Wednesday Readables

- John Kay creates analogy between investors and tailgators; proceeds to beat metaphor to death.

- The New York Times to imitate the Financial Times' gated system; Felix Salmon analyzes

- Zimbabwe becomes more mobile, faces dollarization difficulties and even, um, deflation

- Why cable television is bundled. (But just because consumers prefer flat rates, it doesn't necessarily make them a good idea for most people - ditto with gym memberships).

- "If you find yourself in a suddenly resource-rich emerging market and you're interested in knowing whether revenues are being put to the proper uses, just go find the houses of the local government leaders."

- More evidence that Britain is drinking more, binging more, and being less social about it (as if we needed any)

Efficient Markets Hypothesis: Further Reading

We've seen an uptick in traffic to the site today thanks to Matt Yglesias' reference to the ketchup economics post from a while back. If anyone is interested in exploring this topic further, try reading this discussion of the efficient markets hypothesis.

The challenge for the ketchupal economists is not an abstract one: it affects business execs, government bureaucrats, and huge sections of the financial industry on a regular basis. When attempting to quantify the something as complex as the marketplace, you leave yourself vulnerable to the unquantifiable & the unforseen. For more, see this post about the pretence of knowledge.

(Alternatively, if you're more interested in all things ketchup, I'm sad to say we've got that covered as well: see here and here.)

A Reminder, Revisited

(Our look back at 2009 is stretching out into January a little, but I'm not quite finished with the stock-taking exercise. Our soap box, our rules)

Around this time last year, I pointed out that, if nothing else, 2008 drove home a fundamental lesson of IPE: the economy drives politics. Many of the best laid plans of early 2008 were sucked down the toilet along with the global economy, leading to some surprising outcomes.

My question for 2009 was therefore: how hard would politics push back? Because push back it did: countries that once championed free market principles quickly turned inward in order to protect their interests and respond to popular outrage. Let's have a look back:

Protectionism

As discussed below, the spectre of protectionism was haunting us early in 2009. In Britain, we suddenly saw shades of populist xenophobia from Gordon Brown (pray tell us, Gord, what exactly constitutes a British worker? shall we ask the BNP?). In the USA there was the noxious "Buy American" clause, the auto-bailout, and some other hilarious examples. India banned Chinese toys for six months. But the most gregarious example of all comes from China itself: the undervaluation of the yuan, and its consequences for everyone else, is probably the biggest protectionist story of the year.

Tobin Tax
While not exactly a crackpot policy proposal, the Tobin Tax (explained here) is still a bad idea. Unfortunately, because it was re-introduced by Lord Turner of the FSA in a widely-publicized report, it got a lot of media play. Thankfully, the US made it clear that they weren't interested so the idea was stillborn (er, maybe not).

[Don't get me wrong - sometimes capital controls are a good idea, especially for emerging markets facing massive inflows of capital, but more on that later.]

Pay czars! Wait, Pay czars?

Somehow the use of the term "czar" here just doesn't inspire confidence. Here we have liberal, democratic, relatively free and competitive societies appointing pay czars to set limits on the compensation of a particular subset of society. I get that skewed pay incentives led to excessive risk-taking, but there were much bigger factors at play.

However, as one astute observer pointed out, the job description of the pay czar is not to curb bankers' pay but rather to curb public anger at bankers' pay. I hope it worked, since I'll bet there were some Frenchmen dusting off their guillotines... just in case.

SuperTax 2009

Further caving to popular anger, the UK and France introduced the SuperTax 2009. I feel no sympathy for the uber-rich bankers traveling in their Mercedes to the Human Rights Tribunal to plead their case. But why stop at bankers? You should at least be consistent.

We Still Like Capitalism, Though, Right?

Taking the long view, capitalism has been a resounding success for humanity. It is the single biggest poverty-killer in history. But as we have seen, the free market is a fragile thing, and prone to excesses. These excesses produce backlash, and the backlash can be severe.

We need only ask John Maynard Keynes, a first-hand observer of how bad the backlash can be. An astute observer of history and human psychology, Keynes had the following to say about pre-WWI Europe:

The power to become habituated to his surroundings is a marked characteristic of mankind. Very few of us realize with conviction the intensely unusual, unstable, complicated, unreliable, temporary nature of the economic organization by which Western Europe has lived for the last half century. We assume some of the most peculiar and temporary of our late advantages as natural, permanent, and to be depended on, and we lay our plans accordingly.

Those advantages collapsed spectacularly in 1914. We spent the next seven decades sorting out the mess. Now, I'm not suggesting that pay czars and supertaxes are the first steps towards a return to communism or fascism or whatever - not by a long shot. But try to remember how unlikely those things would have seemed a couple of years ago. Things change in a hurry.

The lesson that I take from all of this is as follows: the liberal market economy is a fragile social experiment - it is not a naturally occurring phenomenon. We need to keep this message in the back of our minds as we take stock of recent events. This little project of ours requires safeguarding, not hysterics. So let's tone down the ideology and tone down the populism and instead focus on pragmatic ways to keep it going a little longer.

