Promises, promises...

Paragraphs to ponder, from Karl Smith. Although I've had this point explained to me many times, it never hurts to reflect upon how interconnected and, ultimately, fragile our socio-economic structure really is: 

"All things financial are ultimately promises.

Promises, however, matter. Ultimately they matter because promises are how we coordinate people to make stuff that is bigger and better than any one person could make alone. If we couldn’t make promises to each other we could never build factories, homes, cars, etc. In truth specialization would all but collapse and the modern economy would cease to function.

Many economists like to pretend that the economy functions on the basis of trade. The baker makes bread and trades with brewer who makes beer. But, this isn’t how the real world works is it? The real world is full of promises.

When the baker wants beer he give the brewer a promise. When brewer wants bread he gives the baker a promise. If they don’t trust each other very much they trade in government promises, that’s called legal tender or money. When they trust each other a lot they trade in private promises, that’s called credit.

I have occasionally received gifts in appreciation for my lectures but mostly I receive a big chunk of promises at the end of every month. I use those promises to meet other promises that I have made. And, with the promises I have left over I can get other things that I might want for the month. I keep some of my promises stored away, as a promise to myself.

In the old days when even trust in the government was low promises took the form of metal. For most people the metal had little value but they knew someone else might want it so it was good enough. Today, trust is high. Our legal system is strong and most promises are just bits in a computer system, a little electronic maker that says society promises resources to John Doe. Promises are the foundation of our economy.  That’s why when promises go bad, as they did in the sub-prime crisis, the whole economy goes bad. That’s why some of [us] think the government needs to make some new promises. We are running short."

The Autumn of our Discontent

Adam Posen, of the Bank of England's external monetary policy committee, is now convinced that the Bank needs to act fast to avoid a prolonged period of Japanese-style economic stagnation. He argues that the accumulating evidence suggests that the downside risk to doing nothing far outweighs the risks of inflation.

When the overwhelming bulk of pressures in the economy are disinflationary, and when the level of output and employment is clearly likely to be below potential for an extended period, it is right for central bankers to take the additional negative effects of protracted recession on trend productivity growth and on capacity into account.

Is Posen right? I haven't a clue. But he does raise one point which I think is worth noting: there's more at stake here than simply a bit of lost productivity growth and economic capacity:

Let us not forget that it was sustained high unemployment and austerity, the sense that governments were unresponsive to average people’s dire economic conditions, which led to the rise of extremist intolerant parties in pre-war Europe

I've used this historical reference a number of times, but it is an admittedly extreme example. Posen is right to use the language of "let us not forget" as this is merely a reminder - not a prediction of what is to come. Nevertheless, the point is well taken. Last year, Rory wrote a great piece on the brewing summer of discontent: the seething popular anger in the aftermath of the financial crisis and the demand to do something. 

Thankfully, some of the worst predictions have not come to pass. But the danger has not disappeared; a casual scan of the recent news reveals as much. The US has its own backlash in the form of the surging Tea Party movement. The British Labour Party just recently elected Ed Milliband as their leader, indicating a sharp tack to the left. In both cases, these shifts are likely to be politically counter-productive. But in both cases, I read this as a giant "Fuck You" to the ruling consensus that has dominated Anlgo-American policymaking since the late 1990s. 

Granted, prolonged recessions do not necessarily result in deep social unrest. From my (limited) knowlege of Japan, it does not appear that over a decade of economic stagnation has resulted in major upheavals in society. I suspect that this has much to do with the structure and characteristics of Japanese society, however. And it should be pretty clear by now that Europe is definitely not Japan.

To borrow the text from Rory's post last year:

"This poses obvious risks to political stability and commerce. It also constrains the options available to policymakers, making beggar-thy-neighbor actions such as the imposition of trade barriers, subsidization or nationalization of industries and currency devaluation more likely. History tells us that these domestic political considerations, particularly in the developing world, risk reinforcing the downward economic spiral, as policymakers appease factions and fail to reach coordinated regional/global programs. They also risk, particularly in the case of currency devaluations, setting off a [chain] reaction of competitive responses that, in the absence of regional cooperation, ultimately destabilizes the system as a whole."

So it's clear that while inaction is not an option, the kind of response that the political leadership provide matters even more. The G20 proved to be surprisingly successful in coordinating a strong response to the crisis itself, but that level of cooperation is starting to fade in the aftermath as leaders re-focus domestic priorities. The recent signs of a looming "currency war" are a worrisome case in point. 

