Technology In Jobless Recovery

The technology-update dynamics (see previous post) is central to the argument that the current crisis will finish with a jobless recovery, similar to the years after the 2001 dot.com bubble burst.

The raw form of the hypothesis suggests that the firms that had shed labour during the recession subsequently invest into technology, new technology in particular, rather than expand their labour force, when demand for their products is renewed. Here are some interesting graphs (source: Fed):

Or, in a different version (using the same data as that behind the second graph above):

(The above graph: US manufacturing growth rate MoM, minus the same without the high-tech sectors. The red line is the 12 month moving average. The second half of the 1990's is clearly over the average of the rest of the period, and the return to normal is rapid after the 2001 drop. Although this is no proof, it seems at least consistent with the hypothesis.)

Both of the above graphs suggest that there was a substantial amount of over-investment into technology before the 2001 crisis, and thus the 2002-04 years saw a productivity rise as a result in part of using the previously acquired technology, and only in part because of purchasing new technologies.

Interestingly, this is not necessarily the case for the current crisis: the level of investments into technology seems to have been on par with the rest: there was no over-investment into technology that would jump out of the data, at least not the data I am looking at now. However, the hypothesis does not necessarily require a previous over-investment, only the potential to increase production without new labour. Thus a lengthy halt to the technology-intensive fixed capital could do the same. If this was to happen so, there would be a fairly straightforward equity price consequence...

I have been trying to find data for comparable variables for the rest of the world. (The usual trouble: lack of comprehensive global statistics). The best I could come up with is the share of computer and communication services in services imports by the WBDI. Each regression had a linear time variable, and a dummy for the 1996-2004 years. Here is the result:

Eastern Europe, Latin America, Middle East, South Asia: either not significant, or low R-squared. East Asia, and the Euro area behaved - at least by this measure - in line with the US and the hypothesis. And so did Sub-Saharan Africa (but why, if the rest of the emerging and developing world did not?)

In sum, these back-of-envelope results do not contradict the hypothesis that jobless recovery stems from an underlying technology dynamics. In the case of the 2001 dot.com bubble, it seems that the productivity rise came, at least partially, from the over-investment into technology during the preceding years. This seems to be true for the mature economies, not only the US, but less so for the emerging world.

It also seems to be the case, that the mid-2000's did not accumulate excess technology intensive capital. Thus the current crisis would be different.

At the same time, the length of this recession means that investment is halted for a long time. Perhaps that means a strong demand for the new technologies after the crisis, as well as another jobless recovery.

The Jobless Recovery Scenario

The jobless recovery scenario goes like this. (1) During a recovery (as at all other times) the basic labour market identity holds: the number of people employed depends on overall demand and productivity. (2) Productivity growth depends on innovation. (3) While the relationship between employment and demand is short term, the relationship between productivity and innovation is long term. Therefore, when there is a short-term drop in economic activity, you can expect to see a fall in employment, but innovation goes on. (4) Thus when demand rebounds, there are a lot of new technologies around, and it pays to be the first to invest into them.

There was an important ‘if’ at the core of the worse case scenario: the recession will not end if the global confidence level goes where it should - to the bottom of a deep mine. Unlike with real gravity, economics is an odd place, where one might actually lift oneself up by pulling one's own hair, Baron Münchhausen-style. We saw a similar global bubble before the crisis, where most of the justification for one’s enthusiasm kept being others' enthusiasm. Bubbles can work for a surprisingly long time.

For if people want to believe that the non-existent global policy framework works, if people want to believe that the recent return to growth by asset prices has anything to do with fundamentals, and if people are willing to believe that everybody else is willing to believe, then such a global pyramid scheme might even work. In a Startlingly Pink World, there might not even be a reason for this new would-be bubble to burst; reality might grow up to it.

If that happens, an old phenomenon might return: a jobless recovery. Except, this time, potentially on a global level.

When the troubles started, there was an inevitable comparison to the last Bad Times: the 2001 burst of the dot.com bubble. Though fun, a consensus quickly emerged that there was no similarity whatsoever… Maybe, on the way out, there will be.

The most conspicuous feature of the last time the mature economies returned to growth was the delay in job creation. When the economy was already booming, employment kept lagging.

Here is the original version:



In the above graph: the red line is US industrial production, and the blue line is unemployment (both are re-based to 1997 M7 = 100%). While production returned to previous levels, unemployment stayed at a high and surprisingly stable level for years.

There has a been a lot of discussion about it; here is my version:



The above graph takes the change of the monthly rate of US unemployment data, and regresses it on the change in the monthly rate of US industrial production, and time. All are moving averages of 20 months (that’s where the R-squared peaked). A one-month lag is employed. The time series is the longest I found: 1961 to 2009, and the relationship is very close: 82% R-squared. The graph shows the fit residuals. The interesting part comes when there is a lengthy period away from the mean: the end of the 1960’s and early 1970’s see a long period of ‘too many’ jobs being in the economy, while most of the 1980’s is ‘jobless’, and then comes the ‘jobless recovery’ after the 2001 dot.com bubble.

The whole point is that there is an underlying story about productivity. If you think that in the long run, productivity dynamics rule, then the recovery is catch-up time for firms. During recession, investment into new technologies halts, and thus when there is a return to growth, the surviving companies have the option to buy into the latest technology. As the innovation cycle is much longer than most troughs (if you want evidence, look at the OECD patent stats here), this means that for a while you can increase production by investing into new technologies, and thus delay re-hiring people.

The first time this hit me was during the 2001 crisis, when I was heading an investment banking research unit and a physicist friend of mine told me about the latest developments in the physics of computer technology. We realised that if half of what he saw was really getting into production, the economy coming out of recession would be all about this and not about giving jobs back.

Investment into technology has almost entirely stopped all around the world in the past 18 months. Yet, it is very clear that the advancement of technology has been as fast as ever. And thus, we are wondering if there will be a repeat show.

(Although, I am not at all convinced that this really is the end of the recession, see the previous post. But, if it is…) You could well argue that many of the forces that created the jobless recovery seven years ago, are here now, too. In particular, the productivity mechanism might be very similar.

So, are there any signs of this?

Well, look at an interesting confidence measure from the US:



The above graph is the differential between the demand confidence and employment tendencies, survey based, from the US. (That is above zero means that the demand confidence is above the employment confidence level. The red dots are the 2002-04 years, as well as the last month's data.) Not only it confirms the jobless nature of the post 2001 recovery, but it also provides us with one point, which is very much in the same direction.

Furthermore, if you look at the other countries from which comparable data is reported, support for this argument emerges. Here is the picture of the industrial confidence and employment sentiment data from 19 OECD countries (the red line stands for the annual averages, similar confidence differential as above, positive signalling that industrial production confidence is stronger than the propensity to employ people):



And here is the same, dissected: the red countries are the four that saw the most negative differentials during the post-dot.com burst recovery, and the blue is the rest. (The lines are averages for the respective groups):



Just like the US case, it is clear that at least for the countries that saw a jobless recovery last time around, there are signs that this time might not be that different.

All this depends on the optimistic assumption that the crisis is nearing its end. Which is either still (a) in the confidence measures only; or (b) directly related to fiscal spending. (Sorry, no time to illustrate the second one in this post). This makes this scenario just as likely or unlikely as the worst-case one.

If you wanted to pick, probably it will be the size and length of the boost in self belief that will decide. If there is a moral here, then it must be about there being no point in having small Münchhausen lies.

Now What? The W-Shaped scenario

Is this really the end of the recession?

Perhaps, there is reason to be sceptical about last month’s fashion of optimism.

The new framework for modelling the world economy in a post transition-phase state is still missing. The models we use still have major systemic errors in them, we obviously still have the same valuation problems and mis-specification of the policy mix. Despite some calling for the New Thinking, there is little new that has been put forward in reality.

Much of the problem in valuations is still here. Others argue that while the visible part of the sub-prime mess is mostly cleaned up, a lot of the less visible, but rather sizeable side-effects of it are still on the books, without ‘proper’ valuation. I would add my own observation, that the way the markets approached emerging markets has not really changed much, differentiation is still not really the name of the game. If the capital markets asked for the a realistic risk premium, some emerging market treasuries would have gone into default, whatever the urgent ambulance package was. In any case, we would see a much wider performance range from emerging markets than was the case the past months.

Plus, the policy response has been mostly inadequate. The global economy has gone through a transition phase the past ten years, making national level policy responses unlikely to do the job. The problem is that to tackle the kind of global crisis that is at hand, one would need to have enforceable monetary and fiscal policy in place, on a global level, and that is clearly not there. What has been there instead, after an initial bout of panic, is a set of protectionist measures, and a happen-to-be-at-more-or-less-the-same-time fiscal stimuli around the world that kind of works as harmonised global stimulus.

Yet, the current stimuli take most governments way-way beyond known territories: deficits are up to levels unimaginable before, and debt as well as debt projections are through the roof. For the majority of the governments the current stimulus it is a one-off action. This one really needs to work.

Which takes us to the really bad news: most of the ‘green shoots’ seem to be directly dependent on the fiscal stimuli. There is hardly anything else. Scratch any bit of ‘end of recession’ data around, independent whether the US, China, Germany, or Australia. Although there is some actual money in the pockets, it is not that much. The biggest across the board factor is the change of confidence. In other words, the governments are inducing a new bubble, and we lay all our hopes on it.

This might work. Yet, there is a significant momentum towards further slowing in the global economy. The multiplying effect of the initial hit is just taking shape. The main survival strategy in sectors hit only indirectly by the crisis has been to cut back spending as much as possible, and try to bridge over the shortage of revenues from reserves and bank loans. Banks are still hesitant to lend (even if they are ordered to by their respective governments, as we have seen many examples around the world), which means that the bridging exercise is mostly from own reserves. And there signs that reserves are running out.

If the global confidence boom will not be sustained, and there is plenty of reason why it should not be, then the coming fall might turn out to be even bigger than the one allegedly bottoming. The W-shape scenario might see a deeper, and longer, second trough.

China Hugs The IMF

(Some good news about China's strategic choices in the global arena)

China's role on the global scene has gone through a spectacular metamorphosis in the past ten years. In the early 1990's China was still very much in the developing economy category. Although it was very large, its international behaviour resembled that of poor countries. Then, around a decade ago, its global action-set started to look more like a powerful emerging market. These were the BRIC years (an term that never reflected any real group of any cohesion, apart from encapsulating a somewhat similarish policy problem). By the mid 2000's China grew out of this category; running short on raw materials it needed to step up the power of its actions. China's search for reliable, long - and short - term sources of ores, hydrocarbon, and food led to a strategic change in the way the country approached its international relations, in particular vis-à-vis developing countries. Hence the new-found Chinese interest in African, South American, South East Asian countries.

As the current crisis intensified, China saw a strategic opportunity to forge closer, long term relationships with a host of weakened emerging markets that found themselves in desperate need of short-term funds. By doing so, China emerged as an alternative to the path offered by the international organisations, the IMF in particular. This reinforced a pre-existing battle between Chinese companies and international aid and development agencies. (I happened to see one of these local battles from close proximity, and can report that (a) it is a very real competition, and (b) all that is said about difference in post-material values is true. The international community's regard for environmental and cultural diversity, and procedural transparency - even if I sometimes feel that its by far not enough -, seems almost entirely lacking on the side of resource extraction focused Chinese approach.)

And thus the news that China committed a large sum (even if only 2.5% of its total reserves) to purchase IMF bonds is so good. Perhaps it has something to do with the country finding itself being less isolated from the global crisis, and thus weaker than it expected. Certainly, the strategic aspirations to take a global role reflecting its perceived self image are also at play here. It almost does not matter. The fact China wants to take stronger role in the global governing institutions as opposed to building its own is the best possible news.

Now the only task is to find out what these global governing institutions will do.

Self-Delusion, Here We Go Again

Many economist spent the years before the current crisis in utter frustration. They saw their bit of the world being upside down, valuations being all over the place, and their arguments being not heard by the markets. "Hey! You gloomy guy! Shut up! If you were right, the markets would have reacted! Have you heard of efficient markets?" And thus the markets pointed at themselves as the justification for their own valuation. "This asset's value is here because we think so. Don't come to us with this shadows -in-the-cave story. That's so last millennium." (OK, millennia.)

This is why it is such an entertainment to watch the global financial markets talk themselves into exactly the same trap. "The end of the fall is here because the prices go up. The evidence is that the prices go up." And we see the analysts modelling the fundamentals scratching the wall in frustration, again, as they try to point out how meaningless the markets' very recent moves are.

Here is an example from the FT:

Traders pointed to China, which yesterday revealed a large increase in raw materials imports, reflecting in part the economic recovery but also Beijing's attempt to take advantage of lower prices to stockpile commodities. Iron ore and copper imports reached a record high last month, while crude oil imports hit their second best month at the same time.

Other analysts said supply and demand fundamentals were still weak, even taking into account China's swelling imports, and said that speculative money was the main reason behind the rally.

"Recent price strength is not based on fundamentals, but on financial flows," said Mike Wittner, oil analyst at Société Générale in London. He said investors' appetite for riskier assets such as commodities was "better entrenched, and more sustainable" than earlier this year.

That't it. "Recent price strength is not based on fundamentals, but on financial flows." Oh, how well I know this song!

U’s And V’s

(Fooling around with the credibility of global forecasts. Or the lack of it therein.)

The collapse of ability to forecast during this current global economic crisis, resulted in the abandonment of the previously employed semi-sophisticated merge of national level macro models, and the return of the U’s and the V’s. The debate is reduced to discussions whether the recession will take a u-shape or a v-shape. Not being able to do anything with the data, one can always ignore it, and assume that whatever is happening is merely a blip in the trend. All you have to do then is to figure out how fast your subject, the global economy, will return to its well established long term behaviour.

And thus the two new ‘theories’ of this crisis were born: u-shaped versus v-shaped. In both cases, the previously ‘detected’ trend will return, the only question is how long we will have to wait for it. ‘Phase transition’ is not exactly in the vocabulary of economics…

On the history of U’s and V’s.

Incidentally, I witnessed a previous occasion for these two letters to rule the explanations-and-forecasts-find-it-here business. The history of economic thought during the post-communist transition will surely spend many words on how the lack of any adequate model of what transition was, of how an economy behaves during those times, and what comes after, had resulted in the rise of discussing curve shapes. Even in some textbooks taught today, well after the rise of the New Theory of Transition, intellectual laziness keeps winning, and the discussion of the u-shaped dynamics persists.

Yet, in reality, the reduction to observing the shape of the curve, an arbitrary pattern projected onto a time series, very much in line with the statistically irrelevant, but much watched ‘technical analysis’ of capital market price data, was merely the result of no models working at all. In the early years of post-communist transition, there were three sets of theories that were offered as ‘the truth’. A bunch of economic-liberal economists, mostly of Anglo-Saxon origin, pushed ahead with the microeconomic theory of privatisation. They should have given up after a quick check, for it is obvious that the privatisation of an entire economy has nothing to do with the lessons learned from the nationalisation-privatisation saga of the British Rail. Nor, did the Theory of Poor People (a.k.a. development economics), for although the poverty stats showed a fairly bad picture, the reality had more to do with very high human capital levels all across the transition world, which rendered much of the prescriptions entirely irrelevant. Nor did the balance-obsessed monetarist approach, for - at the beginning at least - there were no institutions around that could deliver the ‘adequate policy mix’, while the underlying structure was going through a rapid and radical change.

Thrilling it is, how similar the the global economy theory-pretence is to the transition theory-pretence. The intellectual abyss is paired with a yes-of-course-I-know-EXACTLY-what’s-happening shamelessness.

On the consequences on ‘What the hell is happening to me?!?”

The previous post discussed how the IMF’s Word Of Final Truth, as usually taken without the warning about the side effects, has nothing to do with reality. Even if they happen to be right in retrospect, that will be a random event (and an unlikely one, in my view). However, there is one more phenomenon, which is mostly disregarded: the Other Views about where the current troubles come from.

One of the favourite economist bashing topics of our days is how unforeseen the current crisis was. And then a few puts their hands up and say, well, actually, they themselves had foreseen these events, and then follow on with digging up some old forecast of theirs as an evidence. That exercise is semi-interesting at best, though. For forecasting is a multi-dimensional effort in a random world, and thus if a high enough number of people are involved, there will always be some in the tail, to point at their amazing-foresight once the low probability event they forecast takes place.

A lightning will hit this bush! A lightning will hit this bush!! A lightning will hit this bush!!! Watch out!!!! Bang. Thump. Fire. OMG, OMG, I am a prophet! ... Okay, people, here is what you need to do from now on.

(Btw., my mother thinks she has healing power in her hand, so I have been well versed in the beauties of self-delusional explanations well before my first macro class… What the funniest is that she is also exceptionally gullible to the same tricks coming from other charlatans. See also the economics equivalent: the consensus long-term forecast...)

There is perhaps another interesting feature here. That is the other tail-forecasters who foresaw the end of the world, but via a different mechanism than the sub-prime and co. story. I was one of these lunatic visionaries, arguing that the sky is about to fall from some six years ago onwards. But my own eschatological visions were more to do with emerging market macro than with US mortgages. There were also the people who were worried about too high complexity of new instruments, those who worried about excessive risk taking in general (a.k.a., bonus structure induced gambling), and those who kept fretting on about global imbalances, particularly the current account deficit of the US. What is interesting maybe is the common element in the thoughts of all of all of us crazies.

