Friday, 26 December 2014

Hits and misses: Evaluation of last year's predictions

As 2014 is coming to an end, this is a good time to wrap up the year and look back at some of the events that passed us by, but most importantly it's a good time to present a quick overview of the predictions I've made in the beginning of the year and assess how good they were. 

I actually had quite a lot of hits, and only a few misses this year. I won't be modest in saying that I'm getting pretty good at this. Perhaps reading Bueno De Mesquita's "The Predictioneer's Game", and Nate Silver's "The Signal and the Noise" rubbed off some of its magic on me?  

Here goes (the predictions for 2014 were made on January 2nd 2014):

The Hits: 

1. "next year a stronger recovery should finally kick off in most of the Western world. Emerging markets will grow too, however less dynamically than before...In America the energy boom will reignite the recovery momentum...America's stronger growth will rub off on Europe as well, so we can finally expect to see the Eurozone with positive growth rates next year (around 1%)...."

This was spot on. The Eurozone grew at 0.8% (the EU at 1.3%), the US reignited their momentum, while the emerging markets slowed down (their growth dropped from an average 7% to 4.4%, amid rising bond yields). 

2. "Central banks will keep rates low in 2014."

This was kinda obvious.

3. "I often make predictions of the World and Euro Cup winners just before the tournament, and I often come close. This time my call is Germany...
...In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose..."

Painfully accurate! (painfully for Brazil of course)

4. "In Europe, the EU parliamentary elections in May will give rise to anti-EU parties (both far-left and far-right), mostly thanks to low turnout and discontent with economic recovery from the majority of the population."

Yet another painfully accurate prediction. 

5. "In the UK, growth will be better than last year, probably somewhere around 2%. It will mostly rest upon the housing recovery and an improving global environment."

Not too far off, growth will probably be around 2.6% for this year. 

6. "The Scots will vote no. The majority of the population is Scotland doesn't want independence, but rather more power for their country within the Union... They will get this, but not next year."

Got that one right too, even on the long term issue of constitutional reform in Britain.

7. - 12. A number of predictions for the US came out true:

"An immigration reform is expected sometime next year...
...Obamacare, the hot issue in America, will not be repealed. The individual mandate will be triggered in 2014, but despite this many will still stay uninsured...
...The health spending budget will rise even higher, currently around 18% of GDP. This will most likely hurt the Democrats in the November midterm Congressional elections, ... but the power struggle in Washington will remain as it is...
...The recovery will continue steadily with the country growing at around 3%, led by a housing recovery and an energy boom."

Only one miss here: "the power struggle in Washington will remain as it is"

Republicans got hold over the Senate. However one can say that the power struggle on the line President vs Congress did actually remain as it is.

13. "India expects general elections in 2014, where Narendra Modi is expected to become the next PM. The economy will remain to be weak, suffering from high inflation, a large budget deficit, weak currency, rising debt and loss of international confidence." 

Modi did become the PM (and it was a landslide victory), while India's economy remained structurally weak. It does however have reasons for optimism in 2015 (in part due to declining oil prices), but that will be covered in next week's post, in the predictions for 2015. 

14. "In Brazil ... I don't expect the mass protests that have happened last summer during the Confederations Cup to be repeated this summer."

15. "The recovery is not happening because of the policies enacted by the politicians, it is happening despite them (like the housing and energy booms or the reemergence of international trade). It will be bad if the politicians take this good news lightly and halt the necessary reforms. Unfortunately, it seems that this is exactly what will happen." 

A warning sign that went unnoticed. Particularly in France and Italy, so it seems. 

The Misses:

1. "Japan too will continue with positive results, riding on Abenomics, although it will most likely fail to lift inflation to the targeted 2% next year." 

I predicted correctly that inflation will stay low, but I was way too optimistic on Abenomics. I blame it on the bias of the Economist. I got carried away after reading their optimistic reports on Abe as the Japanese Superman (I'm not kidding, this was even a cover of an issue in 2013).

2. "Latvia will once again be the fastest growing member at around 4% growth...
...the largest negative growth will face Greece or Slovenia (around -1%)..."

Latvia grew (at 2.6%), but it wasn't the fastest growing member. This esteemed title went to Ireland (4.6%). Greece was a miss (kudos to Greece for finally reaching positive growth figures, even if marginal) as was Slovenia. The worst was - Cyprus (-2.8%, according to the EC). Note: these estimates don't take into consideration the final quarter of 2014, but already we can notice the trends and declare "victors". 