Thursday Readables

- Britons decidedly skeptical of global warming. Children are thrilled; Arsenal fans less so.

- Dispatches from countries that do not exist. "I had my leg propped up on a dark wooden desk and was wincing at the sting of a vigorous alcohol-swabbing by the health minister himself. I was not accustomed to such personalized government service. Fake countries have to try harder, I thought." Outstanding.

- Remember Calvinball? Meet something similar, but more sinister: Terrorball. This game has only two rules: (1) the game continues until there are no terrorists left, and (2) if the terrorists manage to kill, injure or seriously frighten anyone, they win.

- Finally, the chart of the day: the accuracy of economic forecasts from the past decade (or not). Unfortunately, this little graph doesn't tell you who'se forecasts are being plotted, what the forecast time-periods were, or even what the Y-axis represents (GDP, presumably) - so its credibility is suspect. Nevertheless, it vizualizes an important point about market forecasters (or forecasters of almost any kind): they're usually wrong. Forecasts huddle around the median, reality does not.

So the next time a professional economist, government official or IPE blogger offers you a specific forecast - do yourself a favour and ignore them. (...then go read this book!)

That Was the Decade That Was: the long view

In looking back at the past decade, most commentators have forfeited any meaningful narrative in favor of the proverbial 'better luck next time.' But if the following trends are taken in toto, the past decade in the markets looks downright revolutionary:

-The S&P500 fell 24%, its worst performance since the 1930s, FTSE down 7.3%, DJIA down 9.3%, Nikkei down a massive 44% over the past ten years. Contrast that with the major emerging markets: Russia's Micex index hit the moon with an astounding 802% rise, Brazil's Bovespa jumped 301%, India's Sensex rose 249% and the Shanghai Composite closed 140% higher.

-The benchmark Nymex crude oil contract ended the decade up 210%, but the story in between is among the most volatile in memory. Oil closed out 1999 at $25.60 a barrel, hit $147.27 in July 2008 and ended 2009 at $79.36.

-Spot gold closed the decade up 281%, while copper ended 290% higher.

-Two major stories in the currency markets: the dollar's long decline and the euro's rise to viability. The dollar ended the decade down 23.5% on a trade weighted basis, while the euro gained 43% on the dollar.

So what can we extrapolate from the data above? The 'rise of the rest' is the defining trend of the past decade; loose monetary policy contributed to a great capital flight from developed market equities; the dollar's long relative decline has eroded the US' influence internationally and will shape the coming decade as much as any other trend (politically, financially and economically); emerging market industrialization made commodities a really, really good bet; and precious metals retained their mystical aura in uncertain times.

If you ask people in China, India and Brazil for their impressions of the past decade, I suspect you'll get a more positive consensus than 'good riddance.'

A decade in the markets

The FT has, as usual, fantastic graphs charting the course of different major markets over the past decade.

From the tech bubble to the great credit crunch, this has been a bumpy ride indeed.

State vs. Market

Arnold Kling presents a brief history of state-finance relations. Whereas modern economics assumes a market economy and explains the use of money as a tool to make it work better, Kling argues that, in his "skewed view" of financial institutions, the use of money developed well before the market:

According to the skewed view, there was never a state of nature in which financial institutions roamed free in the wild, to be later tamed by regulators. Instead, financial institutions were fundamentally institutions of government. Entrepreneurial finance is a modern development, and its separation from government may always be tentative.

Skewed? I thought that this was mainstream. The emergence of "the market" as a distinct entity is extremely recent in terms of human history. If you had asked a peasant in 16th century about the market, he/she would have pointed you towards the stalls selling produce in the town square. The whole concept of shifting power from the state to market forces would have been nonsensical.

This is why, prior to Adam Smith and his contemporaries, economics (or political economy, as it was then known) did not exist as a field of study. How could it? Every aspect of what we would now label economic activity was deeply intertwined with social, political and power relationships.

Of course, it still is. Marx and his followers represent one version of this story, but there are many variations to choose from. Oxford and Cambridge still offer courses in PPE (Politics, Philosophy and Economics) because they recognize the necessary overlap. This makes the attempt by modern academia to separate political studies from their economic counterparts all the more frustrating.

Not only are the Wall St./Main St. dichotomies annoying, they're misleading. If anything, the recent financial turmoil has reminded everyone of the importance of treating "the state" and "the market" as complementary, not adversarial, components of our social structure. And in case there was any doubt: Rory and I started the IPE Journal to explore this relationship and try to make some sense out of it all.

How are we doing so far?

In Defense of Capitalism in the Long Run

My co-author has pointed out that we've become a little too focused on the global financial turmoil of recent months. But before we go back to covering our more diverse range of topics, I want to give some overall impressions.

In short, I think we're in danger of overreacting to dangers facing our economic system. It is now common to hear from our political leadership and media reps that we're facing the greatest financial crisis since the Great Depression. This, in turn, has opened up a lot of space for commentary to the effect that we've let capitalism run away from us, or that our financial system is run by corrupt, greedy, modern-day robber barons that are going to drive our country into the Third World. The gods of the free market have failed and capitalism is in convulsion, declare the pundits.