The intersection it seems is complaints about the markets misjudging a particular risk element, and thus ending up with ‘wrong’ valuations. In my universe, it was the lack of separation of different emerging markets. For it seemed very clear that the risk associated with different developing countries by the financial markets had little to do with the real underlying fundamentals. All our forecasts were based on national level behaviour being projected onto a global economic trend, the latter being entirely exogenous variable, in just an aggregate in essence. If the global forecast is solid growth, then portfolio flow dynamics will rule the day. That’s it.

My suspicion is that it was the same lack of real global modelling that lay at the base of all of our fringe end-of-the-world-is-here predictions. In some cases directly (emerging markets, global imbalances), or indirectly (mostly due to lack of adequate policy response to misalignments, valuation or structural, or the misjudgement of the impact of deregulation).

In the post-communist transition case, the u-shape focused intellectual abyss was followed by a set essentially random policy action (a true lab-experiment, given the high number of countries involved in it at the same time) coupled with an independent theory-event (the rise of the endogenous growth models) that gave rise to an understanding about what was really going on. If we insist on being optimists, we might say that the current U’s versus V’s nonsense may give rise to real thinking. For that, of course, you need one of these random policies work first...

IMF In The Dark

Last week, the IMF published its updated global forecasts, as part of the IMF World Economic Outlook, titled ‘Crisis and Recovery’. All the media, all around the world, was completely full of it (FT, NYT, Bloomberg, China Daily, Gulf News, Jakarta Post, The Times of SA, etc., etc.).

Given the hype, it is striking how different this 2009 growth forecasts is from those published half a year and a year ago. The IMF's 2009 world economy forecast, as published in April 2008, foresaw a global growth rate of 3.77%. This was 14 months after the inevitability of the global crunch had gone from being a fringe topic to being top of the agenda. Then half a year later, the 2009 forecast was pushed down to 3.03%. More than a month into the severe crisis (counting from 16 September 2009, when after Lehman Brothers folded in US time, the World woke up to a very different reality). Clearly, the IMF forecasters did not think that the challenges would not be met. Their world economy growth forecast was shaved only by 0.74 percentage points.

In its World Economic Outlook Database update, published last week, the IMF sees the world growth rate in 2009 at -1.32%. That is an astonishing 4.35 percentage point correction on a variable that averaged at 3.45% during the last two decades with a standard deviation of 1.05. In other words, the forecast does not have any meaning, apart from the IMF announcing that it thinks, that it is going to be ‘kinda bad’…

No meaning whatsoever. No meaning.

This is not the first time that the world financial markets, the economic policy makers, and the global economics community, have fallen for a confidently put precise number. I would have thought though that the experience of the past years might incline us to guard against such follies. And make us double check.

Here is a graph with the successive forecast updates from the IMF World Economic Outlook Database: April 2008 in green, October 2008 in blue, and April 2009 in red, with the forecast bit being a broken line.

The first thing to notice is that the forecast changes after the data comes out... The IMF's very complex and sophisticated system yielded an 'adaptive forecast'.

The second thing to notice is that there is always a sharp return to growth (the end of the recession) forecast for the next period. This picture will be familiar to anyone who has spent time listening to economic policy makers around the world explaining away their particular crisis, and trying to convince you that the good times are really just around the corner... I have not seen one treasury presenter, minister or lowly analyst, who would argue otherwise. For their eyes (and tongues) the crises are always about to be over. This experience makes you rather sceptical about graphs with an exceptionally quick return to the previously predicted growth trend.

Here is the same graph zoomed in on the current period.

This helps to point out one more thing: that the April 2008 IMF forecast for 2009 growth assumed that the crisis would already be over by now, and thus 2009 would be the year of recovery.

The uneasy feeling one is left with is not only that the IMF forecasting system is completely (fully, entirely, wholly, utterly, 100%) unreliable at a time when it really matters, but also that they are somewhat dishonest about it. When investment bank analysts produce a rosy picture of their respective instruments, that's sales. So is your average Treasury's similar efforts. But the IMF? Did that red line really have to go back to the trend within a couple of years? Is there any reason why we should believe that the forecasting system (one of the best in the world in my view) that produced this miserable result is going to be any better for the next period? Or should we face the fact that the IMF, and probably all governments around the world are in the dark about what is going to happen?

However, trying to be constructive...

I was wondering, if there was a pattern to the IMF's failure to forecast the world economy's crisis behaviour in a credible way. Are there common characteristics among the countries where there was a large IMF forecast correction, as opposed to the countries where there was a small one?

The second half of this post is a toy study asking that question. There are two hypotheses.

The first hypothesis assumes that there was a common, global shock to the world economy, which hit every country. Then the IMF forecasters might have been wrong about the size of the overall shock, but right about the reaction. If this were true, it might be possible to discern some common characteristic of governance among the effective adapters, and the absence of that characteristic among those struggling.

This hypothesis would be anecdotally supported by the qualitative observation that, among a group of similar countries in Eastern Europe (the best economics lab of recent years), those that have deeply divided societies are doing much worse in the current crisis. (The Baltics, Hungary, Romania, Ukraine all have pilarised elites).

There are some really interesting studies out there connecting economic growth to pilarisation (or fractionalisation) in a convincing way. Jose Montalvo and Marta Reynal-Querol for instance, in their paper, provide a strong case linking economic development to religious and ethnic polarisation. An analysis connecting their polarisation and pilarisation data to the IMF growth forecast correction would be then one way of following up on the East European observation about divided society. (This is how I while away my time...)

Sadly, this yielded a non-result. Although all three forecasts for 2009 growth (April, October 2008 and April 2009) are explained well by the four fractionalisation and polarisation variables of Reynal-Querol, confirming their original finding linking societal division to bad growth performance, none of them have any significant explanatory power vis-a-vis the IMF forecast correction. (One possible reason is that, although the dataset has 131 countries, almost all post-communist transition countries are missing. Hence the anecdotal observation cannot be checked either.)

An alternative approach would be to take indices measuring aspects of governance directly. The Bertelsmann Transition Index, for instance, is a useful set of measures of the 'matureness' of developing country governments. The results (n=117, a few countries from the BTI had to be dropped as they are not reported by the IMF, all mature economies are missing) are more promising. At first, at least. There are quite a lot of factors that have strong and significant explanatory power towards the IMF forecast correction: out of 77 variables there are 15 that have their (second degree polynomial OLS) AR-squared above 10%, the highest being 18%.

Yet, they are all going in the 'wrong' direction. The more advanced the country is, the higher the IMF forecast correction was. This cries for checking these results against the wealth of the nations, proxied by GDP per capita. And there it is: almost all of the effect is picked up by the GDP pc, almost nothing is left. Three variables remain with significant, if rather small, explanatory power: 'stateness', 'no religious dogmas', and 'UN education index'. They are still going in the 'wrong' direction, though, suggesting that the more advanced a country is, the larger the IMF correction was.

Thus Hypothesis 1 is rejected. The IMF forecast correction does not seem to pick up the effect of the respective governments' ability to adapt their policy to the crisis.

However, the above points to a different, second hypothesis. What if the IMF errors are linked to how developed a country is? For this I used the GDP per capita and the UN education index (the latter being the only one from the BTI significant set that is available for all the countries) to explain the IMF 2009 economic growth forecast correction.

The variables are:

IMF: forecast correction size (difference in IMF GDP growth forecast for the year 2009, as projected in Oct 2008, and Apr 2009);

EDU: UN education index (log);

GDP: GDP per capita (IMF data, for 2008; log).

Altogether 171 countries.

Regression 1. IMF on EDU. The AR-squared is 11%. Negative coefficient.

Regression 2. IMF on GDP. The AR-squared is 8%. Negative coefficient.

Regression 3. EDU on GDP. The AR-squared is 55%. The residual is then taken from this regression, with the name 'RES'. Positive coefficient.

Regression 4. IMF on RES. The AR-squared is 3%. Negative coefficient.

Regression 5. IMF on GDP and RES. AR-squared is 11%, with both being significant (P-values under 0.01 for both). Both have negative coefficients.

(All the above are linear OLS, with occasional mild heteroskedasticity.)

Thus it seems that Hypothesis 2 cannot be rejected. The IMF forecast correction tends to be stronger in the case of high GDP and high education levels. (Although the overall explanatory power is not very high, thus pinches of salt should remain at hand.)

In other words, the IMF thought that the rich and well-educated countries would not end up with much trouble on their hands. And they were very wrong.

By October, the credit crunch had been on the agenda for 18 months, and we were well after the Lehman-bankruptcy landmark. Thus, the IMF was very aware that the crisis was upon the global economy. In this light, the above results perhaps suggest that the IMF was in an 'effective government myth': if you are a rich, educated, non-dogmatic country, then you have good economic policy institutions, thus you will be able to react. It seems that no economic policy institution really worked, which surprised the policy optimists. (But, incidentally, not those who argued that national level policy could not possibly suffice without an effective global umbrella.)

So what have we learned? First, that the world's best global economy forecasting system is really, really bad. Second, that early hopes for being saved by government eminence were misplaced. The door is open to new ideas, I presume.

Designing Taxation

Some years ago I got involved in the very practical exercise of designing a real tax system. It was in a transition country, in Europe, and it was messy.

I learned a number of lessons, some of which might be distantly relevant for the current fashion of re-designing tax systems. So, here they are.

Lesson number one. There is no possibility of an ‘engineering’ debate when it comes to taxes. Anyone who has seen the emergence of a real tax reform can attest: it is always political. And deeply so. For political scientists this is a triviality. However, for economists, far from it. For macro people are acutely aware that - apart from the politically sensitive reallocation of resources - the choice of tax system always has major consequences for the efficiency of the economy. Politicians are usually pre-occupied with the slicing of the pie, and tend to ignore the fact that the way it is sliced is a key determinant of the size of the pie. Economists tend to ignore, in turn, that it is ultimately the politicians who do the slicing.

Thus the first lesson I learned back in those days was that whatever the arguments were (Vickrey-Mirrlees's optimal taxation, Laffer-curved based, progressive or flat) - in real life they are always employed to support a political position. You need to know them all well, otherwise your opponents will slaughter you, but they are still just covers in an essentially political debate.

The upshot is that almost all tax systems have efficiency flaws. So, if you happen to find yourself on the losing side of the ‘debate’, at least you can always attack the winners with valid arguments.

Lesson number two. Even if you wanted to see the project as an ‘engineering’ problem removed from politics, there is no clear evidence about what the ‘best’ solution is. The two tails are covered: we know what is definitely not best. No taxation, no government services: clearly only for the nutcase anarchists. And total taxation leads to the disappearance of economic activity whatsoever, as proven by the total disaster that real world communism was. However, as for the refinements that represent something in the middle, the jury is out. In fact, probably they have gone home and will never come back. There are simply too many countries with too many peculiarities to control for to give a general answer.

Again, the upshot is that you will be hard pressed to find an ‘ultimate piece of evidence’ either for or against any in-between, sensible-sounding solution. So, any real tax system can always be attacked and defended using a carefully selected set of proxy cases from around the world.

However, that means the game is on. If you are a non-political, macroeconomy efficiency maximising social engineer, then you do get to design your optimal tax system. You can play lego with it. You import elements from different countries, from different historical periods, and try to see if they’d work. It can be a surprising amount of fun.

Lesson number three. The hitch is that when you present your freshly finished, super-innovative tax regime you will certainly hit a wall. Big time. First, the revenue people from the Ministry of Finance or Treasury will scream about the added uncertainty any change to the tax system necessarily brings. You may try to look at their models, and argue that they have as little real idea about the revenues as you. But still they have been doing the budget for years (probably decades), and there is no amount of economics argument that you can possibly come up with to counterbalance the fright of the politicians when they are told by the Revenues Experts that inevitable crisis, and the End Of The World is upon us. Unless a gag is put on you, the Risky Economist, your feet are immersed into concrete, and you are promptly tossed into the river.

This wall of macro-accounting conservatism is the main reason why major tax reforms are always the product of crises. Nobody takes the risk in normal times. In meltdown, you might have a chance to push your ideas through. You will still be seen as nuts, anyway.

Lesson number four. Politics is always political. This is sometimes forgotten by economic advisors, but is definitely the case.

The only time when I had a real chance to push through what I thought to be the best tax solution, it would have been a political coup. The freshly elected minority party I was harassing with my ideas needed to cheat on the freshly elected majority party via a clandestine co-operation with the freshly ousted, and much despised, former majority party. I did have an emotional stake in the previous campaign, so this was not exactly my idea of a first best solution. But it would have allowed an important piece of policy to go through.

Somehow, the party leader was convinced that such a trick on the majority party could have been fun - I suspect that he actually cared some of the time - and so he tested the idea in a press leak. He received floods of phone calls from old ladies, who did not know the first thing about the tax system, or care at that, but hated the idea that we would co-operate with the other side. The tax coup did not happen. The country lost all its previous competitive advantage, slid into government overspending, and is now on the brink of bankruptcy… (yes, it is all my fault).

Tax is always political. Even if it was not, there is no obvious ‘best’ solution. Even if there was, there is a murderous bureaucratic conservatism against anything new. And even if a crisis helped you struggle through that, the constituents the politicians play to have no idea about taxes, but very strong preferences nonetheless. Good luck.

Rules Versus Discretion, Once More

(About the emotional decision making of the Global Economy)

One of the earliest posts of this blog was about policy rules and policy discretion. The original economics model is generally used to provide evidence for how short term optimisation of policy can screw up your long term rules, and thus lead to a sub-optimal outcome. It is an economy level procrastination problem, which - on the individual level - is also well described, by the behavioural economics lot.

A ‘rational expectations’ approach to the rules versus discretion problem, however, changes it a bit. In this form, the economic agents come up with new assumptions about policy rules when they see the policy maker’s short termist behaviour. And thus not only do the originally announced or implied policy rules go out of the window with the discretionary measures, but new rules also emerge. This is especially the case when the policy maker herself does not have any idea what is going on. Which is, incidentally, the situation now…

Given the above, it is striking how little is discussed about the long term consequences of all these semi-random and fully-random and even-more-random policy ‘innovations’ that governments around the world keep coming up with.

Like, what is going to be the long term consequence of a government backed mortgage payment holiday during crisis? How on Earth will anybody be able to come up with any robust probability function for mortgage defaults? Like: if the debtor gets into trouble, she defaults, unless, there are a lot of others, who are also in trouble, and all of these happen to be the constituencies of the ruling political party… Now try to squeeze that into an algorithm…

Or what is going to be the basis for assessing financial risk? Where will bank valuations come from? Will you have to categorise financial institutions into sizes, the big ones being saved for sure? Is it going to be a continuous distribution? Is there going to be a threshold for triggering government action? How many peaks will this distribution function have? E.g., you don’t save the first big one, then save all further big ones, until too many need saving. Or maybe just one or two more… I would shake the hands of the bank equity analyst who can deal with this one in any credible way.

Or countries. What will be the default probability assigned to any country? Now are these lower or higher than before? Lower, for the behaviour of the global governing institutions the past months suggests that no country is being allowed to run into real bankruptcy. But higher, for if these institutions run out of money, or more importantly political capital, then a lot of countries will default at the same time, pulling each other down.

The trouble is that although all of the above can be modelled, but not in any robust way.

Hence the importance of short term discretionary policies re-defining long term rules. Seeing how these novel ‘rules’ come to life is really disheartening. As if we all, as individuals would make our most important, long lasting decisions based on ad hoc emotional impulses.

Which, incidentally, we all do, of course… Life is a mess for everyone, even if you happen to be the Global Economy.

One More Cup For You, Perhaps?

Now that the economic forecasting profession has sunk to the standards of the tea leaf reading lot, it might be worth highlighting the occasional shine through of light. Consider the FT's interview with Cao Jianhai (spread into two articles, on property prices and on macro data). His cautious assessment of the outlook for the Chinese economy should warn all those who read too much into the recent Chinese data. Especially given that the latest fad is to base speedy global recovery scenarios on expecting China's rapid regeneration. And, given that unlike many verbose observers, Cao Jinhai might actually know what he is talking about...

Many in the global forecast profession have argued that the steady Chinese real estate demand will be the ultimate factor we will look back to as the cornerstone of the global recovery. Now here is the Cao-forecast:

average urban residential property prices to fall by 40 to 50 per cent over the next two years from their levels at the end of 2008.[...] Prices may not fall in the near term but I expect a collapse starting next year, followed by many years of stagnation.

He also pointed out that the positive stats people are so excited about were at least partially due to measuring fake transactions as people try to buy into the government stimulus...

Instead:

The volume of empty apartments across the country hit 91m sq metres at the end of last year, up 32.3 per cent from a year earlier, according to official figures.

Those numbers included neither the huge volumes of completed real estate projects whose owners are waiting for market conditions to improve before they put them on the market, nor the estimated 587m sq m or apartments sold in the past five years but left empty by their owners.

And:

[Cao Jinhai] says positive signs in the property sector are being partly driven by a surge in bank lending, which grew a record Rmb1,890bn in March, bringing the total for the first quarter to Rmb4,580bn. That is more than the entire amount of fresh loans extended last year and nearing the government's full-year target of at least Rmb5,000bn in 2009.

On Thursday, government is expected to announce first quarter GDP growth of 6-7 per cent. But without the surge in new loans, growth would have been closer to 4 per cent, by internal government estimates.

"External trade is dead and it is impossible to force domestic consumption to take up the slack immediately, so we have to rely on bank lending for now," said an official who asked not to be named since he was not authorised to speak to the media. "But the government will never allow the banks to lend like this for the entire year because otherwise we will face hyperinflation and that is what the government is most afraid of."

In my experience, CASS is one of the best places to turn to when one tries to understand what is going on in the Chinese economy. (Here is another one, though.) And thus, to put it bluntly: do not expect global momentum coming from China anytime soon.