3. "Chinese growth will drop down below 7%. Will next year be the year of the bubble burst in China? Possibly." 

Underestimating China again? Oh well, maybe next year.

4. Brazil: "I'm not sure Rousseff will hold onto power." 

She did. A very narrow victory (51.6%), but a victory nonetheless.

5. "World Cup: The wild horse will be Belgium, which could reach the half-finals, where it will probably face Spain or Uruguay. In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose, but will go on and win the third place playoff." 

Ok, so Spain and Uruguay were misses, as was the Brazilian third place, but Belgium did ok, didn't it?

Under the radar: 

I didn't include anything on the Ukrainian situation, as by the end of last year it merely started unfolding. This set the stage for a whole new, cold-war-reminiscent, foreign policy battle that hardly anyone could have anticipated. For Putin I stated that the Sochi Winter Olympics are "expected to be a combination of extravagance, glamour, waste and corruption. But also it will be a new showcase of Putin's power to the rest of the world."

Well, Putin used something else to showcase his power. Something much more convincing - the Russian army.

And with this image I wish all my readers a Merry Christmas and a Happy New 2015!

Monday, 15 December 2014

Why Germany is right to "hold Europe ransom"

As I've stated in an earlier post, my recent trip to Germany has been full of positive experiences. Most importantly I gained insight into why Germany (i.e. its formal institutions) feels so strongly about the agenda for structural reforms and why it opposes any alternatives, particularly looser monetary policy and the idea that Germany should stimulate its economy to raise European aggregate demand.

A country that was once called the "Sick man of Europe", was the first to undergo painful reforms. Back in 2003 they started with preparation and implementation of the so-called Agenda 2010, which I covered on several occasions in the blog (see here or here). The Agenda carried a series of reforms, but the most notable and important ones were the labor market reforms (i.e. Hartz reforms), because of which Germany was able to cushion the blow of the 2008/09 crisis. Germany had the lowest increase in unemployment (virtually none) of all European countries during the crisis. 

The labor market reforms necessitated a joint approach from all sides, so the negotiations that started in 2003 included the federal government, businesses, unions, parliamentary representatives (i.e. all political parties) and even scientists. The centerpiece of the labor market reform was to curb the power of unions and craft guilds, making it easier for the young to enter the market, while contributing to the labor market flexibilization. The unemployment benefits were cut (a German can draw unemployment benefits only around half as long as an American), tax reliefs were introduced to those hiring, in addition to a whole set of marginal but important measures. The initial reaction was, as always, a shock. Unemployment increased as businesses started optimizing their labor intake (and hence firing more), coupled with dissatisfaction among the unions and guilds which in the end cost Chancellor Schroeder the elections. But the system was reformed. And it was precisely because of these reforms that Germany weathered the crisis much better than any other country in Europe. 

Leading by example: a balanced budget 

And once again Germany is leading the way in showing how to get out of the mess of unsustainable debt and sluggish growth. It is leading by example - next fiscal year Germany will have a balanced budget for the first time in decades. According to the debt projections, labor market trends and most importantly demographic trends (an ageing population), cutting debt is essential. An old population overburdened with debt is no promising future. Which is precisely why the number one priority of the government at this moment is to cut debt. How does one do that? "Easy", start by balancing your budget. The figures below show a strong statement of intent: Germany intends to have a budget surplus until the debt-to-GDP level is cut down to the Maastricht ratio of 60%. According to the existing projections, Germany will achieve this in 2018, so in only four years! Take note Eurozone periphery, this is what proper austerity looks like: 

Source: Federal Ministry of Finance
Source: Federal Ministry of Finance
Will this affect their GDP growth? Most surely. Growth will remain to be low at around 1 to 2% in the next few years, but just like in 2003, the system needs to be changed. And in this case the system needs a debt decrease. The opportunity cost of a temporary slowdown is low enough to justify the austerity approach applied by the Germans.

Criticism from the EU

However this zero deficit approach generates fierce criticism across the EU. Many have stated that Germany should continue to pile up debt to keep aggregate demand in Europe higher. They blame Germany on "holding Europe ransom" by forcing them into austerity without providing any relief. Germany should, according to the critics, provide more fiscal stimuli into Europe (indirectly of course) to help the rest recover as quickly as Germany did. However the German logic makes more sense. Germany is not in a recession (contraction) so it sees no point in applying the classical counter-cyclical solutions such as large spending hikes. Instead they opt for encouraging private investments instead of large public investments. This is best done with measures such as capital gains tax write-offs, lower corporate taxes, lower income taxes and other regulatory and non-regulatory (legal) measures aimed at helping businesses grow (see here a short guide for attracting foreign investments). Attracting private investments is the right approach, everything else in a state of unsustainable debt is wrong. FYI, private investments in Germany consist of 17% of its GDP, whereas public ones consists of only 1.8%. 

