more applicable in today's situation. He advocates restructuring, competition, evaluation and accountability in order to turn big, useless states into efficient ones focused on the quality of the public service they offer. It's all very clear and straightforward. And yes, even in 2007 Tirole called for reforms. What does that tell you?

The contributions he has made in industrial organization theory are particularly important in terms of understanding how 'imperfect' markets work. We are surrounded by such imperfect markets, suffering from asymmetric information and monopoly and oligopoly power (this means that one big firm or a group of big firms dominate the market - there are so many industries today where this is a fact: from the automobile, telecommunications, energy, to even some aspects of finance and even some fast consumer goods). For regulators it is often very hard to evaluate all the details of the firms, particularly in terms of costs and benefits of improving quality of the offered product or service. The regulators, just as consumers, also tend to suffer from an asymmetry of information, since firms between themselves enter into a variety of games and interactions, all which would be far too complex to model and particularly to regulate and supervise. Tirole and his range of co-authors have used game theory and contract theory to explain how particular tools can be used to overcome these difficulties. The scope of his contributions is thus monumental for industrial policy and the market failure problems in general. He helps us understand how one can avoid both market and government failures in producing an optimal outcome for societies. 

Finally, have a look at some reactions and comments from notable economists: Tyler Cowen has a great post celebrating Tirole's achievements, so does Alex Tabarrok at the same blog, The Economist offers a series of links where they touched upon some of his ideas, the WSJ blog explains who he is and why he deserves it (my former LSE professor Torsten Persson explains it in an interview), Mark Thoma provided a series of other links, etc. 

Most notable (selected) works: (all available here)