Hopelessness At The Bottom Of The Pit

Emerging markets have always been an enigma for economists. They are poor, but unlike the ‘poor’ countries, they have a lot of economic dynamism. They have functioning governments, and they have economic institutions such as a central bank, or a stock exchange, like the developed world, but these are often erratic in their effectiveness. But most of all, these countries, should they be in East Asia, Central Europe, Latin America, or southern Africa, always tended to produce macroeconomic numbers that would be impossible for mature economies. Our models and theories that work for the developed world (or at least used to) were unable to explain a host of phenomenon in the emerging markets. Hence the regular use of the adjective ‘miracle’.

For instance, in a developed country, it is impossible to have the kind of simultaneous fall of budget deficit, current account deficit, inflation, and unemployment that is frequently observed in emerging economies. It just does not happen. Moreover, a host of theories tell us why it should and will not happen. Unless, of course, you are undergoing rapid structural change in your economy, a typical dynamics of emerging markets. And there you are, a miracle is born.

Now, we have a couple of negative miracles on our hand... Similar to the positive versions, economics has hardly any standardised handle on the problem.

One of the very interesting phenomena in the upswing phase of emerging market development is the switch from export momentum to domestic one. It is interesting, for in almost all the cases, much of the domestic demand that is seen as inherent, home grown etc., keeps being dependent on export performance. It is easier to see this in smaller countries, such as Thailand, Poland, or South Africa, but the past two years also shed light on the very same phenomenon in some of the larger ones, such as Brazil, Russia, and - increasingly obviously - China. Remember the arguments about domestic dynamics in the emerging markets being the new global driving force, voiced at the beginning of this crisis? (This myth fully endorsed by the political classes of the above mentioned emerging markets, less for lack of understanding, and more for good old fashioned political populism. And they were just warming up.)

The trouble is that once you realise that domestic demand is indirectly linked to export performance to larger extent than you previously thought (and overall, to a very large extent, especially in the longer run), then your options to weather the crisis are suddenly radically diminished. Especially this kind of crisis, where the global economy is shrinking to such an extent. For all economies, emerging or mature, this translates into policies that try to generate domestic demand, rather than export competitiveness. At first, you would try the old fashioned way: monetary easing with fiscal tightening (or at least the promise of the latter). Then, when it does not work (independent whether the reason for disfunctionality lies in the monetary transmission mechanism being screwed up by the local excesses of the capital markets, or the lack of a global policy framework), you move on to the next level: fiscal stimulus. It is less sophisticated, bears more long term risks for your economic system, but hey, that’s what’s left.

This leaves emerging markets in an odd place. Their monetary toolbox had already been generally weaker than that of mature economies. Furthermore, they do not have the advantage of them being the ‘safety’ bit in ‘flight to safety’, thus liquidity dries up even faster. And as domestic demand turns out to be much more dependent on the - collapsing - exports, they would need disproportionately large fiscal stimuli. In most emerging markets, the space for the latter had already been tight. The government spending needs - and demands - during the rapid structural change years had been phenomenal, pretty much exhausting the fiscal capacities. And of course there are those that had been irresponsible on top of it (Hungary, Argentina, Iceland, Ukraine, I am talking to you!).

So, you are an emerging market crisis-policy-maker. What can you do? You will certainly go to the end of your fiscal abilities, if there is any left. But, for most, this direction will yield very little. The only strategy there is left for you to play is going back to ‘emerging markets amidst globalisation 101’, and return to generating export momentum. This is a tall order, for the global markets are contracting, and countries are locking up. However, you do not have much else left. (Especially, if the crisis lasts much longer, and even those little remaining fiscal capacities will have been used up.) Some emerging markets will be able to play this game very well. Look at the behaviour of Singapore during crises of the past decades, for a textbook case. Some others, however, will have major problems, for their past lack of structural reforms and the tax legacy of their past, and current, fiscal overspending will leave no room for measures to improve export competitiveness.

Significant currency devaluation (with or without government default), or serious social discontent will follow. Or both.

Letter from Sydney

(A guestpost from my travelling friend and corespondent, Balázs Szendrői.)

In this day of global multiculti, we constantly walk past, and sometimes interact with, people whose cultural background is very different from ours. But this was not always so. Here in Australia, I am reminded of one affair in particular, in recent (painful) memory, relatively well-documented, which took one party completely by surprise: when the Australian Aboriginal communities first spotted The White Man.

Talk about a complexity difference: the typical toolkit of mainland Aborigines consisted of 31 items; that of Tasmanian Aborigines had only seven. Captain Cook's hair styling alone, recorded on contemporary paintings, must have needed more tools than that. But the first encounters between whites and Aborigines were made difficult by more than just "the differences in the technology set".

One misunderstanding concerned skin colour. Apparently black corpses become whiter with time. On top of that, one of the Aboriginal burial practices consisted of removing an outer skin layer, leaving behind a pinkish corpse, looking not unlike the newcomers; in South Australia, the Aborigines actually called the first Europeans "grinkai", a word also used for "peeled corpse". So who else were these white creatures, but spirits returning from the afterlife? Of course they forgot how to speak properly, because of the shock. Moreover, they became sexually amorphous: from a distance, they looked like women, with no facial hair, but upon closer examination they exhibited male features too. Expeditionary parties were sometimes called upon to reveal their gender - with proof! That's what I call the beginning of a beautiful friendship.

Once gender established, it seems to have been traditional among Aboriginal communities to offer their women to travellers who passed through the country, as a friendly gesture, for the night they spent in the neighbourhood. White Man knew two answers to this: either politely refuse, which amounted in Aboriginal customs to a hostile response, or else, assume that his hosts thought nothing about sharing women, so return again and again and assume that any woman of his choice could always be his. This of course broke several taboos, including incest, since by befriending one of the women, the others apparently became sisters to him.

After this, came smallpox, abductions, the dreadful choices involved in entering the Native Police, and other all-too-familiar stories, leading to the Lost Generation. It will take more than Cathy Freeman's Sydney Olympic Gold to atone for all that.

Pictures and Expectations

Fascinating how politicians, commentators, and the markets alike are in constant search for the turnaround. It seems that even after almost two years of slide, it is still difficult to take in the magnitude, depth, and length of the crisis.

Amidst all the talk of optimism and rebounding markets, consider this picture of the Japanese export dynamics from today's FT. Remember those times a year - year and a half ago when we were still debating whether the East Asian region will 'decouple'?



Of course, one could argue that Japan is different, the ultimate trump card in any macro conversation. If so, what about the German business confidence? Spooky how the two are almost identical.


Turnaround?

The Stone Axe of Economic Policy

Now there it is. We have kept trading down the policy tools. By now, only the stone axe is left. Just as the super-sophisticated inflation targeting (or almost that, in the case of the Fed) has by now been replaced by the 1 trillion intervention (a.k.a. The Round Large Red Panic Button), the fiscal intervention has reached a new peak (or low - depending on your point of view) with the Geithner-plan.

Most commentators failed to notice that the markets rallied due to the expected relief of the banks, rather than a positive systemic impact. And, in this case, the two are not the exactly the same. From the troubled banks’ point of view, this is great, for they will get to rid themselves of the burden their ‘expected-not-to-perform’ assets pose. (Although, the usual devil will be in the exact definition of these.) But, from the systems point of view, only a small step forward.

The state provides almost all the funds, takes most of the risk (and most importantly, the entire bad side of the tail of the distribution), in a move which cannot be seen anything else than outsourcing an auction operation to a bunch of investment management firms. At rather high fees, one might add. This is not private-public-partnership, this is a public-hires-private game.

The funniest thing is that the structure of the Geithner-plan is the same as the investment banking bonus system, the subject of that ludicrous ‘debate’ of the past weeks. Think about it: an investment manager (a) plays with others’ money, (b) has only very limited pain if the portfolio goes sour, (c) has a very high payoff if he gets lucky -- a large part of which is being paid in the form of a ‘bonus’, and (d) in return he is expected to structure and manage risk in the best interest of his employer. The Geithner-plan is exactly the same.

To be fair, this plan, if seen through, will indeed serve as a small step from the system’s point of view. Perhaps even two small steps. First, it could reduce the uncertainty about what is on the balance sheet of the US banks. The ‘toxic assets’ will come out onto the daylight, and will be assessed by the financial market. If economic theory is still to be trusted, this will be the best assessment one might ever achieve. Second, the relieved banks could stop being completely paralysed and start operating as banks should.

The trouble is that although transparency will increase, we will still not know what to do with it. The risk valuation problem, the phenomenon that lies at the origin of the rise of toxic assets, will be still here. And they will be until we move economic modelling from national to global level, and thus allow ourselves to describe the economic processes encompassing all the factors that affect our financial assets. (With the added trouble - as this blog pointed out before - that we do not have the theory that could provide such a truly global framework.)

Furthermore the trouble with the banks getting rid of their shackles is that this in itself will not make them return to the market, and behave just as before. The less-troubled, and the non-so-troubled didn’t do it, why would the newly-relieved do it? Same song: until effective policy emerges, there will be little economic incentive to do so. Effective policy in a global economy means global policy. Unpopular as it may be.

The Future of Economics

Economics is a prostitute, really. After having managed to turn itself into the most science-like of all those groups thinking about the ways and whys of societal behaviour, a feat done mostly via the application of mathematics as language, it has sold itself, body and soul to, well, whoever pays.

The people who try to figure out how economies behave tend to be preoccupied with the question of how to make money (how many investment bank ‘research’ analysts are really interested in the way the society works?), or with how to keep the economy going so that the next election can be won (or retrospectively, which of those populist promises must be delivered on if the election was won), or how to keep the bankers and politicians from ruining the economy for good (enters the central bank).

The people left in ‘academia’ either tend to do a lot of consultancy for the corporate/policy researchers, and thus are steered towards answering the same questions but do it using slightly different frameworks (and earn less money for it), or choose to remain on the fringe of the debate.

Thus, economics has become more of an engineering discipline than a science. If its subject matter were houses, for instance, it would be concerned with how to build, or maintain houses, rather than what houses are, or where they come from. Maybe think of it as the relationship between physics and engineering; only with the physics bit mostly missing…

As a consequence, economics is the most coherent, but also the most backward social science. Its usage of mathematics ensures rigour, but the prostitution of the questions asked disrupts any real scientific endeavour. Incidentally, the parts where the applications are the least profitable tend to be the most innovative (game theory, networks).

The failure of the discipline is most evident in the current crisis. Analysts in investment banks keep giving in to the latest fads, seeing no point in making calculations any more. Policy economists appear to have decided - for some very odd reasons - that the old models must have been fine, it was just the implementation of the consequent policies that landed us where we are (a bit of self flagellation is always fun, but that is no guarantee for being right). Academic economists are mostly left baffled, living off their reputation, taking any opportunity to pretend that they know something of an Answer.

I challenge all academic economists to recognise the need for a new theory. In particular, a model describing how the global economy behaves is needed. It is increasingly evident that the world economy is as much not a macro economy, as a national economy is not a large market. We will need to depart from the macroeconomic theories, just as macro had to depart from micro some eighty years ago.

The future is global economics.

Read Excerpts And Wait For Their Next One

(A review of the book ‘Economics 2.0’ by Norbert Häring and Olaf Storbeck)

I set out reading this book (I was asked to do so by the publisher) with great expectations. The blurb and the reviews that the publisher provided suggested that although this will probably be no economics revelation, a lot of fun was guaranteed. Well, the first part was definitely true. But fun?

This book is economics 2.0 in its title only. The book has a very limited offering regarding the frontiers of economics. It assumes that game theory and experimental economics are the main drives. Where is the great merger of the three schools of macroeconomics? Where is the rise of mathematical finance? Where is the completely new economics of transition? And most of all, where is the emerging global economics?

As for new, dare we say, economics 2.0 methods: where is high computing in finance? The role of simulations in macro? Or, the use of networks? 

Furthermore, the text flows as well as a compilation of 150 abstracts would. The fact that the papers behind the abstracts are really interesting makes it even more annoying. You would actually want to read this book, but it is just so unfriendly. For instance, it is peppered with names (and often titles) of economists. A randomly selected 15-page sample included 61 mentions of economists’ names. Very tiresome.  

The book sees the discipline of economics through German lenses. In particular the ‘frontier’ is noticed in areas where German economists are strong. (This is probably no surprise as the two authors are well established names in German financial journalism.) This makes me want to be nice to them: it is great when there is a local economics culture which is actually good at something. Unfortunately, there seems to be no self awareness about this feature of the book. The discussion of the problems to be solved, and the solutions, are all from the perspective of that particular Frankfurt-Zurich-Bonn-Munich based economist subculture. The fact that they quote the work of non-Germans, in other academic centres of the world, comes across as mere decoration. 

And in any case, unlike the behavioural economics bit, which is fairly up to date, most of the macro could have been written fifteen years ago. The chapter on globalisation is especially annoying,suggesting that “Vasco da Gama was probably the first global player”, and offering such insights as “No doubt, globalisation has changed the world we live in at breakneck speed.” Grrrrrr.  

In conclusion, this book is a lost opportunity. The subject is great, the work the authors have put in is substantial, and it is clear from the occasional shine-throughs, that they have a really good sense of humour. They could have written a brilliant book, the one that was promised. Sadly, they didn’t. My suggestion is that you leave this book aside, and wait for their next one.

Minus Six Point Two

It is almost an axiom that data revisions almost never matter, at least not in the short run. Maybe this one will be an exception... If you wanted to have a symbol for how bad things are turning, and how unexpected that is, consider this revision of the US GDP data for the Q4 2008, down from -3.8 to -6.2. And the forecast that we will mention this news a few times, is fairly straightforward.

The World As Emerging Market

Mature economies increasingly behave as if they were emerging ones. If you look closely, they are.

When dealing with emerging markets, you always have a problem: figuring out which country is really your subject matter. When does an economy leave utter hopeless poverty and get on the - always bumpy - road towards affluence? When, during its rather rocky past decades, did Cambodia enter the emerging market category, for instance? Or Morocco? Or Colombia?

(Drawing the line at the political transition is always tempting, but often wrong: think about the hopeless early years of the European post communist countries, or, the ultimate example from the other side: China and the Gulf states. The first bunch went through more or less free elections, but did not really get onto the emerging path until the mid-90’s, while the second lot clearly embarked on the typical rapid structural change pattern that characterises the emerging markets, but with, let’s put it this way, no landmark events towards democracy.)

Maturing emerging markets pose similar problems: when do they leave this category and become ‘developed economies'? Isn't it ridiculously silly, for instance, to treat Singapore and South Korea as emerging markets? Or, from the other side of the category: are Portugal and Greece really ‘mature’?

Maybe the term emerging market is not useful after all. At least by the mid 2000’s the line was already blurred: everyone was going through some form of rapid structural change, institutional reforms, and those who did not - we learn these days - should have done exactly that. Was the debate about the role of government in the economy in Germany really that different from that in Central Europe? Was the economic strategy, and the consequent structures, that different in Dubai from Switzerland? Was the role of the financial sector in Iceland really on another planet compared to, say, the UK? And, was the structural dynamics due to the new technologies that different in the US than in India?

Arguably, in all of the above examples, there are large differences between the two sides. But are those large enough, distinct enough, to justify a different category? Or is there, instead, a continuum of behaviours that are associated with integration into the emerging global economy and the adoption of a technology-intensive economic development path?

Thus we end up sceptical about the usefulness of the term emerging market during the past decade, at least retrospectively. But then, consider the behaviour of the mature economies during the current crisis. The ineffectiveness of the policy measures. The lack of proper data. The immature reaction of the political class. The depth of the social consequences. The unanchored systemic risk. And most importantly, the wildly uncertain future. Who is the emerging market now?

Global Thinking Ban

Amazed at the extreme reaction to ideas related to global government institutions.  People treat those who even enter the discussion as if they were obviously nuts. There is hardly any debate involving arguments about potential merits. The recognition, by both sides, that the establishment of effective global government agencies would be politically very difficult, finishes the discussion at the starting point, and is presented as failure of those suggesting the need to think about it.

How silly is that?

The Global Ducks of the Oxford Canal

Do you want to know the real mechanics behind the rise of the global technological society? Well, if Bob Allen is correct about the origins of the industrial revolution, it is not geography, nor human capital, nor institutions, nor culture.

His fascinating reading of the origins behind the industrial revolution goes like this. First, discoveries of the 15th century led to increased trade, and that in turn, to increased urbanisation (the expansion of British trade resulted in the population of 16th century London multiplying ten folds). Second, increased volume of urban population changed pre-existing price structures (the demand for heating was too high to satisfy from logging, and thus coal was used en masse; after the initial fixed costs, large coal reserves were tapped, at a low marginal cost, which led to the eventual fall of the price of coal). Third, changed price structures of commodities altered the relative price of labour (especially in Northern England where coal was coming from). Fourth, this made labour-saving technological innovation economically sensible (and thus the industrial revolution was born). Fifth, the same line of argument holds for the adoption of the new technology (and thus the industrial revolution ended up being a primarily British phenomenon for a long while, rather than the emerging technologies spreading rapidly to other parts of the world).

The consequences, if this hypothesis was to be true, would be far-far reaching.

1. What is the upshot for archaic societies? Would the above argument mean that their opening up has more to do with the economic incentive structures embedded in the pre-existing social structure and technology set than either with lack of inventiveness, or cultural norms keeping the society closed to the new. 