Germany has its own problems it needs to take care of. As mentioned, with an ageing population large public debt becomes a big problem. Not now, but in the near future. And Germany wants to address this issue immediately, not wait until it's too late. 

Furthermore the rest of Europe isn't far away from the German problem. They too are overburdened with debt, and Europe in general is ageing. Demanding large stimuli and further indebtedness is self-defeating, particularly in the long run, which isn't so far away. Even in the short run it won't cause the effect it is supposed to. Why? Because the private sector deleveraging in Europe as well. Two IMF economists show why this is a drag on growth particularly if all three major sectors of the economy (government, households and corporates) have high debt levels:

Source: VoxEU
The other reason is lack of lending. Banks are safe (according to the latest ECB stress test), but still unwilling to lend. And then we reach monetary policy. Critics of the ECB (and hence the Bundesbank) call for looser monetary policy, i.e. for a more expansionary approach. According to this argument it would be best to simultaneously apply both expansionary monetary policy and an expansionary fiscal policy to raise European aggregate demand. And then do the reforms, which everyone agrees are necessary. 

Where have I seen this approach fail most recently? Oh, that's right, Abenomics, the policy package of Japanese PM Shinzo Abe aimed at finally pulling Japan out of a 20-year-long stagnation. It's not so wise however to use the same policies that have failed consistently for 20 years and then hoping that suddenly they will make a difference. Even if applied simultaneously

Europe tries to do the same thing. Avoid a painful solution and provide persistent short-term stimuli, hoping that at one point they will make it. Economics doesn't work that way unfortunately. Not when there's so many structural unbalances as they are today in Europe (and Japan). Which is why, in my honest opinion, Germany holds the key to Europe's success. Leading by example in balancing their budget, while forcing structural reforms upon other nations is the only way to go for Europe. Everything else leaves them in a state of Japanese-style decades-long stagnation.

***

Addendum: One of the most commendable things about Germany's economic policies is the continued increase of investment in education. Despite the crisis and the (brief) recovery period, Germany increased spending on education from 3% to GDP before the crisis to almost 5% to GDP in 2014. This will be increasing even more, as the Germans have recognized where the foundations for long-run growth lie in (see here for greater detail). 
Source: Federal Ministry of Finance

Sunday, 7 December 2014

The German Social market economy

I've spent the entire last week in Germany, as a part of a delegation of Croatian economists and economic experts, organized by the Konrad Adenauer Stiftung (KAS). The idea was to visit the main economic and political institutions in Germany and open a dialogue on the problems facing Croatia, but primarily to learn about the experiences of the German solutions/responses to the crisis through the conceptual framework of their Social market economy (i.e. the German ordoliberalism). We have visited a series of institutions, starting with the Bundesbank and the ECB in Frankfurt, and ending with the Ministries of Finance, Economy and Energy, Labour and Social Affairs, and even the Office of the Chancellor, all in Berlin. In the middle we visited a series of other noteworthy institutions like BaFin (the regulator of financial services), the Council of Economic Experts, DIW institute, the banking association, a few members of parliament and so on. I plan to write a separate post on some of the main outtakes of the trip, with emphasis on how the Germans see their role in Eurozone, opposed to how the rest of Europe sees it. And rightly so. Before I descend into commenting the actual state of the German economy, I would like to extend a few thoughts on their "unique" idea of the so-called Social market economy. 

But first a little bit about the trip initiators and organizers, the Konrad Adenauer Stiftung. KAS is a political foundation (stiftung means foundation), associated with but independent of the German center-right party CDU which currently holds power in Germany. The idea of the Stiftung is to promote the ideas of freedom, liberty, peace and justice, democratic consolidation, and development, mainly through their civic education programs, but also to provide a basis for political action, all around the world. A similar institution to KAS is a foundation called Friedrich Ebert Stiftung (FES) aligned with the social democratic SPD. Both of these political foundations act as a sort of a shadow embassy outside of Germany, that connect their own parties (parties they're aligned with) with the opposition and in-office party of the country they reside in. In addition to this role, they both act to promote the civil society. KAS has offices in more than 120 countries worldwide, and thus serves a foreign policy role as well. For example they had an important role in the reconciliation and partnership between Germany and Israel, a relationship previously rebuilt by the Chancellor whose name the foundation carries - Konrad Adenauer. Rebuilding this relationship was crucial for Germany after WWII, and was the final step towards designing a new German society, one based on strong institutions, competition and democracy. Or in other words - ordoliberalism. 