What we may be facing, then, is a prolonged period of discontent. The only solution is to avoid political posturing and short-termism and take the necessary steps to restore healthy economic growth. These steps may end up being painful or risky but, as Posen rightly points out, the downside risk to doing nothing at all is far too high.    

(photo: Reuters)

Readables

Interesting, if superficial, profile of Paul Krugman's recent economic writings. Provides yet more confirmation for why I rarely bother to read them.

Soooo, does this mean Republicans oppose lending to small businesses? Politics: what fun!

Why football (soccer) is a bad business: irrational capital. Proposed solution: ownership by fans.

The voodoo economics of the TV/movie business

Yet more evidence of China moving up the value chain: a collaboration with Japanese companies in computer microchip production.

How to help people in developing countries and make a wicked profit while you're at it.

Intermission

Posting has been light of the last week or so as I make adjustments for a recent change in my career path. As a result, most of my recent post ideas are currently stuck in draft format - a variety of scattered thoughts lacking coherent direction. (Although really, what else is new?)

Things should return to business-as-usual in the next week or so. In the meantime, feel free to submit any ideas you have for topics you would like to see discussed.

Sentence of the Day

From The Economist:

"....Indeed, the problem with the tax debate is not that Democrats and Republicans disagree, but that they mostly agree. Democrats think 98% of Americans should not pay higher taxes; the Republicans say 100% should not."

Readables

From the previous week:

The biggest problem with Basle III

A conversation with Richard Dawkins and Sir David Attenborough

A conversation with Lee Kuan Yew, prime minister of Singapore for 25 years after its founding, reflecting on old age and the risk that Singapore's success will be taken for granted.

Globalization at work: Chinese factories that are moving up the value-added chain to stay competitive.

Are emerging market bondholders ignoring history?

Paul Krugman has a bone and will not let it go, no matter how confused his thinking may be. (To be fair, I think Sumner has Krugman's arguments about the link between currencies and surpluses completely backwards, but he addresses this here).

Summary of the state of world trade

"Science: it works." The auto X-prize winners

Hunting Black Swans

Last December I wrote about Nassim Taleb's The Black Swan and proceeded to tell anyone who would listen to Read This Book. You will have to forgive my boyish enthusiasm. It was probably a classic case of getting really excited about that-which-you-have-read-most-recently. Happens all the time.

Since then, however, I've read a number of criticisms - concerning both Taleb and his ideas. None, however, was nearly as comprehensively devastating as this one by Eric Falkenstein. Although written some time back, it's new to me and in the interest of balance I feel obliged to link to it here. It's certainly worth a read if you've read Taleb or are at all interested in questions of probability and prediction. For instance:

"Taleb is consistently amusing because his criticisms of others apply so neatly to himself: he claims he is an empiricist yet supports his points with anecdotes. The Black Swan makes fun of ‘experts’ with credentials, but he states he does not deign to engage with anyone not sufficiently expert; he states he is not interested in being a speaker-bureau commodity , but routinely travels the rubber chicken circuit; he derides forecasters who don't give a full accounting of their prior forecasting history, yet delinks old remarks about Value-at-Risk, and recategorized his extinct Hedge Fund as a hedge, not a fund; he claims to prize humility, yet is most immodest; he argues against applying the law of large numbers, and also of inferring too much from small samples; people apply models to reality in biased manner, people naively extrapolate data without the appropriate theory; forward thinking is adaptive, forward thinking is error-laiden. Some people think inconsistency is a sign of genius; I think it just reflects confused thinking."

There are some valid arguments in here, so I encourage you to read through the rest. However I don't think everything in the essay is spot-on:

"Black Swan argues that standard statistics is flawed because it is backward looking — it uses ‘historical’ data — and argues that standard measures of risk like the normal distribution are ‘frauds’. I too prefer future data, but it is hardly a practical alternative. The Gaussian distribution is common in theory because it is so analytically tractable; it often creates closed form solutions that allow one to see how one variable affects another, and has nice properties, such as the fact that two Gaussian random variables added together is also a Gaussion random variable. In practice, no one actually believes in this view, and makes ad hoc adjustments.... Non-economists often giggle at the term ‘fat-tailed’ or homoskedasticity, but indeed most real world distributions are not ‘Normal’ or Gaussian, they simply have fatter tails than average. Does this imply statistics is a fraud? Well, if you mistake the map for the territory, indeed, this is news."

This is all well and good if you're a responsible risk-analyst like Falkenstein presumably is. But not everyone understands these limitations, and this is precisely the point. During the boom years many of the biggest decision-makers in the financial sector did mistake the map for the territory: Felix Salmon's piece on the formula that killed Wall Street is a case in point.  