This would be supported by the observation from Papua that, contrary to the way I imagined before, there seemed to be a substantial drive to opening up. The impression left was that rather than the base case being a culturally closed human group/tribe etc., it is more that you would need a cultural process introduced to shut down the opening up process. Our cultural diversity sustainability worries would take a completely different lighting. 


2. What is the upshot for development economics? To what extent could this result be translated into a general observation towards a relationship between relative wages and technology spill-over? 



It is striking how different technological adaptation is among developing economies. For instance, the former communist transition countries saw a lot of variation in this regard, despite being rather similar in their base setup. It seems that it has to do more with the effective labour cost than purely the abundance of human capital. Compare the economic transition story of Slovakia to Croatia as an example, in the early 2000’s. Despite the timing of starting the change in earnest was the same, and the initial setup, at least in economic terms, were similar, the high Croatian tourism revenues kept the kuna strong, and resulted in lack of the kind of rapid structural change that was witnessed by Slovakia. A similar point could be made when comparing a transition country to a non-transition emerging economy, say end of 1990’s Hungary to Thailand, and observe that although price levels were not that different, the difference in the cost of effective labour due to differences in human capital led to entirely different technologies being adopted, despite both undergoing substantial structural change.


3. What is the upshot for government innovation policies in economies integrated into the global economy? Would this mean that instead of state support of innovation, governments should meddle with the returns?



In fact, perhaps the argument could be extended into a speculation about the kind of innovations that will be favoured in a fully integrated global economy of the future. We have much better ideas of where individual currencies’ purchasing power is going than before, and thus perhaps about the long term relative prices in the global economy. If the relative prices could be thus somehow guessed, maybe that would have a direct implication towards innovation drives. Could this be used to speculate about new technologies emerging?


4. Is there a minimum wage argument in here? In the early 2000’s I was involved in a debate about the merits of ‘graduate minimum wage’ in the post communist transition process. I hated every bit of the idea. Maybe I was wrong. Maybe the supporters’ point about multiple equilibria referred to discontinuities in the technology set, and thus to an effective labour cost based argument similar to Allen’s. 


Therefore, does this hypothesis mean that the level of effective minimum wage would have an impact on kind of technology the economy adopts? 


What do you think?


Endnote

My favourite cycling route goes along the Oxford canal, which is incidentally one of the routes in which coal was taken from North England to London. I will have a new topic in my chat with the ducks next time.

Letter from America

(A guestpost written by Balázs Szendrői.)

Walking across the University of Berkeley campus one sunny afternoon, I could not help but notice two young, scantily dressed people on the grass in front of the Campanile, Berkeley's iconic bell tower. They were engaged in an activity which, in most countries I know, would have counted as sex and therefore strictly forbidden in public places. Not in California; the words "yoga", "acrobatics" and "massage" were whispered amongst the small but reverent group of casual onlookers of whom I was by no means the only one.

America: the Land of Freedom. And the Land of Free Enterprise. Well, you could argue that Free Private Enterprise has not been doing so well here lately. Yet it is clear that even at this hour, is the world's largest economy that the rest of us look to for leadership, growth generation and a general cure to our ills. Despite its evils, in a way the USA still seems to be the best we have.

One way out of the present mess might be a global framework along the lines of the federal structure the USA has successfully adopted over the course of its existence. It might perhaps be of interest to pause and recall one or two factors that played a role in its formation, at least in an impressionistic way.

First, necessity. The cellar of the apartment block where I am staying contains, along with the expected assortment of broken light bulbs and other assorted bric-a-brac, a collection of about fifty leather bound volumes humbly entitled The Annals of America. Volume 1 contains the documents relating to the prehistory of the USA, starting with Columbus' triumphant report of his first encounter with the Indians. Later, there are long descriptions of the now well-known difficulties the first settlers encountered, including loss of crop, hunger, cold and isolation. But one striking aspect was the description of the first encounters between emissaries from Virginia, Massachusetts and other early colonies. It is clear from the excitement of the reports that the settlers thought of unity and cooperation as a necessary virtue.

Second, the Founders, among them the Committee of Five who drafted the Declaration of Independence. John Adams, lawyer and historian. Benjamin Franklin, polymath, scientist and author. Thomas Jefferson, philosopher. Robert Livingston, diplomat who helped Fulton develop the commercially viable steamboat. Roger Sherman, influential lawyer without any formal training. Surely not without their faults, nevertheless these were people of huge intellectual and moral standing. Along with the other Founding Fathers, they were entrusted by their communities with the job of creating a system that would outlive them. This they certainly accomplished.

Third, America's moral Coming of Age: the long civil war, starting with the Civil War itself, and culminating in the Civil Rights Movement of the 1960's. Walking the streets here, talking to people or looking at the newspapers, it seems clear that people of colour get more opportunities, have more freedom and command more respect than anywhere else in the developed world. And this was true (and had to be true) even before one of them became President. Some American (wo)men are more equal than others in many respects, but at least this is decided to a much lesser extent by their racial heritage.

Back to us, then. The necessity for global governance has been amply argued elsewhere, not least in these pages. How about founding fathers? It is clear that the election of President Obama has presented the US and thus the world with a unique opportunity; just imagine attempting to build global institutions with a US president with 20% home and 10% overseas approval ratings. Looking further afield, an unlikely globalization hero has recently emerged in President Ghaddafi of Libya. Bring along President Lula of Brazil, the reluctant European Union, start talking to China, and we would have most continents covered.

Finally, the moral coming of age. If there is to be lasting peace, surely a condition for a successful global governance framework, it is necessary for different communities to accept, trust and value each other to a much greater extent than currently is the case. The Israeli/Palestinian conflict is but one of the starkest illustrations of this. It would be truly tragic if mankind were destined to only achieve moral peace through many more local, or even worse, global wars. Give peace a chance.

A 50,000 Year Old Global Network?

Last Thursday I went to a fascinating talk by Graeme Barker on the shift from hunter gatherer to farming societies on Borneo.

I went along to understand more about the technology dynamics of the Papuan Highlands, but I picked up something very unexpected.

Graeme Barker discussed the orthodox models of the spread of agriculture around the world, and compared it to the new understanding that has been emerging recently. The former model supposes that there were a few migration waves, and a few innovation events. Opposed to that is the new model, based on recent archaeological and ethnographic evidence. This suggests that there was relatively intensive interaction among neighbouring groups that facilitated technology transfer over long distances. Mango from India grown on Borneo, and bananas from New Guinea carried to West Africa - are the suggested evidence for that.

So, based on this, here is my speculation.

What if our (or at least, my) model of the global society is completely wrong. If there really was so much and such constant interaction among neighbouring groups for tens of thousands of years, then maybe a good model would be a network of societal relationships that have existed since the rise of our line of humans. (If you wanted to be truly outrageous, maybe you could extend this argument further back, to some previous homo species.) Then what we'd have is a description of this network, and the rifts along this network, say due to geographic reasons (rise and decline of the sea level, for instance). This network would give a completely different story about globalisation, or what we mean by it now. In this reading, the term ‘globalisation’ would be a reference to the dynamics of a particular network property.

I work on a network model of the global economy, and keep getting into fights with economic historians who claim that the level of globalisation was much higher, say, two hundred years ago, than now. They use macroeconomic measures, which I think misses the point of network complexity. (The latter concept is not really in the toolbox of macroeconomics, so the debate is really futile. It tends to be fun, though...)

But maybe the picture of the global network being there all the way back to the spread of the homos would change the entire discourse. You would have a global network, maybe, with more or less complex structures being built up in different geographical locations. Then the current globalisation would be, perhaps, a build up of a complex structure that covers the entire geographical spread, with any new local complex ‘outgrowths’ necessarily being integrated into the global one. In other words, ‘globalisation’ would not merely refer to the existence of a global network - as that has been around for a while - but the emergence of an overall structure which would encompass all new network build ups in a way that they could not be regarded as separate systems.

What do you think?
(Maybe modelling the global economy’s network structure for the past three decades is an un-ambitious project after all, how about 1700 times longer?)


---------
Digression

At the Barker lecture, there was some meat on the expected topic as well. The description of two tribes, living next to each other, with entirely different approaches to their immediate general environment, the technology set they use, and the attitudes towards non-traditional consumption, was extremely interesting. One completely refusing to open up, being very mindful not to harm their forest, sticking to old technologies, and refusing new products, such as rice. The other one, the exact opposite: treating the forest as their ‘property’, quickly adopting new technologies, and taking up new consumption patterns. Beautifully highlights how impossible the quest is to have an economic development plan ‘good’ for all. The ‘incremental, local, community based’ just got an other supporting argument?

Bank Nationalisation Is Charlatan Medicine

It is now demonstrated beautifully that giganormous system level risks originate from the financial sector, which then banks accumulate in a very non-transparent way. As a consequence, an unexpected - and sizable - shock hit the global economy. The panic button was promptly jumped on, and governments around the world started to shoot emergency cash injections towards any bank standing up. (Ok, not quite anyone: sorry Lehman...)

Shockingly, even some decent economists started to advocate for state ownership of banks, arguing that nationalisation of the banking sector was the way forward. Ha!

Thread 1: Systemic Risk

Con, against the nationalisation of banks. Banking is not a strategic industry where direct security risks would arise.

Pro. However, it can create systemic risk that could (and did) result in a major disruption of the entire economic system.

Con. The level of systemic risk is contained by the set of (effective) rules that the banking system operates in. In other words, it is the regulatory-supervisory framework that sets the level of systemic risk. You could have fully private owned, and fully state owned banking system, and any of the two blowing up, or remaining in control.

Observation. Look at the relatively large number of banks in the mature world, which are in some form of community control, state, municipal, co-operative. Their exposure to the current crisis varies along their countries regulatory regimes, rather than their ownership background.

Thread conclusion. The presence of systemic risk in the financial sector is no valid argument for nationalisation.


Thread 2: Societal Needs 

Pro. If the banks were in direct state control, they would allocate their lending to areas where the society would really need it.

Con. There is no natural monopoly in finance. Instead: it works best when driven by private profit motives, as proven by not only the historical efficiency of most of the banking functions (market failure tends to originate from some external distortion), but also the innovation track record.

Observation. “Development banks” have, in general, been a disaster. You could perhaps argue that they can supplement outright government subsidies, but any of their efforts to compete with the ‘real’ banks has been a remarkable failure due to the inherent inefficiency coming with bureaucracy-determined allocation of credit.

Thread conclusion. There is no valid efficiency argument for the nationalisation of banks.


Thread 3: Asymmetric Information

Pro. There is a major asymmetric information problem. Although mature supervisory agencies have strong mandate, and could, in theory, monitor every aspect of a supervised bank’s operations, in practice such full transparency is not possible. State ownership could increase the transparency.

Con. It is true that there is an asymmetric information problem. But. Changing ownership will not, in itself, alter the setup. There is no reason why an effectively run state owned bank would have different incentives not to allow full supervisory transparency than a private owned bank. In fact, what is needed here is a better regulatory coverage, which, I would argue, will not be achieved before a truly global regime is not implemented.

Observation. The banks that have rogue traders do not know of them. Obviously. So that will not be affected by state ownership. Whereas, the risks that are know, like large NPL stock in subsidiaries seated in other countries, are best controlled by a regulatory regimes that monitors all possible areas where subsidiaries may be. That is global.

Thread conclusion. There is a strong asymmetric information argument, but that calls for better, and, in particular, wider regulatory regime than nationalisation.

Thread 4: Crisis Action

Pro. The governments around world reacted to the financial crisis by de facto nationalisation of a host of banks. This has not stopped the crisis from deepening. Other, previously shielded banks are coming under threat from the ripples of the previous ones going down. Nationalising now, not as a long term policy, but as a short term crisis measure would reduce the societal cost of clearing out. Then once a new regulatory regime is implemented, the entire banking system can start with a clean slate.

Con. It is true that once the crisis has started, and mass bail-out was the chosen (accidentally emerged) technique of dealing with it, seeing it through might make a lot of sense. However, the bail-outs so far, essentially imply a full guarantee of the entire banking system. The first bail-outs might have made sense, as a short term policy, an attempt to stop the crisis unfolding. The implied full guarantee of the entire banking system was a gamble on not having to back the whole economy. It is over now, and very clear that none of the world’s governments is strong enough to bail out their respective national economies. (Even less so, if you take into account that the global linkages would mean that any of these governments would effectively have to back more than its national economy. Unless of course there was a fully global harmonisation of policy, and an enforcement of it. We end up with the global government function again.)

Observation. The implied probability of government default is on the rise in a large number of mature economies. At the same time several sovereign bailouts are on the way. This cannot go ad infinitum.

Thread conclusion. The reaction to the financial crisis in the form of de facto nationalisation of banks made (at least some) sense at the early stage. However by now, it is blowing budget capabilities up. No government is strong enough, and a sovereign default would be carry much higher systemic risk.

Overall Conclusion

Nationalisation of either the banks, or any other sector in trouble is not the way forward. It is merely a pseudo action (apart from the populism) instead of the politically still difficult support for the inevitable rise of the global economic governance architecture.

At this stage of the crisis, bank nationalisation is the charlatan’s medicine. It’s the global regulation, stupid.

Britain, An Unlikely Default Story

When I moved to the UK a few years ago, I did not expect that I would ever take a break from my new discipline, global economics, and return to the old one, emerging markets macro. And especially not with my new home country being the subject matter. And yet, the day has come. The fiscal response to the credit crunch combined with the implied and not-so-implied spending promises by the government towards a host of different industries - among them practically the entire financial sector - translate into an essentially unlimited government guarantee of the British economy. This, as I pointed out earlier, is a gamble on time, a bet that the global crisis would not last very long and thus that the state’s guarantee about keeping the entire economy afloat would never be called in. Now, it seems, that bet is lost.

Let me tell you what a pair of macro eyes that were trained by watching emerging markets sees now in the UK.

First, a country needs to have really bad numbers to go into default. That is a necessary condition. There is no amount of bad policy that could force insolvency in itself, unless, of course, a madman was in charge. (For an example of the latter, see North Korea 1987). You need awful numbers. Otherwise, bar that madman case, any government can avoid bankruptcy by changing its policy course, probably in line with the demands of the creditors (usually coming in the form of IMF ‘advice’). Turkey 2001 for instance had really bad numbers: large twin deficits on current account and budget, coupled with a largely malfunctioning banking sector. (For a brilliant summary read Ozatay&Sak)

The UK is producing some spectacularly bad numbers. Yet, the current picture looks bleak only in the mature economy context. As far as emerging markets go, there would still be a long way before hyperventilation really started… (Try, for instance, comparing the current UK situation to that described by the above mentioned Turkey crisis paper.)

Second, the country needs to have ineffective government levers. The point in debt default is that you can’t find anyone else to give you any loans with which you would be able to cover your previously set payments. Nobody, at any price. Which means that your would-be creditors think that the level of your debt burden is larger than anything you could ever collect in taxes, at any probability. This does not really happen with well-managed economies. This is one of the main differences between countries that we call ‘mature’ as opposed to ones that we call ‘emerging’. In an emerging market you tend not to trust the government (usually alongside the entire population…) to have the means to get debt payments collected. In 1997 and the first half of 1998, for instance, Russia was hit by a string of external shocks, a combination of bad policies (e.g., exchange rate regime), budget blasts (the cost of a war), and a worsening international finance environment (1997 Asian crisis melting demand for bonds), and falling commodity prices. Even then, all of these would not have been enough to sink Australia for instance. Thus for a sovereign default, you needed to have an inefficient government, too.

The UK is clearly a very well-run economy, with extremely well-oiled levers. It would need to be far from the current situation for us to need to start worrying about it. (The spectre of net government debt rising from 36% to 60% might be unsettling, perhaps. However, if this was an emerging market you would not even blink, as long as you trust the government to be able to control the process. You would call it ‘timely correction’, and ‘rightful counter-cyclical fiscal measures’.)

This is especially the case given that UK government debt is in pounds. You need to have a particularly stupid government/unlucky country to run into default due to a run on domestic currency-denominated debt. (Argentina 2002 defaulted for instance as nobody was willing to refinance its external - mostly dollar-denominated - debt. Had the government debt been denominated in peso, they could have avoided insolvency. At least for a while, as they also managed to meet the other criterion...) You might think that some of the policies of the British government are debatable. But that is not enough. We are nowhere near.

Third, although the default does not necessarily come as a surprise, it tends to. Especially, if the financial sector is not well developed. Any emerging market government presiding over an economy with a mature financial system would, in practice, see many first signs, such as the premium on its previous debt obligations going sky high, before creditors, en masse, would turn away from it.

Have you seen the UK Treasury spread lately? You would need a different number of digits!

In conclusion: fears about the UK running into insolvency any time soon are far (far, far)- fetched. End of the Earth.

...

Having said that...

I would worry about the long-term implied guarantee though… At one point either the downturn ends naturally (if there is such a thing), or the global fiscal/monetary policy institutions are stepped up, or this country - and many others - will have to take back its word re what it would do to save its people. Still, defaulting on your promises is not the same as on your debt, is it?

A Post-Crisis Prediction For Global Emerging Markets

(This is an unpublished note that I wrote last March. Strictly for the buffs.)

What to expect when the recovery comes

Maybe it is time to talk about the coming upswing, whenever that is going to be. Since the previous downturn, emerging economies have come to play a far greater role in the global economy. This will change the way that the global financial system adjusts to the current crisis, and mean that the structure of the global economy will change for good.

A comparison with the recovery after the dotcom bubble burst is instructive. The ancient adage about every general fighting the previous war has been a valid criticism for forecasting the next crisis. But only the most arrogant military strategist would not try to learn from the mistakes of past campaigns.