Social Market Economy

So what is the Social market economy (in German: Soziale Marktwirtschaft)? According to the prevalent German interpretation it represents a type of market capitalism combined with policies promoting social insurance (protection for the poor, unemployed, health benefits, etc.). It is based on the idea that markets must be in the center, coordinating the economy (prices), while market participants must be constrained by strong and enforceable institutional rules. It is a system based on competition, order, and most of all on setting a clear institutional framework in which the market actors must participate.

Germans are proud of this model, introduced by the great Ludwig Erhard (pictured) back in 1949, who was then a Minister of the Economy, under Chancellor Konrad Adenauer. Erhard was the Economy minister for the entire duration of Adenauer's Chancellorship (14 years, from 1949 to 1963), and succeeded him as the next Chancellor from 1963 to 1966. He is widely lauded as the creator of the Social market economy, presented at the time as the compromising "Third way", something between the laissez faire Anglo-Saxon liberal capitalism (which was still, in the mind of the Germans, to blame for the Great Depression of the 1930s), and the communist central planning system (introduced during the Weimar Republic and fully applied during National Socialism). Germany needed something new at the time, an idea that transcends the fallen ideologies of the past. It needed, for the first time in its history, to apply a truly capitalist, market democracy.

That's why the model was so successful. From 1949, Germany, for the first time in its history, has introduced a democratic system with a market economy. The term most usually related to Erhard and this initial period of German democratic consolidation is the German economic miracle, which has in the 1960s and 1970s crated an economic powerhouse that Germany is today. It didn't start without problems however. In the begining, after the destruction of the Second World War, Germany was under occupation and under price controls and rationing. Housing was destroyed, industrial production as well, food production halved, inflation was an open threat yet again, and a lot of male population died in the war. The task seemed impossible, particularly due to the country being split in half and the animosity arising among its occupiers. But Erhard was stubborn enough to push through his reform despite the fact that many opposed it at the time. Even the allies weren't sure of his ideas. But he abolished the price controls and rationing of food, he limited monopoly power by introducing antitrust laws, reduced marginal tax rates (from 95% to 18% marginal rate), introduced a new currency reform to bring back price stability (and eventually turn the German Mark into the strongest currency in Europe). All the reforms came as an initial shocks, particularly the contraction of the money supply, but the stage was set for Germany to take flight. Literary overnight the country came to life. 


One might ask how is this economic model any different from the one applied in most of Europe today? A market economy with a welfare state - that's what Europe basically is. Some are more successful at it (Germany, Scandinavia, even the UK), while some are less (France, Italy, Spain) - relatively speaking. Who is to say the UK isn't based on the very same principles, even during the Thatcher era? A strong market-based economy, which has a notable social category. The difference here is not so much Germany vs rest of Europe, as it is Germany vs the United States. However the difference here is also in the margins. The US has something called cut-throat capitalism which fosters huge innovation and a keen trial and error process, while Germany (as well as the rest of Europe) has cuddly capitalism, which also innovates but to a lesser extent primarily due to a more lenient trial and error process. (These terms are used by Daron Acemoglu in a very interesting paper he co-authored with Robinson and Verdier, and which raised quite a discussion back when it's working paper version was published).  In Germany for example if you start a business and fail once, you don't dare repeating the same mistake again. In the US it is quite common to start over 4 or 5 times before finding the right recipe for success. After all Merkel recently expressed concern that there is no German Google or German Facebook. There is a reason why this is so, and why those kind of companies originate in the US, not in Europe. Which is not to say one system is better than the other. Both have their strengths, but both have weaknesses as well. The US exhibits higher levels of inequality because of this (even if we look at it historically), but due to its entrepreneurial spirit it has a much shorter time span for recovery and a much quicker response time than Europe. 

Overall, the German success is a unique story, but it's not a unique economic system. It is a market democracy with strong institutions. As easy as this sounds, for many countries there's still a long way to achieve it. 