Falkenstein suggests that Taleb's argument boils down to, essentially, "shit happens." I don't think that quite does the concept justice, but to the extent that people continue to discount shit happening, The Black Swan remains a worthwhile read.

[edited for clarity]

DO NOT DIZPUTE ZE GERMAN WACHSTUMS IM EXPORT!

A week or so back I took a sarcastic jab at economist Heleen Mees for suggesting - on thin evidence - that the German current account surplus was "less damaging" than China's. Since then, there has been some back-and-forth among actual experts fellow commentators over what to make of Germany's fantastical export-driven growth.

Tyler Cowen argues that "German imports have risen to new highs and it is also apparent that the Germany economy is a positive-sum locomotive for most other countries. And a lot of the German exports contribute to the productive capacity of other nations." Tyler would seem to side with Ms. Mees on this one. However, in making this statement he cites an FT editorial as backup, which - by its editorial nature - is light on details.

Meanwhile, Wolfgang Munchau argues that Germany's economic strength could well be toxic for the rest of the eurozone.  Germany's growth should be offset by an adjustment in consumer demand and labour costs within the eurozone. But since the eurozone is an imperfect market, this adjustment is not happening. The resulting imbalances have already contributed heavily to Europe's current sovereign debt crises and are an ongoing threat to the long run health of the eurozone, he argues.

So who is right? The lack of quantitative evidence in this discussion sort of leaves you hanging. My suspicion is that both sides are right, but one side is, um, righter. Let me explain.

In terms of the specifics, Tyler's point is correct: Germany's exports are a locomotive for growth. Trade is good for both exporting and importing economies. Similarly, Germany's re-investment of its funds into neighbouring countries will, in many (though not all) cases, lead to growing productivity. Both of these factors are positive.

But are they positive sum? In other words, do the positive aspects cancel out the negative factors that result from ensuing current account imbalances? That's far from clear.

I would argue that the sovereign debt problems in Southern Europe are in fact a collective European problem: it is not simply a story about profligate deficit spending in Greece, Italy and Spain. In the case of intra-eurozone trade - given the fixed exchange rate - someone's current account surplus is someone else's current account deficit. Greece and Italy don't have the option of devaluing their currency to stay competitive because they do not have their own currency. To adjust, they must cut costs and deflate, and somehow "increase productivity." They have obviously been reluctant/unable to do this, and the resulting crisis and severe austerity measures have deepened the recession in Europe. Clearly, this impacts negatively on their European neighbours who have to bail them out or risk having the eurozone collapse.

It may be true that Germany's capital account is not in surplus due to their high levels of foreign direct investment into neighbouring countries. However, for this to be positive sum this capital needs to be 1) invested in productive enterprises AND 2) the productivity gains must offset the imbalances produced by German growth. From the current state of Southern Europe, point 1) is potentially true while point 2) most definitely isn't. This is likely what Mohammed El-Erian means when says that the positive spillover effects from Germany's export growth have been "immaterial."

Does this mean that Germany should slow its economic growth? Of course not. But it does mean that there needs to be a recognition that "surplus=good, deficit=bad" is not a helpful paradigm: balance is important. Unfortunately, the current state of European institutions do not create effective incentives for maintaining that balance. We've already seen the results. A reluctant-to-reform Greece needs to be saved by a reluctant-to-bailout Germany. The euro can't carry on like this, not forever.

I will borrow my conclusion from a recent paper by Barry Eichengreen and Peter Temin:

"The point is that an exchange rate system is a system, in which countries on both sides of the exchange rate relationship have a responsibility for contributing to its stability and smooth operation. The actions of surplus as well as deficit countries have systemic implications. Their actions matter for the stability and smooth operation of the international system; they cannot realistically assign all responsibility for adjustment to their deficit counterparts. This was the lesson that Keynes drew from the experience of the Great Depression. It was why he wanted taxes and sanctions on chronic surplus countries in the clearing union proposal that he developed during World War II. Sixty-plus years later, we seem to have forgotten his point."

Readables

- Why are women leaving Wall St.?

- Dan Ariely on the darkside of "productivity-enhancing tools"

- "Syntactically speaking, the correct noun phrase to pick to get a target of predication for the preposed adjunct is not the subject of the main clause, it's buried as a genitive determiner in a noun phrase inside a relative clause modifying the object of the main clause" Got that? That is an actual sentence from an otherwise funny post on "an appalling piece of bungled headlinery."

- Sarah Palin: the sound and fury

- the future of playgrounds

- NASA experts to help trapped Chilean miners.