During the dotcom crisis, the downturn in the business cycle caused the real economy to hold off on investment spending, and as a result production technologies gradually became outdated. The underlying drive to innovate, however, was not much affected by the slowdown: new ideas and solutions kept coming. So when companies could afford to invest again, and indeed were compelled to do so to keep up with the also-recovering competition, they invested in the latest technologies – and saw their productivity increase rapidly.

What we macroeconomists saw was a sudden increase in productivity, while employment was much slower to pick up; it did, eventually, once the catch-up in technology adjustment was complete.

Much of the same logic is present again now. Firms might have stopped investing, but technological innovation has its own momentum, from which they will be able to gain when they can afford to spend again. Right now, we see investment falling in response to reduced demand. We might expect, on the post-dotcom pattern, that this will be followed by a catch-up in technology investment, increased productivity growth, and finally, after some delay, a pick-up in employment.

Yet there is one major difference between this trough and the last: that is, the role of emerging markets in the global economy. The way in which emerging markets adopt, and increasingly generate, new technologies will alter the upswing after this trough significantly.

Producers in emerging markets are not suffering as much as their counterparts in mature economies in the current slowdown. Sure, their exports have been hit, but many of them have found that domestic demand is relatively buoyant. That is because their own economies are on an upwards growth path that is not so cyclical, but reflects real structural change. As a result, they do not have to simply sit out the global slowdown, but instead can turn to the domestic market and exploit pent-up domestic demand. When global demand for their products recovers too, they should find that they are better off than before the crisis. Quite likely they have access to extensive cheap labour, meaning that they can easily expand production to respond to increased demand.

Producers in emerging markets have also shown of late that they can adopt new technologies extremely rapidly. Spillover from mature markets happens much faster than it used to, and sometimes these countries are themselves the source of innovation. This too means that they have especially good potential to increase productivity quickly once the recovery comes and they can invest in new technology.

The technology catch-up effect, with companies preferring to update to the latest technologies before expanding their workforce, is likely to be repeated. However, emerging market countries are set to benefit all the more from this process, since it is in these countries that the cheapest skilled labour is to be found and the greatest productivity gains to be realised. Furthermore, for companies in developed countries, once they are in a position to start investing again, they are likely to weigh up the options and find that starting a new production unit in an emerging economy makes more financial sense than expanding existing capacities at home.

This means that the pick-up in employment in mature economies will be delayed further. Much of the job creation will be in emerging markets, with the latter seeing another big expansion boom.

Of course not all emerging markets are the same, and the recent troubles have confirmed that a separation is occurring between the more and less robust emerging economies. Those with weak fundamentals will have neither the cushion of buoyant domestic demand now nor the capacity to attract FDI when things begin to look rosier globally. However, the many emerging markets with stronger fundamentals, that have really done their homework in terms of changing the structure of their economies (or are lucky enough to sit on abundant natural resources), are about to see the benefit of all their hard work (fortune). They could be catapulted into a very strong position in the world economy within a very short time. Then we will really see what they are made of.

Regulating Knowledge Creation Of Global Finance

Our crisis is a crisis of knowledge. We witness a remarkable market failure in creating high quality financial research for the global economy.

There is plenty of evidence. The lack of adequate modelling framework for the global economy results in the absence of effective asset valuation; the lack of price anchors lead to major bubbles in boost times, and a downward asset-price-spiral in bad times. The standard answer has been to blame rating agencies and the lack of 'deep-thought' on the part of investors. Calls for more or different regulation are ample. 

The cause for the problem: 

1. Investors were looking at a new horizon with the old set of tools. Their coverage grew from local to global in a very short time, and thus there was, and is, a complete lack of adequate in-house research capacity in most investment houses, especially outside the main financial centres.

2. There is a significant incentive compatibility problem with the bulk of the external investment advisory services. The investment banks do offer global and universal research coverage, but the advice provided is often superficial, and despite the Chinese wall regulations, is still broadly in line of the interest of the banks; at the same time the business model of rating agencies further amplifies the incentive compatibility originated distortions. 

Alternative source of modelling innovation has so far failed to deliver:

The upgrade of the in-house research capacities of global investors has so far lagged due to the very large cost of building up global modelling centres, coupled by the uncertainty of the pay-offs due to the lack of adequate modelling framework. Furthermore, the induction of such build-up might lead to major concentration of investors on the global scale, creating a new set of problems.

State-provided research has been entirely inadequate in providing the necessary innovation, while academic research has been lagging, probably due to data availability reasons. 

The small set of independent research houses are struggling for being driven out of the market by the large amount of low quality free research published by investment banks: as a consequence, most of the major independent global research houses are politics centred.

The consequence is a market failure without an obvious regulatory solution. 

There are three main non-regulatory solutions:

Solution: reputation. Deal with the problem from a reputation angle. The argument goes like this: the market learns from its mistakes, this is ultimately a reputation game. This argument suggests that investment banking research is a product with asymmetric information problem, where credibility collapses in one-off games, and a reputation based equilibrium emerges in the repeated game. 

Solution: refined regulation. Recognise that the core of the problem is a regulatory failure, and seek a solution through the refinement of the regulatory system. The burst of the dot-com bubble resulted in a wave of regulation that tried to tackle the incentive problem inherent in the investment banking research. The refinement of this regulation may result in increased efficiency, especially if accompanied by a global regulatory umbrella ensuring coordination and some universal standards.

Solution: global economics. The core of the problem is that the emergence of the global economy has not been accompanied by the rise of a new, global level socio-economic modelling framework, and thus the solution is ‘global knowledge leadership’. The basis of this argument is the assumption that the knowledge and theoretical underpinning about the socio-economic universe around us is essentially a public good. Thus, although arguably the monitoring of the movement of the system given the availability of the data and the framework is delivered most effectively in a competitive framework, we cannot expect the same institutions to provide an innovation in the framework itself. As the new organisation level, the global economy, emerges, the existing toolbox becomes obsolete, the data inadequate. Consequently, the creation of the new framework is a global quasi public good, with manifest policy implications.

It is not going to be a surprise that I’d go with the third version...

A Policy Speech, But No Global Leadership

Most commentators are underwhelmed by Obama’s inaugural speech. However, an analysis of the text reveals the reason for the disappointment. Going against the expectations, this was a mostly policy speech, although you have to work a bit to uncover the content.

In my count (and categorisation) 43% of the speech was directly policy related. Of that, around half (21% of the entire text) was dealing with the US economy. Here is my translation of the contents of economic policy bit: The US economy is in crisis. The endowments are still the same, but effective government action is needed. The coming government measures should be judged by their quality and not by their size. His government’s investments will be in: infrastructure, science and technology, alternative energy, all three tiers of the educational system.

There was zero mention, or even a hint towards the global economy, and the fact that the US economy is part of it.

Yet, there were three different mentions of the global socio-economic system.

One. Global society -- the most circumvent way of putting it:

We are shaped by every language and culture, drawn from every end of this earth; and because we have tasted the bitter swill of civil war and segregation, and emerged from that dark chapter stronger and more united, we cannot help but believe that the old hatreds shall someday pass; that the lines of tribe shall soon dissolve; that as the world grows smaller, our common humanity shall reveal itself; and that America must play its role in ushering in a new era of peace.

A translation of the above would be something like this: The US is a culturally diverse place that managed to form an identity out of a series of shocks. The global society is also a culturally diverse thing that will see a common identity rise, and the US should be instrumental in that.

Two. Cooperation with others on two global problems:

[We] can meet those new threats that demand even greater effort - even greater cooperation and understanding between nations. [...] With old friends and former foes, we will work tirelessly to lessen the nuclear threat, and roll back the spectre of a warming planet.

Thus he supports a global-level policy on nuclear non-proliferation and climate change, as far as ‘cooperation and understanding among nations’ and ‘working with all others’ counts as such). In any case, there are existing global institutions for both, which the Bush government largely ignored, so this may only be a promise towards the US takings its share, rather than any new global leadership.

Three. There is no mention of global economic policy architecture, but there is an indirect, implied presence of some kind of global policy institution in this quote:

To the people of poor nations, we pledge to work alongside you to make your farms flourish and let clean waters flow; to nourish starved bodies and feed hungry minds. And to those nations like ours that enjoy relative plenty, we say we can no longer afford indifference to suffering outside our borders; nor can we consume the world's resources without regard to effect. For the world has changed, and we must change with it.

Despite a relevant point (economic development aid in poor countries works better if it comes especially to healthcare and education, and in the form of assistance rather than aid money), the global policy promise is there only if you want to imagine it: effective delivery of economic development aid, as well as an enforced global constraint on resource extraction would imply some form of policy forming, implementing, monitoring, and rule enforcing global body.

Overall, this speech has not done much towards outlining a global economic policy architecture, which would be, and probably will be, necessary to contain the current global crisis. That’s a pity.

Obama Writer’s Block

I never thought this would ever happen to me. I have an Obama Writer's
Block. (Check the time stamp of the previous post.) I have been
waiting to chew on something, and there is nothing given. His 825bn
package, I could tear apart (at least part of it) with harsh words on
'more of the same', with 'hey, don't you get it, you cannot achieve
much without global action' etc. But, my mature and and well placed
friends keep calming me down. Not so fast. He can hardly emerge as the President he is elected before the inauguration, and cannot possibly
act as the leader of the world, I have been betting on.

And thus, there was the long wait (and my pause). Until yesterday, I
heard the first global reference. Not much, but at least global
something: 'mankind'.

Today evening (well, our time at least) he will be sworn in, he will
give that speech. He'd better tell us that he will want to build a new
global economic policy architecture. A truly global regulatory
framework, an institution delivering global harmonisation of monetary
policy (and, yes, including currencies), some sort of global fiscal
policy co-ordination (with enforceable rules), and maybe, some form of
universal development agency (going way beyond the World Bank's
mandate). He'd better tell us that he will be all of mankind's
president, not just the American president. He'd better recognise the
political capital that he piled about around the world. And he'd
better promise to use it.

Khm.

Talk about the impossibility of meeting inflated expectations...

Global Economics and Local Cipollas

Even if nation states were on their way out, some governments seem to want to linger around. They are thrusting themselves onto the global arena with a whole new set of aspirations, quite detached from their original functions. And by doing so, they meet entirely new forms of appreciation by the World.

Some will be happy, it seems, to subject themselves to ridicule: the Polish government banning the ‘super-gay teletubbies’ was an instant classic. Or contempt: the US deluding itself into a ‘global policing’ function did not exactly meet widespread appreciation around the world. Or admiration: did you register what AUSAID, the Australian government’s aid agency, did in Indonesia after the tsunami? Or, sometimes, the combination of contempt, ridicule, and admiration: remember the French government’s attempt at the global Francophone television? (Or, in fact, remember the “French government’, as such?)

The interesting thing is that these New Government Actions are mostly independent of their respective societies. And as they are busy reinventing themselves, the national economies that they have been presiding over are gradually dissolving into the global economy.

It started so much grander… 

At the beginning there were the sovereigns. Those mighty times of rule-free orgies and joyous beheadings. The times when the sovereign was still truly sovereign on its own land. 

But then, a glitch emerged. Even if slowly. 

Land was less and less important, people mattered, their heads mattered (and, shocking, more at the end of their necks, rather than on the top of a spear). With all the new ways of moving around and difficulty in stopping them from doing so, the people turned out to be not-so-loyal subjects. Huh, hard times came for the sovereigns. They had to compete with each other! Efficiency mattered. And worst of all, I kid you not, it was not even clear any more who the sovereign was. Can you imagine that? Sick world!

And thus the ‘government service providing institutions’ were born in the place of the Mighty Sovereign. But it might still end on a sweet note. 

As the world economic crisis is taking its full shape, and the national government’s services are becoming less effective by the day, a new, global set of institutions will emerge. And thus, the newly underemployed national governments will face the choice of reducing their size or finding new roles. (This is not the first time in recent history. See the variation with which the newly formed Eurozone’s old, national central banks reacted to their sudden lack of tasks. Some downsized, some magnified past functions, some created whole new ones...) This will be the moment, for national governments to reassess the globally interesting positions they sit on. There are some things, thank heavens, that cannot emigrate. Mountains rich in ore, seas of oil reserves, or nice beaches, coral reefs and snowy slopes are difficult to drag away. (Although some do try: witness Dubai’s two-piste mini ski resort.)

It might be a long time before these are submitted to global level control (do you know who owns the larger Schlesswig-Holstein banks? That provincial government never really came to terms with German reunification, did it? And I am talking about the one by Bismarck and not by Kohl.) We already began to discuss the consequences of this coming phenomenon, when the increasing role of sovereign wealth funds came into our sights. But the real thing is yet to emerge.

It is not that bad, is it? It will, or at least should not be necessarily very different from city municipalities playing a role in a nation’s economy, providing say infrastructure services, and at the same time maybe being an important, but not dominant player on the local capital markets. 

But some of the global players of government origin might turn out to be Cipollas. Excessively large accumulated wealth (maybe in sovereign wealth funds, maybe somewhere else, such as in government controlled mining companies), combined with lack of transparency, lack of any form of external oversight, and power hungry power-hungries. 

The newly emerging global state functions (well, if they emerge at all) might just start off with an unexpected rouge opposition. 

Cornish Love - Off Global Economics...

(more from those equatorial forests of Cornwall)

We also collected some real gems:

One. In the village shop where we stayed, people were very friendly to me. Liz suggested that here it might be better to be a foreigner than a non-Cornish Brit… So there was this guy, the local baker, who wanted to show off his freshly baked bread to me, accompanied by the words: “I bet that they did not tell you at Immigration about how great the bread is going to be here”. Sure, they did!

Two. It was also in this village shop that I witnessed firsthand two 50+ men say in all seriousness to each other: “see you later alligator”, “in a while crocodile”. I kid you not: they were not joking. Even a bit grumpy. And thus was the true etymology of the term ‘corny' uncovered.

Three. Although the Enlargement of Europe is recent, Central Europeans are already making a mark on the local culture. I overheard the conversation of two eight-year-olds at a kids’ slide place: “I bet you are a Romanian!” It was not discovered whether the term was used in a positive or a negative context.

Four. But the best of all was the large poster hung on a house at the end of one of the small towns: “Love Sale Festival” (heart, heart, heart). I guess the recession has now officially spilled into all the sectors of the economy.

Desolate

(notes from one other remote, exotic place, with strange people and customs: Cornwall)
 
In a Papuan rainforest location I recently witnessed a PR person bragging about how her company had really not done that much damage to the environment at all. In a field which had previously been a complex forest ecosystem on the equatorial, there now lies a grass meadow with grazing cows, right out of a Constable painting. And we thought that clichés were only harmful to the soul...
 
Now, in Cornwall, I am struck by how desolate the land is in the ‘mature economies’. The beautiful meadows, with the gorgeous rolling hedges (the latter - to be precise - can contain a surprising complexity of life in them), the cows and horses… It all seems so empty and destroyed compared to the real thing. Desolate, really, is the word. 
 
Csaba Aradi, the former director of the Hortobagy National Park in Hungary once played a little game with me. I - in my usual polite manner - asked him, why on Earth people are so interested in the flat barren land over which he resided. Hortobagy is a great plain. It was, I suggested, just grass and nothing. His response? He made me walk in a random direction, of my choice, for a random distance, also my choice, on this ‘empty field’. Then we kneeled down, and he made me count the species I could see within a circle of one-metre diameter. It took a while: there were a lot of species. Then we stood up, he made me choose another direction, and we walked just two metres. Kneeled down again, many distinct species again, almost none of them the same. The species diversity in this ‘flat, barren field’ was very high indeed. 
 
Now take Papua, the extreme version of ecological variation. You cannot say this slowly enough, for my mind to take it in. There are more than 2000 different orchids on Papua. Two thousand. More than 600 birds. Incredible. 61 different species of snakes. Some 2400 different fish. How many birds, or fish can I name? Or remember ever having seen? Including the zoo, the nature books, the Attenborough movies, and all my hikes altogether. I guess - I have seen quite a few – but it is maybe 300 max. Now Papua has double all the birds I think I have ever glanced at in life, on the screen or in books. Or fish: if I spent only a minute looking at each species, I would need almost two days of constant looking to get through them. (This is why people come up with silly comparisons -- the magnitude just cannot be felt through a number on the screen, albeit a four-digit one. The next thing I will do is calculate whether all the fish species lined up one after the other would actually reach the moon...)
 
And to top it all, you have more than 100 thousand insect species alone. Now, that is a lot of bugs.
 
Then look at the English landscape. Grass and grazing cows. That is two species. Well, grass is a little more complicated, so maybe a few more. And the weeds. And the crows. And… Er… There is also the fly, yeah? It is a desert.

This Guy Is Boring!

The emerging economic policy of the Obama administration can - at best - be described as  enlightened left wing policies, the kind that has been practised by the better of the European social democrats. The usefulness of these might be a revelation for the government-fearing US conservative elite, but economic policy innovation it is not.

There goes our hope for global leadership.

A vision about creating global policy institutions? Global regulatory framework? Global fiscal and monetary policy harmonisation? Leading the world to find a globally legitimate set of institutions, and thus transforming his enormous political capital into finding a global political channel to achieve all of these?

Nope.

It would have taken a ‘world leader’ to create a new, global institutional framework with foresight, in preparation of what is coming, rather than always moving as the reaction to the latest immediate pressure. At this time, Obama is the only person who has the global clout to do that. All others who could have done it have either already burned their capital in futile actions, or are yet to emerge, but are still not on the horizon. And Obama is not doing it.