Thursday, 27 November 2014

Two faces of modern entrepreneurship

The Atlantic had a very interesting recent text on the "Mysterious Death of Entrepreneurship in America" where they tell the tale two breads of entrepreneurs, one thriving and the other one hopelessly failing. At the same time when Silicon Valley entrepreneurs are soaring, the smartphone app market is booming, pages like Kickstarter are redefining the the very supply and demand for funding (providing a very interesting alternative to all sorts of traditional lending schemes), but on the other hand business dynamism overall is declining. Mom and Pop stores are dying out. BLS has the data: 



Brookings has produced a study describing the very same process of entrepreneurial decline, where the declining business dynamism is obvious across all sectors of the economy. As I've written before, the process of creative destruction in the US has halted in the past years. And why is this worrisome? Because of the effect on job creation. No longer are US SMEs the key driving force of new employment. 























This could be down to several reasons. One is surely the effect of the recession, even though the trends of declining business dynamism go all the way back to the 1990s (see further data here). Another could be the fact that the big companies are expanding more and more and are thus simply taking up more space in the corporate game, successfully running the small stores out of business. These big companies are usually not the source of major job creation (see the final graph), since they tend to expand abroad after reaching a certain size, where they focus much of their new job creation. This is why historically the domestic job growth in countries like the US has always originated from SMEs. Which is also why Americans like start-ups and small businesses. This is the famous US entrepreneurial spirit: 
"One paradox of globalization is that it's localized employment. Since big companies off-shore much of their job growth (or replace what's left of it with software or smart hardware), the future of work in the U.S. will come from work that absolutely has to be here, like health care, education, and food services. Start-ups can be special for many reasons—they can challenge lumbering incumbents, they can create new demand for stuff, they can introduce more ideas—but from a big-picture macroeconomic standpoint, they're also special because they're here, and when they expand they tend to expand here. It's easy to make fun of Silicon Valley these days. But at least its companies have a California address."
All in all, the declining trend of entrepreneurship is something to be worried about. It explains well why the US employment population ratio is still low, meaning that the US labor market hasn't really recovered (despite a low unemployment rate - I've mentioned this distinction several times on the blog). Furthermore all this could simply be pointing out to a new equilibrium for the US (Europe as well), where creative destruction has slowed down. The question is why? If it's a short-term consequence of the crisis, then a decade or so later we might see a reverse in trend. However, if it has slowed down due to structural instabilities and what Fukuyama refers to as political decay (I recommend his new book; read an excerpt from the book at Foreign Affairs), then the problem is extremely deep and it will take unprecedented effort to fix it. 

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)

Books:
Papers: 

Sunday, 5 October 2014

Imports and exports - two sides of the same coin

International trade seems to be one of the most misunderstood areas of economics for the average layman (the leading position of the most misunderstood area of economics is still being held by monetary policy, and the international monetary system in general. Why, I'll never know). People like to simplify things in order to understand them, and by doing so they often look at things from a one-dimensional lens, very often succumbing to Hazlitt's economic fallacies of focusing policy solutions on one area alone without taking into consideration the widespread effect on all groups nor the long-term impact.

I've written on international trade many times before, emphasizing its importance in wealth creation, and I've also written on the persistent mercantilist fallacy, where people can't seem to shake off the notion that exports are 'good' while imports are 'bad'. How ridiculous! Almost as ridiculous as claiming that selling is good while buying is bad, or in other words that only those who sell stuff will profit, while those who buy stuff are losing out. Nonsense.

Imports and exports are nothing more and nothing less than transactions of sales and purchase, except that the buyers and sellers are from two different countries. People buy products to satisfy their preferences, while sellers of goods aim to satisfy these preferences by supplying the goods the people want to buy. Both buyer AND seller will always profit from such a transaction. A matter of buying and selling is a matter of free will. A consumer will only buy a product if the value of that good is equal or greater than its price. If the good carries a price higher than how much you value a certain good you won't buy it. Voluntary transaction and individual expression of value is at the heart of every transaction, which implies that both the buyer and the seller must always be satisfied after a trade. Whether this implies buying food at the local supermarket, buying a pair of pants at a department store, or ordering stuff online, regardless of which countries the buyers and sellers reside in.

After all, governments (countries) don't import nor export. Companies do. They sell (export) and buy (import) on the international market. To be more precise the indirect 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 them from abroad since they know someone will buy them. Therefore, we as consumers determine the demand for imported, foreign goods. Whether it's clothes or food, that almost any country can produce on its own, or cars and IT goods that most countries can't. 