It is important to recognize that the rhetoric from politicians and mainstream media commentators is as much a reflection of popular opinion as it is an influence upon it. As Bryan Caplan has argued, the general population has an anti-market bias and this crisis has brought it comfortably out into the open.

Two points need to made here. First, this crisis is as much a failure of regulation as of market forces. Second, capitalism has a proven track record of raising our living standards and material well-being, consistently, for the past two centuries. This, often in spite of government failures and broader public sentiment. This is often difficult to see in times of crisis or personal misfortune. Here is Joseph Schumpeter:

Rational recognition of the economic performance of capitalism and of the hopes it holds out for the future would require an almost impossible moral feat by the have-not. That performance stands out only if we take a long-run view; any pro-capitalism argument must rest on long-run considerations.

Well, here is the long run perspective on real income per capita in the US since 1820 (via Chris Blattman):
Except for a blip in the 1930s, there has been steady, consistent growth. Even the Great Depression was not enough to throw off the overall trend. Elsewhere, Caplan has pointed out that in 1800 it took 95 out of 100 Americans to feed the country. Now it takes 3. The success of the market system is undeniable.

Of course, this is being insensitive to the trauma of the 1930s and is no consolation to those who are currently unable to sell their homes or secure a loan for their business. It also fails to recognize the impact of increasingly interconnected global economies that makes unhealthy economies more contagious. So public fury with Wall St. is understandable, but risks being overstated.

The most astute political economists since Adam Smith have recognized the need for government to accommodate for the excesses of the market. Our regulators failed to do this in the mortgage market, and steps need to be taken to remedy this to prevent future crises. But we need not throw the proverbial capitalist baby out with the bathwater.

Luckily, I think our political leaders understand this. As Simon Jenkins has convincingly argued:

The banks have not been "nationalised", just deluged with money. They remain pluralist and competitive institutions, with independent boards. Their workers are not civil servants. Investors retain their shares. The bonus culture will revive. The impresarios of greed have been punished, or at least a few of them. But this is not socialism in our time, just public money hurled at the face of capitalism.

My prediction is that in 12-18 months, the rhetoric of financial armageddon will be a distant memory and people will return to their regular concerns of providing for themselves and their families. That is what the market does best.

A Suspiciously Simple Supply-Side Solution (to the Credit Crunch)

Alliteration is fun! Alex Tabarrok proposes an alternative approach to dealing with the credit crunch at Marginal Revolution. First a recap for the uninitiated.

Briefly stated, the effect of the "credit crunch" is that banks/financial institutions are not lending money to other banks/financial institutions. Moreover, they aren't lending to firms, government organizations, individuals, etc... This means that all sorts of things - funding new enterprise, getting a new mortgage, getting a student loan - has become more difficult or impossible. In short, the financial gears that keep our economy running smoothly are grinding to a halt.

Why did this happen? Again, briefly stated, banks made mortgage loans to people with poor credit ratings (or people with poor credit history took on loans they couldn't afford, depending on how you look at it). These are the sub-prime mortgages. When the housing boom slowed, mortgage rates went up and many of these people defaulted on their payments. Some mortgage lenders went bankrupt and banks lost large sums of money.

Furthermore, banks used credit derivative "vehicles" that packaged sub-prime mortgages with higher-grade assets to spread the risk. These bundles of asset-backed securities were then sold on to other financial institutions. When the value of these securities came into question following the housing collapse, more losses and uncertainty ensued.

That's a painful oversimplification of things. But basically the double-shot of large write-downs and uncertainty about the value of assets has left credit markets dry. As Alex explains, banks are the bridge between savers and borrowers. Those bridges are now collapsing. The US Treasury plan is to prop up those teetering bridges; Alex's alternative solution is to encourage savings and thus increase the flow of credit across the bridges that are still structurally sound. He proposes a tax holiday on contributions to an Individual Retirement Account for a year, with the governenment matching a certain amount as well.

Cool idea, but I'm not sure that it will do the trick. The problem is, saving today means forgoing consumption today - that's bad news for an economy facing a recession. Also, as Keynes pointed out, it does not necessarily mean consumption later: uncertainty about the future economy means people may save to have liquidity (assets that are easily accessible/convertible to money) as insurance against economic misfortune. Money saved in liquid assets doesn't automatically increase demand for 'producible' goods that lead to more employment and a stronger economy. In other words: a penny saved does not equal a penny earned.

Also, if the real problem is uncertainty - financial institutions hoarding liquidity and refusing to lend to one another - it's really not clear how an increase in savings will help. Then again, Alex is infinitely more knowledgeable than I am, so I've probably missed something here.

(Photo courtesy of http://www.lewrockwell.com/)

RealClear

One of our overriding missions at IPE Journal is to cut through the partisan noise in the media to bring you critical insight into the issues and trends shaping our interconnected world.

RealClearPolitics is the first website I visit every morning, and is unique in its unfiltered offering of the best political journalism/commentary from around the US (and often the world). For those of you interested in following the 2008 US presidential race, I highly recommend bookmarking it.

And for you blood thirsty capitalists, there's RealClearMarkets.