Now, we will have to wait for the global economy to slide deeper into recession, and then see how global governance innovation inevitably emerges as a response.  Expensive entertainment.

The Other Crisis

When the economic storm had hit us, 10 weeks ago, we were all looking for parallels from the past. Are there similarities with the burst of the dot.com bubble, in 2001. This is really different here, we said. But there are general lessons, no? And we listed those. 

Then things turned worse, the storm became a crisis. We started to revisit, first the 1997-98 Asian / Russian / Brazilian crisis. "How different was that! This time it is going to, rather than coming from the emerging markets." We lingered around this thought for a couple of days. 

However, as the term 'bleak' started to become an insufficient adjective, we were increasing turning to the previous meltdowns. The lessons from 1992, and then 1988, and even 1981 suddenly looked very relevant. Then, we went even further back in time. The prospect of a worldwide economic contraction coupled with expensive commodities were always a brill cue for plunging into the oil price shocks of the 1970's.

As the previously unthinkable kept happening, the bad news did not stop flowing in, it was no more denial any more. The comparison must be with the 'biggest shock ever'. And thus, Great Depression historians suddenly see their business prospering (one of them even became Obama's top economic advisor). 

But why stop at the 20th century? Why not the 16th century's Spanish gold inflation? Or how about the Greeks, or the Romans? 

A friend of mine, Philip Kay will speak on the financial meltdown in the Republican Rome. This Friday, in Oxford. Rome 88 BC. The abstract of the talk, coming directly from Philip is as follows:

"In 66 B.C. the Roman orator, Cicero, delivered a speech, the De Imperio Cnaei Pompeii, in which he argued that Pompey the Great should be given the military command against Mithradates VI, king of Pontus, a kingdom on the Black Sea coast of modern Turkey. In the speech he reminds his audience of the disasters which befell them 22 years earlier in 88 B.C. when the same Mithradates invaded the Roman province of Asia (situated on the western coast of what is now modern Turkey). According to Cicero, this invasion caused the loss of so much Roman money that credit was destroyed at Rome itself. He says:

'For then, when very many people lost large fortunes in Asia, we know that there was a collapse of credit at Rome, because repayments were interrupted. It is indeed impossible for many individuals in a single state to lose their property and fortunes without involving still greater numbers in their ruin. Defend the Republic from this danger; and believe me when I tell you –what you see for yourselves—that this system of monies (pecuniae), which operates at Rome in the Forum, is bound up in, and is linked with, those Asian monies (pecuniae Asiaticae); the loss of the one inevitably undermines the other and causes its collapse.'

This passage is remarkable in its contemporary tone. Substitute US sub-prime for 'the Asian monies' and the UK banking system for 'the system of monies which operates in the Roman Forum' and it could have been written about the current credit crisis.

I will argue this Friday that, in second century and early first century B.C. Rome, increased inflows of bullion combined with an expansion in the availability of credit to produce a massive growth in Rome's money supply. This increase in the supply and availability of money in turn resulted both in a major increase in Roman economic activity and, eventually, in the credit crisis which Cicero describes."

If you are hooked, here is Philip's exact title and address: 
Philip Kay will speak on: 'Financial Meltdown in Republican Rome'
Time: Friday, 28 November at 5.00 p.m.
Place: The Stelios Ioannou School for Research in Classical and Byzantine Studies
66 St Giles, Oxford OX1 3LU, +44 (0)1865 288391
(Philip Kay is a Supernumerary Fellow of Wolfson College, Oxford)

The Pilot of the Nduga

(A report from Wamena, the capital of the West Papuan highlands.)

I have a new friend. He is Papuan, from the Nduga tribe. He is 22. And he wants to be a pilot.

His name is Samuel.

We met at the Jayapura airport. I had to stand around for hours, and in my boredom, started to circle around the departure lobby. There was a young, very university student looking Papuan guy with a girl, also very student looking, obviously a couple. (On a side note: why is it that people in similar positions look exactly the same around the world? Why is a water engineer dressing into exactly the same clothes in Budapest and in California? Why are bureaucrats in the planning department of the economic ministry look and behave exactly the same in Moscow and Brasilia? The clothes? Ok, maybe there is some common culture. The behaviour? Okay, they have to think about the same things. But the hair?) We smiled at each other, Samuel and I. Then again. Then as I was to pass by them for the third time, he had put his hand out, and announced that his name was Samuel. 

We talked the next hour and half.

He spent his early childhood in a little village in the middle of the Highlands. The challenges implied here are enormous. The Papuan highlands reach five thousand meters, on the equatorial. Translation: extremely difficult terrain, constant torrential rain, you live in tiny little huts, in the middle of a forest full of dangers, the next nearest village is half a day away, no electricity, no water, no roads at all, no telecommunication, no school, no healthcare whatsoever, just you, your family, and a few other families. That’s it. You help grow veggies, and look after the pigs. And play a lot. (It sounds rather pleasant, no?)

And then two events came. First, his dad organised that the village would build an elementary school. Second, and “African-American missionary” came to a neighbouring village, and told my friend, Samuel, that he had used to be a pilot. Samuel always wanted to fly a plane, the only transportation he had seen. There was no way, he could ever do that. But that black missionary told him that you see, here I am, black people can be pilots, too. 

My friend finished elementary school. Then had gone to high school. He had to walk three days to get to his school in the big town. Through the forest. Rain. Danger. Barefooted. Nowhere friendly to sleep. Age ten. Then three days back. Then again.

He finished high school. Had gone to senior high in the provinces capital. Then he got into a pilot school in Jakarta. He finished in May. Looked up on the internet that the best commercial pilot training is in New Zealand. He applied. He got in. Now he is looking for scholarship, and I have no doubt that he will somehow, through the impossible, get it. (Nobody is giving pilot training scholarships, especially for Papuans. But if you happen to sit on one, there is no better place for this money to go to -- I’ve got his email.)

I asked him what the people in his village need. Amazingly, he gave me a ten minute structured talk about priorities. First the landing strip, so that people do not have to walk to get the essentials. Second, healthcare. For little kids keep having diarrhoea, and it takes way too long to get to the town, and some of them die on the way. Third, education. The teacher in the school left, and the school closed. He had his chance, but what about his baby brothers and sisters? Fourth, economic development. People need to get access to the market, and have the technology to use the land and the forest without destroying it. (How many 22 year olds could give a priority list like that at a moments notice?)

He said that if he is going to get a scholarship, he will save enough on it to send his brother to medical school in America, for the second thing that his village needs is a doctor, after a pilot. 

The Papuan Highlands is the last place on Earth which is more or less untouched. Before I came here, I thought I would have trouble discussing global issues with people who share with me a cultural heritage from 45 thousand years ago, and nothing since. I thought the question of integration of global culture and economy would be something I would have to think about based on what I hear from them. Instead they are dictating the solution while I type.

We had one more specific topic. He raised the issue of how much economic development can go against leaving the environment intact. I started to explain that the ecological environment is a system, etc., but he cut into my sentence. “I know it’s a system. And of course, it’s unique. I grew up there. You come to my village, and I show it to you. My tribe will look after it for you.” Well, but who is going to pay price of looking after, then, I asked. He did not even blink: “You are the development economist, you figure it out.”

------

At the end, I asked him about Obama. You have not seen a bigger grin.

So?

(A pre-note on Obama’s victory speech, scribbled down in Kuala Lumpur)
 
A few years ago, well, exactly four, Liz and I were invited to a posh dinner on what happened to be the night after the US elections. The organiser was a good friend, who rushed up to me as we were looking for our seats, looking rather anxious. Tamás - she said - I beg you, please, please, no scandal tonight… As it turned out, we were seated next to an elderly Florida Republican couple, who were full of their recent electoral victory. (They were also partially deaf, which, coupled with the news that they financed the concert the next day, I found - shamefully - very funny. Oh those lovely trills of the violin, the nuanced pianissimo of the flute! Ah!) The reason I bring them up here is that they spent the entire evening banging on and on about how we, non-Americans, had nothing to do with their election, so we should just, plainly, shut up. It was none of our business. Full stop. (They probably said ‘period’.)
 
Oh irony! Now they will have the chance to vote for the First President of the World. (Unlikely as it is that they will use the opportunity...)
 
Over the past 18 months or so I have asked so many emerging market economists around the world about Obama’s chances. Now that he is almost there, it might be interesting to recount the universal answer: “That would be amazing. But there is no way it will happen.” The excitement, together with a hushed-worry, has reached an incredible intensity by now. There is very little debate about the real merits of the policies in question, outside the US. But as much as Obama, and Obama’s chance, have become more than the story of a politician in his home country, he has also become the symbol of the non-wealthy world. Tim Russert in his famous reaction to Obama winning the primaries said that he would love to teach history to inner city kids the next day, a point that could be widened to 90 percent of the world’s schools. The World will be a different place Wednesday morning. Or at least the World will think of itself differently Wednesday morning. Which amounts to much the same thing. 
 
And thus, it is surprising that there is very little analysis these days about the impact of this political opera on the non-US part of the world. Ironically, the US is possibly the most Obama-sceptic place on Earth, even as it elects him to be president. (Bar Iran, of course, if polls of these kind can be trusted at all.)
 
Yet there is an important policy upshot of Obama’s victory. He will be able to push through almost anything, at least at the beginning. First, he is rather likely to have a Congress and a Senate that will (a) do what he wants, and (b) perhaps even be filibuster-proof. Second, much of the rest of the world sees him as its leader. Unlike the way my Floridian table companions saw it four years ago, then, and to a much larger extent now, much of the world really does have a say. Their ‘votes’ are not counted, but the action of choosing is there, and that could give Obama a mandate on the global level. Obama will be able to push through a global agenda if he wants. Third, the hunger for sensible global leadership was palpable during much of Bush’s second term.  Now though, the global economic crisis presents an issue where new leadership could really make a difference. This offers a space into which Obama, the new political leader of the World, as opposed to merely the political leader of the superpower of the World, could move. 
 
The time-window will be very short, though. For someone from whom so much is expected, disappointment on specific policy positions could quickly erode political capital. There is no omnipotency in real life. 
 
This is why I will pay a lot of attention to what Barack Obama, the First President of the World, will say when he makes the very first speech in which he can say something. Tuesday night, American time. 

Off for a while

I am going to be on an lengthy trip for a month now. Blog posts will
be patchy.

Sisyphus’s Next Job

Comedy in Three Acts


Dramatis Personae

Problem, son of Old Habits, in love with Global System

Solution, king of Cheap Talk, a.k.a Good Enough

Trouble, cute little Goodfellow, messing with the World

Governors, presidents, ministers, all kinds of further support. Running around the stage at high velocity, in random directions. Some without head attached.


Act I. Regulation

Scene 1. Financial sector rules
(Problem and Solution stand facing each other. Trouble enters, happy.)

Solution: Increase regulation.

Trouble: Increased regulation within the old regulatory framework would only work if an isolationist approach was adopted at the same time. This would cause major inefficiency in the global economy. It would mean the end of ‘global finance’.

Without isolation of the national financial sectors, systemic risk would ‘flow’ to the weakest regulatory regimes. Overall global risk would not be contained, nor would the impact on the national economies. 

Solution: Globally harmonised financial sector regulation. Agency: OECD (you get harmonised as you enter the rich-club), IMF(emphasis on extending the harmonisation umbrella to emerging markets, as well).

Trouble: Lack of enforcement creates incentive to cheat by national governments: free riding on the global stability while boosting financial sector at home.

Solution: More than harmonisation. Global regulatory body with enforcement capabilities.

Problem: There is no existing mechanism to either create such an authority, or to supervise it.

Scene 2. Dynamic regulation
(A large paper-maché puppet falls from the sky. As it lands, it breaks into three pieces and bursts into fire.)

Problem: The set of rules is only part of the effective regulation that creates the framework that channels financial sector activities. Not only the way the rules are enforced is part of any regulatory regime, but also the active and reactive supervision coming from the government and the central bank. 

Any regulatory rule is fully defined only by the framework of dynamic leverages.

Solution: Harmonise the dynamic regulation, as well.

Trouble: It is impossible to harmonise non-conventional intervention, which is the essence of successful central bank crisis management. Game-changing solutions, by definition, cannot come from the game itself. 

For instance, the Brazilian central bank beat the 1998 attack by using unconventional, previously taboo tactics, such as going against particular hedges of the attackers, and thus forcing them to take an unacceptable level of risk. In essence, they stopped the possibility of leveraging, through unexpected through-market tools.

The non-static, active part of any regulatory regime is directly geared towards monitoring and managing systemic risk. Thus the essence is the immediacy and out-of-the-box solutions.  

Solution: A global rapid-reaction central bank committee facilitating harmonised reaction.

Problem: This would never work unless all monetary policy is co-ordinated on a global level.

Act II. Monetary Policy

Scene 1. Interest rate
(A human sized musical note marches through the stage, singing in whispering voice.)

Problem: The market is unable to recover from a systemic shock.

Solution: Monetary policy intervention by individual central banks. If the markets fall due to capital flight, hike rates a lot. If the market falls due to recession fears, cut rates a lot.

Problem: The algorithm will not work. When everyone is having troubles in a full global contagion, both rapidly changing capital flows and recession are lurking. There is no clear equilibrium in the world-wide rate game. Monetary chaos is certain.

Trouble: Thus national level monetary policy action is ineffective both in managing the global economy directly, and in providing leadership through expectations.

Solution: One-off interest rate move harmonisation would provide ‘leadership’ in crisis.

Trouble: Expectations can only refer to future policy measures by existing institutions. Or, at least, institutions perceived to exist. Therefore, one-off interest rate move harmonisation makes sense only as a harmonised expectations management exercise within the national economy framework. One-off moves, thus, cannot move expectations, unless they contain an implicit promise of future harmonisation of policy.

Problem: Thus, one-off, ad hoc solutions as a rule cannot possibly fill the global policy vacuum.

Solution: Institutionalised interest rate harmonisation among at least the leading central banks. Move all rates at the same time, in a harmonised fashion.

Trouble: A half-point cut has very different effects in different monetary environments. Thus harmonisation of rate moves makes sense only if the interest rates are allowed to be different. Only the timing is harmonised, but the moves are independent (even if ‘discussed’). but in this case, not much has changed. There is still no effective global policy.

Solution: Global universal interest rate set by a body with global statute.

Trouble: There are two issues with a single rate for the entire global economy. First, the global economy’s needs in terms of crisis management are very different from the monetary policy demands in the post-crisis world. Effective crisis management means, as argued above, a strong and credible common action, frozen in, that is a global monetary policy authority that can promise future action credibly. For normal times, however, the universal intervention, whose promise is the key to sorting out the crisis now, is too early for the world economy. The needs of the different parts of the world are wide ranging.

Solution: An institution that covers only part of the global economy. Merging the Fed, BoE, BoJ, and the ECB would not be unthinkable, and would cover around 65% of the world economy. Throw in a couple of others, like the Reserve Bank of Australia, or the Swedish Riskbank etc., and the ratio goes up to 75%. That could be a good start.

Problem: Talk about the institutionalisation of a programmed conflict with China.

Solution: Good point. However, if the crisis becomes deep enough to generate the political will for such harmonised global action, then the establishment of a strong and lasting institution in this fashion is not entirely impossible. Political constraints are agenda-defined. As the agenda changes, so does the strategy space.

Trouble: There is a second major issue with the single global interest rate, though. The currencies.

Scene 2. Exchange rate
(A group of currencies, of mixed age, start trembling in the background. The wind blows.)

Solution: Universal interest rate with flexible exchange rate regimes would work. A global authority, with some straightforward decision-making mechanism, decides about the interest rate level. Exchange rate regimes stay in the current, mostly flexible framework.

Trouble: If capital flows stay largely free, then the presence of a flexible exchange rate would substantially weaken the impact of the interest rate move. The consequence would be a world economy that still had the effective interest rates varying across currency regions. Thus each currency would end up with its own interest rate engineered from futures. This would substantially diminish the ability of any global monetary policy to control the global economy.

Solution: Quasi currency union with universal interest rate.

Trouble: Either the currency levels are regularly administered -- but then what’s the point? It would be the same, but less effective than the market set flexible rate - or currency exchange rates are set in stone, but then…

Solution: ...common global currency, universal interest rate.

Problem: There is no political will anywhere around the world to create either a common monetary authority or a global currency union. This direction is entirely unrealistic. It belongs to Fantasyland. You might as well waste your time writing a blog about it.

Act III. Fiscal Policy

Scene 1. National treasuries competition
(Tropical forest. A number of beautiful plants climb high rapidly, with colourful flowers. All in parasitic relationships with the trees)

Problem: You can’t have monetary policy without some fiscal policy constraints: competing national treasuries would destroy the policy of any global monetary policy authority. Under a common monetary policy umbrella the inflationary impact of any individual governments deficit would be reduced substantially. Consequently the real rates would need to be kept much higher than management of the private sector would require to stave off the overspending impetus of national governments.

Solution: Cover the bad end of the tail: have a shared insurance umbrella for governments in trouble -- this would make crisis management of monetary policy easier.

Trouble: Not exactly incentive-compatible, is it? Anyway, an insurance umbrella would only limit the global damage arising from singular overspending. The bigger trouble is that if the global central bank was to set a policy for growth in normal times, this would translate into an incentive to overspend by all governments. The aggregate effect would be too lax fiscal policy on the global level.

Solution: Limit fiscal policy excesses. Implement a set of straightforward rules to which all government budgets should adhere.

Trouble: There are major difficulties with this. To start with, this is a political impossibility, for budgetary constraints would need outside policing if to be effective. That would require a level of transparency that many national governments will not sign up for under any situation.