Should we forbid citizens from buying certain brands of clothing when we can produce perfectly fine shirts and pants domestically? Of course not. One cannot put limits on other peoples' preferences. Consumers will buy the goods they prefer. If someone has a particular taste for foreign expensive brand clothes, he or she will buy them. If a person finds that foreign meat, beer, chips, candy or apple juice taste better than their domestic counterparts they will buy them. And hence encourage imports. If a company can cut costs by buying an intermediary good from abroad rather than on the domestic market, it will do so. And also encourage imports. In today's globalized world, aggregate categories of imports and exports are becoming more and more obsolete. 

Thursday, 2 October 2014

Liberty in the long run

Back to blogging after a short break. I recently came across an older, 2010 article from Scot Sumner on Econlog, where he discussed the neoliberal revolution that began in the late 1970s. A very good text, explaining first of all the confusion over the term 'liberal' and what 'neoliberal' stands for (it "combines the free markets of classical liberalism with the income transfers of modern liberalism"), the confusion of associating neoliberal policies with right-wing political views (since most European countries that have actually been the best neoliberal reformers were social-democratic Nordic countries like Denmark - all hail the Nordic model!), to the very substantial evidence on how the most adamant neoliberal reformers quickly caught up the lost growth of the previous decades, particularly in terms of income p/c. From Britain's success in Thatcher times (where it grew much faster in the 80-ies and the 90-ies than most other European economies), to Australia, Canada, Hong Kong, Singapore, Sweden and of course the US, all of which grew much faster than their relatively more statist counterparts. 

He also explains the problems of perception of and implementation of neoliberalism in Latin America and the transitional economies of the former Soviet bloc. One particularly important issue with transitional economies is an introduction of democracy (free elections) before establishing an effective rule of law and the judicial system (a mistake many of the Arab spring countries are repeating today - elections are not a sufficient condition for a democracy). Because of this, the privatization process in transitional economies became subject to distortions and criminalization, which is at the very center of the critique against neoliberal reforms in transitional economies - that they favor big capital and run over the 'little man'. This is far from the truth, as Sumner also points out: 
"A few years ago, I researched the relationship between cultural attitudes and neoliberal reforms among the developed countries. It turns out that, between 1980 and 2005, those countries with more idealistic or civic-minded cultures (as indicated by surveys on attitudes toward the common good and by indices of corruption) tended to reform their economies much more rapidly than countries with less civic-minded attitudes. Interestingly, Denmark has by far the most civic-minded culture in the group of 32 developed countries, and, as noted above, ended up with the least statist economic system in the Heritage's 2008 rankings (excluding the two size-of-government categories). Greece has the least civic-minded attitudes and ended up with the most statist economy in 2008. Far from being a right-wing plot to enrich corporations, the neoliberal revolution was liberal in the truest sense of the term: a rational response by idealistic policymakers to the increasingly obvious failure of statist economic models in the 1970s and 1980s."
Finally, the results are clearly visible today. More economic freedom (a model close to that of the Nordic economies) implies higher per capita income, i.e. higher living standards. It all comes down to incentives for wealth creation. If the country has build (reformed) its institutional system to support wealth creation, success will not be eluded (but it will always be a rough and long process - see here, here, or here)
Source: Sumner (2010) The Unacknowledged
success of neoliberalism, EconLog
This entire story reminded me of a text published on VoxEU a few months ago, measuring the long term impact and presence of economic liberty.

Here are the results (read about the methodology here):

Source: Prados de la Escosura (2014) Economic liberty in the long run:
Evidence from OECD countries. VoxEU
Observing this long run pattern of economic liberty one can't help at noticing a strong correlation between economic freedom and positive development patterns (higher growth, rising living standards, technological improvements etc.). Whenever economic freedom even slightly declined there were problems for societies. Naturally more research needs to be done to start inferring any causal relationship here, but intuitively it makes a lot of sense. 

Notice the huge drop in economic liberty between the two World Wars (particularly on the lower, bar graph; the period between 1910 and 1950 was characterized by a huge decline in free trade). This reinforces an argument I was making in my essays on democracy (see here, here and here) - back then the people blamed liberalism and laissez-faire capitalism in a desire to achieve an alternative to their existing pattern of democracy. However, that period remains as one of the darkest in the 20th century and arguably in human history. Particularly after the start of the Great Depression where the world emerged into protectionism and state interventionism. Economic freedom was wrongfully accused of triggering crises. 

In the 1960s and the 1970s the same pattern of state interventionsim reemerged, under fears that the Soviet bloc is winning the battle of ideas. However in the 1980s, as Sumner's text shows, the clear victor emerged. And economic growth and living standards once again skyrocketed.