Solution: Have a similar limited global core fiscal policy as in the monetary policy case. The countries that are listed in that 75% of the global economy are all democratic, and thus have largely transparent government accounting. Policing the budget rules would not take that much new intrusion into state secrets.

Scene 2. Global treasury
(The forest opens to a beautiful equatorial lake. With slow, almost animated movement, a group of crocodiles slides into the water.)

Trouble: This transparency argument is based on a myth, that the democratic, western governments have transparent budgetary accounting. Just take the example of what happened to Belgium after submitting itself to ECB scrutiny. What we learned was that before the setup of the Eurozone, the numbers that we were shown were mostly cooked. Or take Italy. Or Greece. This would not be an isolated problem of only a few governments. 

By the way, Eurozone. The second trouble with the pre-set fiscal rules is that they might allow overall limitation of fiscal excesses, and thus more or less effective monetary policy, but still impede any dynamic setting of fiscal policy. The Maastricht rules serve as a quasi-minister of finance, but a very rigid one. Thus there is no system-level fiscal policy. National governments find themselves facing an incentive structure to push to the limit of the rules. The management of the economy then becomes ineffective.

Solution: Actively harmonised global fiscal policy. Limits regularly adjusted to global economic climate, some ongoing decision-making mechanism is needed, as opposed to one-off setup at the beginning.

Trouble: This is not global fiscal policy, this is globally constrained national fiscal policy, what happens to global costs and spending? At least the cost of global institutions has to be covered in some way where the organisation is not hostage to the year-to-year budgets of national political processes.

Solution: Global treasury: tax framework, global treasury revenues, global government services.

Problem: There will never be political will for this. Any legitimate setup would need some kind of minimum harmonisation of the political system and thus political values, at least among the leading global regions. No chance.


Epilogue: The Case For Global Economic Authority

Thus is the argument towards the creation of a set of institutions that would generate and implement global economic policy. At the heart is the observation that neither global regulation, nor global monetary policy can be set without efficient, institutionalised decision-making mechanism, and enforcement. Arguably, if this crisis is truly a global crisis, then there will not be a ‘solution’ until a credible global policy framework emerges.

However, there is no political will at the moment to support the rise of such global policy institutions, and anyway they could not be effective without at least some kind of fiscal policy harmonisation, which would require a politically impossible intrusion into each other’s budgetary processes.

Trouble: Wouldn’t this mean that there’d be a global government that would be tempted to intervene in a host of other issues?

Solution: Like global warming, the relationship with the Biosphere, cultural diversity, etc?

Trouble: Yes… And also global government policing… Do we want that? Seriously.

(Exit all. The World wanders in, talking to herself in low voice. After a short while, she exits looking confused)

The Birth Of The New Global Capital?

(Notes from Abu Dhabi and Dubai)
 
I didn’t plan for this. There I was, arguing for an overarching crisis. That a tsunami was coming. That the outer islands had already been hit, and that we could see that enormous wave coming towards the beach. No one was to be spared. Can’t you see, people, it will hit us all? There will be no dry land left. Run for your lives!

The past five weeks looked good for us, Armageddon-types. 

And then suddenly, there it is. A place that could convincingly be the Winner of The Crisis. Two new-born cities on the coast of the Arabian Peninsula. To my utter surprise, I have started to suspect not only that the Twin Cities of the Gulf could survive the meltdown relatively unharmed, but also that they might even gain spectacularly from it. 

First, the obvious: although Dubai has considerable debt, neither rescheduling, nor financing should be a problem, as long as it can find the right words for a difficult conversation with the Older Brother. The rivalry with Abu Dhabi will give way to co-operation, which will display the fact that the two centres are, in reality, on the way to becoming one.

This One City is sitting on an accumulated wealth in the magnitude of the US bail-out package, even if you correct the latter with a ‘reality-multiplier’ (a.k.a. ‘the second bailout package’...). This is coupled with an exceptionally strong development dynamic, cash-financed in large part, and thus unaffected, or at least not directly affected, by the financial meltdown. 

Financial centres that weather the current crisis without a systemic meltdown will see their reputation gain. There is nothing more confidence-building than the history of stability amidst the storm. Imagine ocean liners about to cross the Atlantic, after a gigantic storm. You probably wouldn’t want to take a small boat. Nor the enormous ship that almost sank, even if it has all the luxury in the world. How about that nice, medium sized vessel almost unmoved by the winds, waves, and storm?

Stability will pay off nicely in the post-crisis world.

Second, the coming global regulatory overhaul is very likely to favour a financial centre with pre-existing buzz and relatively large size, but lack of high gearing. Agile and flexible regulatory response teams, could enable Abu Dhabi-Dubai to make the most of the inevitable global clampdown. Special Purpose Vehicles might be out, yet the need for ‘effective solutions’ will be all the same.

The point is that the regulator here does not need to worry about the global systemic effect. The supervisor needs to be seen to sign up for the to-be-emerging global regulatory protocols, make sure that the local system does not melt down, and then offer the maximum flexibility. The rising global New Rule Book will probably take a multi-tiered form, leaving ample room for local manoeuvring. Both the history and the attitude of the emerging ‘United Emirati Centre of Global Finance’ suggests that the appetite will be there to go in this direction. 

Third, the talent flow will be staggering. The meltdown of the other economic centres of the world will result in a lot of well educated and experienced professionals finding themselves on the street. They might as well find their way to this sunny oasis of opportunity. The human capital shortage in the Gulf may well be a thing of the past. 

As a partnership, then, Abu Dhabi-Dubai could emerge as a winner. If on the other hand the cities prefer to go it alone though, one has a far greater chance of success than the other. Despite the mass denial among Dubai entrepreneurs, the global crisis would be certain to hit them, big time. Credit crunch is already there. There are doubts that Dubai alone has enough to back its banking sector. Abu Dhabi does. The collapse of tourism will hit Dubai badly. Abu Dhabi, being at the early phase of the sector’s development will hardly feel a mosquito bite. The inevitable fall of global transportation will hit the Dubai port. Abu Dhabi, again, will stay mostly unaffected. The ill-conceived manufacturing projects will inexorably be weeded out. The Dubai audacity of unfeasible electronics production will be trumped by the sensible oil-industry support manufacturing projects of Abu Dhabi. It is very unlikely that this advantage will not be turned into hard positions. As the FT pointed out yesterday, it is going to be a tough conversation.

Yet, the potential is there. The Twin Cities of the Gulf might take a new role, this time as the capital of the post-16-September World. Or at least one of them.

Me And My Friend, Alex

“With knots, the best is to use a hatchet,” - he used to say. “Just as it is coming towards you, large and complicated. Dark, and sometimes frightening.” Yes, it happened even to him. Only occasionally, though. “Just cut it right through. That’s all you can do. But, that will take any of them down.”

He was good at knots.

What the world’s governments are doing is using Lilliputian scissors on the knot of the world’s new Gordium. And they can’t even decide which side to start. They may eventually get there, and cut through the systemic entanglement of global finance, but it will cost time and rivers of sweat.

Or in other words: capital markets and banking activities have come to a halt anyway. The bit that is left is mostly desperate attempts of finding cover. There is zero ‘normal’ activity left in the financial sector of the countries that the contagion has already reached. All the rest spend their entire time jittering.

Instead...

Suspend all activities. Stop the knot knotting. [sorry]

Then comes the hatchet. Unwind all positions. Take your time. Clear positions. Clear multiple accounts. Clear entities. We should each have one figure at the end.

You will say that this will require a price for each position, which is impossible. Well, yes and no. It will be impossible to do it fairly, but it is too late for that anyway.

You will say that the ‘hatchet technique’ will not work for the derivatives. Yes, it will not be perfect. But is there a viable alternative?

And meanwhile in the other room…

Design the new, post-knot regulatory system. Try to be a bit more sensible than before. Maybe look at the tried-solutions of some other countries. To give you a hint, I would start with the places that are rich, and highly banked, that have sophisticated capital markets, and so on, but at the same time are NOT in trouble. If the intersection of their regulatory rules has elements, there you are, you have got a starting point. (You might even be surprised about how non-empty that set is going to be.)

Then everyone can take their post-hatcheting figures, and start the game again. With the proviso that the number is strictly positive. As for those with a red number next to their names, this is the time for government led social solidarity to provide that proverbial net.

We are going this way, anyway. The wave of bail-outs allow the financial sector to unwind itself, arguably making more mess, while the prices are as artificial as ever. The new rules will come in, but will be affected by the ad hoc, spur of the moment, immediate urgencies rather than the long term rationales behind the would-be perfect new regulation. At the same time, the non-transparent clearing will make any social protection very costly, and likely to be perceived as unjust.

When dealing with knots, the Greek pros cannot be beaten.

The Song of the Earth

Mahler 1908. The triumph of the individual becoming one with the Earth. Death is merely part of the cycle of Life. One’s Life. Any particular one’s life, and the lives of all of us, individual ones. The highest point reached by human civilisation. The world was becoming interconnected and global, savouring the fruits of rapid economic growth after decades of innovation. New technologies created exciting new ways of life, while art and music thrived on the waves of ideas and thought coming from the other side of the Globe. The “World drunk with eternal love and life” was in sight.

Mahler did not turn out to be an accurate oracle: the highest point happened to be a peak. The Short Century was to be about something other than the love affair between the individual and the Earth. And in it “the earth breathing full of peace and sleep” was a mere dream amidst the terror.

The Century passed. The history of listening to The Song of the Earth through the era of upheaval, the social oppression of the individual, and World’s unhappiness create a backdrop in which the height can now be envisaged as a peak, and we know that the future is not necessarily a straight path from the past.

The horrors of the wars and dictators of the 20th century could, perhaps, have been avoided with foresight. Probably not. Wisdom and leadership need a history of failures. They had no Globe to look back on, the History of the World had been merely a collection of national narratives. For us, it is very different.

Unlike our peers 100 years ago, we can conceive the precipice. And we have the association base that the abstract ‘hope’ needs to manifest in action.

We have the Earth now. Our dreams are still the same. The Song of the Earth may turn out to be prophetic. This time.

“Everywhere and forever the distance shines in bright and blue.”


(Notes from 1 October, Budapest Festival Orchestra playing Mahler’s Das Lied von der Erde, SBC, London, with the super-human voice of Christianne Stotijn, conducted by the genius, Ivan Fischer. )

The Tiger

My Dear Friends, People of Denial. You amaze me.

Don’t you ever wonder why your Explanations and Explications, your Wisdom of Experience, your Expert Authority are so cheap, useless, and empty? These days.

Do you ever suspect that the world financial meltdown might reflect something more than ‘greedy CEO’ contracts encouraging “risk-taking culture”? (Wasn’t ‘greed’ meant to go with being a corporate leader, anyway? Isn’t risk-taking culture the essence of a sophisticated financial sector? Isn’t every word about CEO compensations pure populism?)

Do you really think that the financial engineering of super-highly leveraged derivatives could bring down the entire global economy even if it were under-regulated? Wouldn’t existing policy tools be able to deal with the intermingled mess if something else was not looming in there? (Something large, dark, and unknown...) Wouldn’t you need something more to explain why the over-packaged non-transparent risk bundles have not been sorted out in the last 18 months, since we have known for sure that they are around?

Isn’t it that our assessment of ‘risk’ comes from a particular framework? Notably the same one where Your Infinite Wisdom originates? Isn’t it that pricing risk essentially relies on a particular understanding of the entire system? Isn’t the problem really with our current definition of ‘the entire system’?

Aren’t all of these excuses really denials about the need to go and discover that large, dark, unknown Something?.

Could it be that our perception of what the ‘system’ is, and what we imagine about the ‘way-it-works’ are wrong. In other words. That we have been modelling a different ‘economy’ to the one that is really out there, and we have been mistaken about how it moves, reacts, behaves? If so, we would be screwed, wouldn’t we? We would have incorrect ideas about what the risks really were, and we would price them incorrectly. And when the inevitable troubles came, it would be impossible to pick an effective instrument to sort them out.

Huge piles of incorrectly priced risk bundles and inadequate policy tools? That’s what that would mean.

We are screwed.

It is as if we were vets, and an animal was brought in, in urgency. We rush it to the operating theatre, and get down to saving it. Only gradually occurs to us that we have got the species wrong. “Professor, shall we opt for the sedatives after all? I am not sure if bunnies should have teeth of this size.”

Expectations Bail-Out

What is a bail-out?

It’s just a promise.

A government bail-out of a private company is a promise to provide assistance such that some socially important function of the company can survive without discontinuity. The most often used form is short-term liquidity provision during bankruptcy. However, the ‘assistance’ could be provided in many other forms than mere cash (e.g., procurement orders). You, as the government, do this so that some vitally important products or services are not disrupted, or so that the reallocation of a large part of the labour force does not burden the social security system, etc. Typically, it is a systemic function provided by the private sector that you want to save.

The point here is that the bail-out is usually not immediate. It is a promise for future action. It is the promise itself that provides the stability. Frequently, the delivery is not needed or is not regarded as important when it actually takes place.

When a government offers a large pile of future cash, as in the case of the embattled Paulson Plan now, what is really promised is not the same as the number cited. It is only a “huge number”. It is managing expectations: it serves as a guarantee that the government will provide all the cash necessary to reduce the disruption to an acceptable level.

And this is the problem here.

The power to make such a promise can come from three sources.

First, the government may sit on enough cash to deliver. This is by far not the case now. None of the Western governments have much cash, especially compared to the size of their financial sectors (although there are small exceptions, like Norway). If they had, the power behind the bailout promise would come from their ability to cover the entire system. When the government offers cash on hand, it is essentially playing on expectations based on unrealistic assumptions about the ability of governments. Playing on omnipotence can get you only so far.

Second, the governments can promise future tax revenues, say by announcing that the money needed for the bailout would be borrowed first, and then the repayment needed would be raised from the tax base. However, the indebtedness of most western governments is substantial. That of the US is so large that it would not be able to get membership in the Eurozone. Thus raising the kind of money needed to fully back the financial sector would be impossible. Furthermore, what would be the source of new loans in a global financial crisis? From whom would you get that kind of money?

Finally, and most importantly, a future tax-revenue-based bail out in the magnitude of the annual GDP is unrealistic, to be euphemistic. (One year of US GDP could cover only around one-fourth of the US financial sector, and then the global linkages have not come in yet). You cannot promise to save the entire economy from collapse by promising money that you will collect in the future from the same entity. Thus the implicit promise of a full government guarantee, plays on the assumption that only a partial guarantee will really be needed.

Which leads to the third source of power:

The power of the bail-out promise could come from the government’s singular ability to change the rules. This reads something like this: “I do not have enough money to buy you out. And I cannot possibly promise to raise enough money from you in the future to buy you out now. But I could promise to change the rules under which you operate. Then I could claim that you will be in better condition in the future. If you do believe this then, arguably, you will be in a better condition. Then I can promise to raise taxes from the healthy-you in the future, and thus I can even promise to back you up with money now…”

This argument is entirely based on the assumption that there is a way to change the rules such that the current chaos is sorted out, and not repeated in the future. Hence all the sudden talk of socialism. That would change the rules, that is for sure. Some people might even believe in it. But you would need a mass change in the way western societies view themselves for such an expectations-bail out to work.

Thus...

All of these expectations are based on a framework of thinking which is rapidly going out of date. Since 16 September we have been re-evaluating what is possible.

Which brings us to the ultimate question: can the US government, or any government, credibly promise to deliver systemic solutions now? Doesn’t this crisis, which is still in its early days, reveal that there is a need to replace the national level economy-management toolbox with global policy institutions? Could any local solution be a remedy even for the short term?

Europe’s New Golden Age? Fat Chance!

Europe could become the centre of the world, simply by not screwing up. Europe is big and loves government. But it will miss its chance for want of revolution.
 
When in globalisation, huge and mature is the best. The size of the European economy relative to that of the world makes it the largest economy on Earth that is both mature and integrated. The consequence: Europe possesses internal demand that could bridge over a global recession. 
 
Some emerging market people talk about China or Brazil being able to do the same. But this is a dream. Neither of these countries has made sufficient progress in economic transition to achieve a structure that could produce the necessary demand dynamics. As we have seen in numerous emerging markets before, hopes for a long-lasting domestic dynamo vanish shortly after the export impetus dries up. When things looked good, it was not that external demand had truly diminished in importance, it merely looked that way. Furthermore, despite the impressive expansion so far, neither of these countries is big enough to withstand a crisis. China is the size of Germany.  Brazil is the size of Canada. In comparison: the EU is larger than the US, Canada and Mexico put together. 
 
Furthermore, Europe’s potential to integrate its neighbourhood is much stronger than is the case for other regions. The number of people on the labour market with at least secondary-level education in Europe and its neighbourhood is more than double that in North America, for instance. At the same time, regional integration on a level even remotely similar to that in Europe is out of the question for decades in East or South Asia for obvious political reasons. Witness the ASEAN’s hopeless efforts at policy harmonisation. 
 
So Europe could be the dominant global region. If only there was a policy-making body to ensure that...
 
You must love your government. The European approach to governance makes it well-placed to withstand a global economic storm. Now is the time when it should perform at its best. 
 
Although, there are quite a few versions of the ‘European model’, the main theme is always the same, based on the notion of collective responsibility among independent individuals. 
 
The pure version is the semi-socialism of Scandinavia. The four North-West European countries have the largest presence of the state in the private economy of any other country group north of the 10,000-dollar annual income per capita mark. (Their tax revenue share of GDP is a staggering 47% as opposed to the rest of Europe’s 36% and the non-European OECD countries’ 29%.) But, crucially, their large state works: in the ‘institutions’ bit of the World Competitiveness Index, the four Scandinavian countries occupy four of the top eight slots. Markets and socialism clearly can form a good team. 
 
The rest of Europe acts out a series of variations on the pure case: lingua-etatist France, inflexible but strong Germany, the would-be socialist Mediterranean, the dreaming-of-being-different Britain, and the large-state-rampant-corruption new kids in Central and Eastern Europe. Still, even the UK, which sees itself as closest to the US model, will at one point have to come to terms with the reality of having strong state involvement. (Just as a passing example: the nationalisation of Northern Rock was swallowed much more easily than the US’s Fannie Mae and Freddie Mac a couple of months later. The temporary outrage subsided in seconds on the etatist-side of the Atlantic.)
 
European economic history is evidence that strong government - if done badly - may translate into non-performing economies. But if done well, it can create a framework in which the private economy thrives. Moreover, and critically for the current crisis, it can provide buffers against external shocks. It is, you could argue, to the latter form that Europe’s economic management needs to converge. And - there it is, or would be - the world’s new economic leader born.
 
Or maybe not...
 
A sclerotic pensioner with the identity problems of a teenager. A couple of years ago I was invited to moderate a roundtable discussion on the ‘European social model’. I wouldn’t have subjected myself to the pains of discovering the meaning of this concept, had the conference not taken place in one of the most beautiful Mediterranean villages, in Turkey. (I would have brushed up on the Inquisition for that…)
 
So when my friends called to say they needed a last-minute replacement chair, I signed up right away, although I did not know anything about the topic. (Shameless, I know.) I spent the following two weeks learning about the origin of the concept of the ‘European social model’. What I found was complete intellectual chaos. There is no common element - zero overlap in the 15 or so different definitions that are in use. The term does little more than fill the vacuum left by the absence of real common identity. It is empty. 
 
The elites that created the EU, an otherwise sensible project, failed to design a way to react to a crisis like this. There is no EU-level institution that could deliver the kind of governance that would make the European economy live up to its global potential. The current EU is a decrepit, ineffective and largely illegitimate body, more like a labour-union committee than a source of global leadership or cutting-edge governance. 
 
As we learned in the Central European transition countries, it is much easier to build brand new institutions than reform the old ones. The temptation is to ‘mend’ the system rather than truly reform it. Re-form it. ‘Mending’ means more regulation on top of the overbearing current regime, it means larger state French-style rather than re-thinking the content of governance Scandinavian-style. 
 
The institutional scleroticism of the unfinished EU calls for complete overhaul. But, for that, we would need a way to decide what ‘Europe’ is. In a legitimate way, in the form of Demos Kratia.
 
Funny how the European society, arguably the origin of globalisation, manages to react to the global challenges with the worst combination of age and youth.  It is as sclerotic as an elderly pensioner, but with the identity problems of a teenager.  Wisdom and dynamism would be a much more promising combination.

The quiet contagion

The World’s complacency is deafening.

The ‘explanations’ coming in from around the Globe take a surprising range of forms. All kinds of factors, all kinds of reasons, why that one country, that one region, or even that one city will be spared by this crisis. The denial is the only common element.

For instance...

No, China is fiiiinnnne. More of a problem is the domestic slow-down, if anything, really. But you know what, we’ve been worried about overheating so long. A bit of slow-down is great.

Or: Australia has an excellent banking regulatory system, unlike the US. This is not going to hit us here. We are not worried.

Or: Ah, Japan is a different case. The Americans’ crisis is more of a buying opportunity.

Or: Hey, the Brazilian economy is taking off. The momentum is domestic. Maybe the export markets will get rattled a bit, but there won’t be much lasting effect.

The first thing you learn in the emerging markets business is to suspect arguments about exceptionalism. If everyone is making such arguments amidst a global crisis, that should sound alarms.

My forecast is that there will be a slow, quiet contagion. For a while the (primarily US) policy alternatives will dominate the agenda. A lull of complacency will come in. We will hear a lot about the situation-being-not-so-bad.

However…

Can you assume that this crisis is not going to impact consumer confidence in every place on Earth with a TV? If you are to decide to buy a new car now or delay, what would you do? How about real investment? Would you jump into a new venture at this moment? Or, would you finance one? If you were a retailer, what inventory strategy would you go for? Would you pile up as much as possible, leaving orders for more, or rather risk running out of the current stock first and see how people react to the new realities?

At one point, the hit to the real economy will become undeniable, and the global macroeconomic elite’s hope-bubble will burst.

This might be a good point to recall that the first life-boats to leave the Titanic were two-thirds empty, for lack of interest…

A week-old blog

What do you think?

It was the second day of the crisis when I started this blog. A week ago. It now has six postings, somewhat varying in style and depth. It would be rather useful for me if you gave me feed-back. Its direction, the topics, everything. Please.

Newtonian gamble

It is 1947. The Cold War is starting. A group of defence strategists get together to figure out how to best tackle it. They start with the analysis of the world war finished only two years earlier. They focus on details, where, of course, the devil lives. Weapons, or in general ‘military technology’ is all based on Newtonian mechanics. That is, the weapons that count. Or rather, the weapons that have counted so far. The world war was fought and won with arms from the pre-Einstein age. The two nuclear bombs, used at the very end, did not have much military effect. 



How large a mistake that would have been. To form the defence strategy of the 1950’s ignoring the reality of weapons based on quantum mechanics.



This is the recurring thought I have had reading the end-of-week press digesting last week’s ‘turbulent events’. Certainly, some regulatory armoury proposed in-line with the old thinking might still be appropriate. (Just as Newtonian mechanics does not contradict relativity theory, but is merely a sub-case -- and anyway you can use it to efficiently calculate the trajectory of the defence rockets that are to take down the incoming nuclear warhead-carrying missiles.) Most other ‘Newtonian ideas’ miss the point. For instance, it makes no sense to call for the regulation of executive pay. Do the politicians and their economic advisors (surprisingly from both ends of the political spectrum) really think that the current global meltdown is due to the contract structures of CEO’s? Even if they did encourage a risk-taking attitude?



At the start of last week, it looked as if the coming days were to bring the worst that could come, but would also lead to an entirely new world: the rise and definition of a global-economy-management institutional framework. It has happened to some extent. The US treasury secretary (who overnight has become the fiscal policy opinion leader of the world) is calling for semi-harmonised global treasury action, but with operations staying strictly on the national level. However, the big opportunity to change the intellectual framework and to look ahead has been largely missed. 



Apart from some calls for new thinking in the tsunami of analyses, there is not much that is filtering through. The particular actions, although they look brave (or brash), are products of the old framework. And, mostly, they are attacked or supported with the narrative of the past. 



Furthermore, the actions focus solely on the problems that have surfaced so far. The benevolent observer could argue that by saving the US financial system, global financial contagion can be stopped. Even if it comes at an exorbitant cost to be paid in the future in terms of cash, as well as the mess the uncertainty about ‘rules’ will make. If the world financial system is saved, the argument may go, the real economy impact will be small, while global contagion will be halted. 



People with a more diabolical approach to life would suggest that the wished-for buffering of sectoral and global contagion relies even more on containing the collapse in appetite for risk than on a direct cash injection. The sigh released by the markets at the end of last week is based on the axiom that the government, in particular the US government, is a risk-free institution. But isn’t what happened that the systemic risk coming from the potential collapse of several large actors in the economy has been reduced by shifting the risk onto the level of the entire system? Making the assumption that the system - the framework in which the individual actors operate - is unquestionably stable is an intellectual cheat.



Just as the Cold War turned out to be about perceptions of the two sides’ nuclear abilities, it seems that the perceptions of the global economic framework might turn out to be as important as the national-level regulatory weaponry. It is time to move beyond the era of Newtonian regulations if we are ever to reach the global economics theory of relativity.

Hugging China

Here is a question to you. If you were a geopolitical strategist working for the Chinese government, what would you be thinking about the global banking crisis?

First, your country’s exposure in US capital markets has just been dealt a substantial blow. Clearly, pulling out now is not an option, the drag on the market would be insufferable. (However, the US government bailout implies a free ride for you, as well.) 

Second, your speech writing tasks just got easier. Just as the rules have gone, so has any possibility of credible American lectures. Pretence international selflessness gives way to blatant national selfishness. At least one aspect of economic diplomacy just got easier.

Third, your global strategy space has widened considerably. There is a ripple across the meagre international policy architecture. The depth of this ripple as well as the lightning speed with which it has opened up, creates an appetite for designing global institutions. The previous status quo that so many newly emerged economies, first of all China, had outgrown is now in question across the board. It is the perfect time to push through your own reform agenda. 

Furthermore, the relative positions could not be more favourable for you. Your domestic economy has little direct exposure now, even though the long term Chinese buffers are probably substantially overestimated. (We will learn a lot about the internal dynamics of the Chinese economy the next months.) What might be more important is that your new allies, developing countries with inefficient economies but a lot of natural resources, will be hard hit, and would welcome a ‘global insurance pool’, otherwise known as a short term umbrella in exchange for access to assets. 

A combination of these would create a formidable Chinese negotiating position. If China were in alliance with many developing former Western-affiliated countries (Indonesia, and many states in Sub-Saharan Africa come to mind), it will have the flow of raw materials insured. The financial blow to the Chinese state assets will not have a direct impact in all, but the full-meltdown scenarios. The domestic real economy will be on a dynamo for a while, even if a slowing one. And any basis for western arguments against China’s ‘influence’ on its currency has just been blown up.

In short, China will feel little impetus towards playing a constructive role in building up the new global institutions the West will suddenly be so enthusiastic about. Maybe this is the moment to throw open arms, and give China a big, warm hug.

The Cacophony

The closer you are the more worried you are.

The analysing is almost as frantic as the markets, but there is clearly no agreement even about the basics. Neither on causes, nor on consequences.

The regulation-optimists. A.k.a. the ‘ultimate-denial-people’. The more political function you have, the more likely you are to be here.

The regulation-optimists see the current crisis as primarily caused by lack of adequate regulation. Thus, the solution is to have more of it. As if ‘regulation’ was a type of custard of which you pour more if you want. There is little consensus in the substantive discussion about the details of what is being proposed. The only recurring theme is that it should have been less easy to lend. Really? So all the financial innovations that would allow structuring risk should be out of the window? Is the argument really against sophistication? Oh, no, comes the answer, it should have been less easy to lend to risky people. I see, so your argument is like reacting to a mass highway accident by turning rusty old cars into horse-drawn carriages, while keeping all the Ferraris.

The ‘this will pass’ semi-optimists. The more academic your are, the more likely your argument goes in this direction.

The study of economic history provides a comfortable backdrop against which what is happening now is not necessarily that unique. You are probably using the phrase “yes, that is correct, but history would suggest that…”. And, of course, you can also point to the - historical - fact that market people and politicians always overreact in times of crisis, always ignoring the lessons of the past. It is very difficult to argue against you, for (a) the facts of the past are on your side, and (b) people did try to claim at every crisis in history that their one was special.

The return-to-decoupling semi-pessimists. If you have a strong exposure in China or the Gulf, the idea probably has already crossed you mind. (Russia, with perfect timing, ruled itself out of the oh-no-we-are-immune club.)

The concept of decoupling, very badly defined most of the way, was rather fashionable up until around a year ago. It started with the revival of the ‘global regions’ notion, and ended up using macroeconomic variable clustering. After the fifteen-weeks of fame, however, the idea-bubble had burst, being pointed out that intra-regional trade patterns in East Asia were just catching up to the global level of integration, and macroeconomic convergence is actually the opposite of decoupling. Now, the idea is coming back again. Although the arguments tend to be mostly emotional (“please, please, let something stay safe, I will be good, I promise”), at least we will have the ultimate test of the hypothesis.

The armageddon type. The closer you are to action, on the markets, or in media, or in policy, the more likely you are to be in this category. Disturbingly, that is true within the armageddon group itself: the most worried people are the ones who really see what is happening.

Soldiers tell you that people who get hit by a bullet will most often go into a state of disbelief. Although you have seen this happen to others, you just do not believe that it is happening to YOU. This denial seems to be the only general characteristic of the reactions now. People seem to ‘get’ what happened so far, but the improbable nature of these events make forecasting the consequences emotionally difficult. However, those who are closely involved with sorting out the crisis, and in that are making up new rules, and trying to invent new policy tools, have no choice but to come to terms with the depth and width of the trouble. They are talking about actual banks that will come next, rather than the generalities of financial contagion. They are discussing the collapse of actual countries rather than pondering if the ‘world economy could turn into recession’. Very worrying.

To sum up, imagine that you are rushed to the hospital, you don’t feel well, and a bunch of doctors come up to you. The first one says, oh, no problem, a bit too much running around with wet hair, perhaps; we will sort you out now, and then you just have to make sure you put a hat on from now on. The second one ponders that, well, you do have a nasty flu, but in the past you survived all of them, no? Nothing to be worried about. The third one announces that although, for some odd sounding reason, they will have to chop a leg and and arm off, the good news is that you will have two limbs left. And then comes the fourth, who turns out to be a specialist on your rare virus, examines you thoroughly, and then she comments on how interesting tomorrow’s dissection will be.

Rules versus discretion…

This is the end of market capitalism as we know it. 
 
Imagine this, someone asks you a week ago, to assign a probability to the Fed taking 80% share of AIG and thus the most important central bank of the world effectively nationalising the largest insurance company. Would you have just laughed? Or would you have bothered to actually say less than 1%? Or would you have got bogged down in giving a lecture on the main principles of economics, and explained - probably slowly - the idea behind rules versus discretion? 
 
Clearly, somebody got very scared yesterday. They did halt the immediate meltdown with one bold move. But they also considerably upped the stakes.
 
Short term worry one. Large. This move implies the promise of nationalisation of the entire US economy in a meltdown scenario. Not only participation in the risk pool is not voluntary any more, but the state now chops off the end of the distribution. Although a systemic collapse has been averted, at least for the time being, uncertainty about the framework in which the risks are being priced has increased considerably. Not only are we on a sailing boat out at sea in the middle of a big storm, but at the same time, someone is shaking the entire Earth. A whole new meaning to ‘choppy waters’. 
 
Short term worry two. Very large. This week we have seen the unthinkable. So, here is an ‘unaskable’ question: is the Fed large enough to deliver the implicit guarantee it made? What happens if the gamble of nationalising AIG does not pay off? There are a lot of signs, and even more rumours, about a host of other ‘immediate’ collapses. How much can the Fed and the US government pretend to be merely a clearing house and bankruptcy manager before the markets start discussing the limit to which the Fed can, rather than wants, to go? What would that do to risk perceptions? 
 
Long term worry. Gigantic. Rules are out of the window. In fact the concept of ‘rules’ is out of the window. Ad hoc solutions may be necessary in an emergency, but they nevertheless form expectations and change the perceived rulebook. How high can a pyramid of impulse actions be built before it collapses? This may seem a secondary worry now, given that the world has not yet sunk into abyss by mid-week, an achievement in itself, but will form very hard constraints in building up the post-crisis institutions. 
 
Global worry. Unknown magnitude. How much implicit global risk has the Fed taken on? Where is the legitimacy and mandate for that? What will the ultimate backers, the US taxpayers say about it? How adequate will the Fed’s implicit global economic management be for the rest of the world, either country by country, or - more importantly, for the entire global economy? There are strong arguments that what is unfolding now is the first truly global crisis. It’s not very likely that the unilateral approach from the US would be more successful in dealing with, say, global security issues. 
 
The last few days have changed the way we think about market economies. Systemic mispricing of risks, and thus collapsing financial institutions, could themselves be attributed to the globalisation of the effective economic systems in which these risks occur. We thought that new, global models would solve the problem. Now, the very foundations of the discipline of economics are being altered. Up until the rise of ‘unified macroeconomics’ the debate was between the proponents of a large state and those of a small one. In the past two decades this has given way to a new narrative, about what the state does irrespective of its actual size. Governance, institutional competition, and quality of government services are what mattered. This was, in a way, a downgrading of the state. You are not sovereign any more. You have to be smart. You have to compete for people and capital. What the Fed has done, the most unlikely institution to do so, has put the role of the state at centre-stage again. 

Narratives

It is very interesting to see how the narrative about the current crisis, which in my view is clearly a global one, stays on the national level. This is true for the policy makers, the media, as well as the investment banking chatter. Part of the reason is that the institutions that could do something about it are on the national level, such as central banks, treasuries, as well as regulatory bodies. However, that is perhaps the problem: current regulation, monetary and most of the fiscal policies operate on the national level. And not only the legitimacy and the mandate come from local rather than global entities, but the intellectual focus, the data, and the models stay there too.

As a consequence, we tend to overemphasize the national at the expense of learning about the global. While things were looking bright, prices tended to go up, and risk aversion was at historical lows, this did not matter. It was only a few scarecrows scratching their heads. Now, amidst the crisis, this limitation might impede effective intervention.

It seems that although there is a general recognition about ‘new economy’ and ‘globalisation’, the economics profession, as one, comes to terms with the new reality with a considerable lag. Thus, we keep discussing localised effects, either in geographic or in sectoral sense, rather than getting down to dealing with it on the global level. In the old times, when, say, a national economy recession took place, the economics profession did not have separate solutions for only part of the country, or a few sectors. The entire economic system was modeled, with the sub-national regional or sectoral dynamics making the analysis more refined, but only as part of the overall model or policy.

Now, it's as if we only focused on parts of the global economy, trying to figure out the dynamics of only that part, while ignoring the rest. If the global economy really is a system, this is not very likely to work.