Thursday, May 27, 2010

Sticky prices

This post by Nick Rowe:

Returning from a long weekend's canoeing, I remembered one of the main reasons I am a sticky-price macroeconomist. I checked to see if the economy had imploded while I was not worrying about it. April CPI up 0.1% from March; CAD/USD down about 2%; CAD/EUR up about 2%; TSX down around 3%; S&P500 down around 6%; oil down around 3%, etc.

You get the picture. The exact numbers don't matter. The CPI moved less in one whole month than all the other numbers moved in my 4-day weekend. A whole order of magnitude less. The CPI is a boring number. Anybody can predict next month's CPI within a 1% range; nobody can predict next month's exchange rates, oil prices, or stock prices with that degree of accuracy.

But what does this tell us?

My long weekend was a time of big changes in demands and supplies of financial assets, and the prices of all those financial assets relative to each other changed a lot in 4 days. But nothing seemed to have changed when I took my Loonies to the local supermarket. And I bet nothing much changed when Europeans and Americans took their Euros and US dollars to their local supermarkets, buying bread and milk like I did, even though the Loonie, Euro, and US dollar had all changed relative to each other. (OK, gas prices were about 2% lower when I returned, but that might be because they always seem to go up at the beginning of a long weekend.)

We don't usually think of the CPI as an asset price, but it is. Or rather, its inverse is. The CPI is the price of a basket of goods in terms of money, so 1/CPI is the price of money in terms of goods. Money is a financial asset, so 1/CPI is the price of a financial asset. TSX/CPI is the price of another financial asset, the TSX basket of shares, in terms of goods. CAD/USD is the price of one money in terms of another money. 1/CPI is much more predictable, at a one month horizon, than TSX/CPI or CAD/USD. About one order of magnitude more predictable.

This fact tells me that most of the prices that make up the CPI are sticky. I can't make sense of it any other way. I don't like the assumption of sticky prices; I hate that assumption, because it is assuming something we ought to be explaining. But until I hear a satisfactory explanation for why the monthly CPI is so predictable, I don't have a better alternative.

Why are prices sticky? Is it because consumers expect predictability?
1. Twenty years ago I paid $30 for a pair of sneakers. Truthfully, it would be hard to persuade me to pay any more today. Fortunately, for technological progress and offshoring, sneaker prices have been able to stay around the $30 range. Unfortunately, they're not quite the same quality sneakers. Same with shirts - I'd be more than a little upset to pay more than $20 for a shirt.

2. 5 years ago we spent the weekend at the Hyatt Chesapeake Resort. We probably paid about $250 per night for the room for a stay in October. These days we go during the off season where rooms can be had for $99 per night. Even today I would be aghast at paying more than $250 per night. Prices in fact have gone up to $350 per night during the peak season (late spring - summer) but at in late fall can still be had for $250.

Or perhaps it's not expectations that are sticky and maybe it's just that I'm cheap.

Wednesday, May 26, 2010

Models and reality

The dustup between Mark Thoma and David Andolfatto summarized by Rajiv Sethi is perhaps more symptomatic of the divide between - at extreme risk of too much simplification - "new" macroeconomists and "old" macroeconomists. The macroeconomists of my generation were taught DSGE models. Facts were "stylized" facts, i.e. first and second moments of "key" economic variables such as GNP, investment and consumption. During my entire 6 years at graduate school things like institutional details and historical events that may have affected the economy were laid aside or treated as not being "relevant" to the model. Economies were frictionless and markets always cleared. Sure, some frictions were eventually introduced but perhaps the biggest elephant in the room was that the curriculum cultivated us with a certain attitude that:
1) There are those who can build DSGE models and there are those who can't.
2) All partial equilibrium models can be dismissed off hand.
3) All structural equation models are completely irrelevant especially those not based on DSGE models. (IS-LM or Keynesian "cross" models are definitely in this category.)
4) Any paper that does not present a model can be dismissed - this included narratives as well as historical papers.

Perhaps the economists who fail to understand history will be doomed to repeat them?

Tuesday, May 25, 2010

What I've been reading

Some non-fiction stuff:
1. John Boslough, Stephen Hawking's Universe: short and easy read though somewhat dated. Having read several cosmology type books I was able to follow the arguments and I still think that it's a good introduction.

2. George Smoot and Keay Davidson, Wrinkles in Time. Entertaining though some of the technical details eluded me especially the monopole and dipole discussion. I especially liked the figures especially the one labeled Big Bag: The Evolving Universe.

3. F. David Peat, Einstein's Moon: Bell's Theorem and the Curious Quest for Quantum Reality. The experimental details on Bell's Theorem and its extension of the EPR paradox was well presented. Short and clarifying. Enjoyed it.

4. Denise Shekerjian, Uncommon Genius. Disappointing although I'd have to say that this is a tough subject - to find what factors determine creative impulses of MacArthur Fellows. Ultimately, I think I may have been happier if this were short biographies of the fellows she interviewed and to leave the reader to tie the links together. Alternatively, something in the format of Three Scientists and their Gods might have worked better.

5. Roger S. Jones, Physics as Metaphor. Disappointing. I mostly skimmed it. The book seemed rather rambling and its basic thrust was in the school of "reality is what we make of it". I'm sympathetic to this view though I think the presentation of the ideas weren't as entertaining as I would have liked them to be.

6. Fritjof Capra, The Turning Point. This was a book that 20 years ago I would have whole heartedly embraced. While jaded and indoctrinated by free markets, deep down I still cling to the belief that there are many things that cannot be looked at piecemeal (Capra calls it the Cartesian/Newtonian framework) and that the systems view should be adopted. I think there has been some shift to this (though I suspect not as much as he would like) especially with the holistic approaches to healing and health. But (gasp!) not economices. Yeah, one day I would like to see a book called Holistic Economics or the Zen of Economic Systems.

Fiction reading

Catching up on some regular fiction:
1. Paul West, The Women of Whitechapel and Jack the Ripper: I had to read it just to see what his theory was. The prose didn't really hold me.
2. Jodi Picoult, Plain Truth. I'd have to say that this was a pretty good book and this was my first Picoult which makes me want to try another.
3. Michael Cunningham, At Home at the End of the World. Wonderful writing but the lack of differences among the voices sometimes confused me. I guess I could psychoanalyze this and say that it is a multiple selves version of one character but I enjoyed the book.

Monday, May 24, 2010

Robert Kaplan on Afghanistan

Robert Kaplan writes:

“Afghanistan was a cakewalk in 2001 and 2002,” says Sarah Chayes, former special adviser to McChrystal’s headquarters. “We started out with a country that hated the Taliban and by 2009 were driving people back into the arms of the Taliban. That’s not fate. That’s poor policy.” We enabled an administration, led by Hamid Karzai, that is less a government than a protection racket, in which bribery is the basis of a whole chain of transactions, from small sums paid to criminals at roadblocks in the south of the country to tens of millions of dollars smuggled out of the Kabul airport by government ministers. The myth is that the absence of governance in Afghanistan creates a vacuum in which the Taliban thrive. But the truth, as Chayes explains, is the opposite. Karzai governs everywhere in the revenue belt, synonymous with Pashtunistan, in the south and east of the country: the Taliban succeed in these very places, not because of no governance but because of corrupt and abusive governance.

Referring to the evolution of the former mujahideen commanders into gangster-oligarchs under Karzai, an Afghan analyst, Walid Tamim, told me: “Warlords like Rabbani, Fahim, Sayyaf, and Dostum have all been empowered by Karzai and the U.S. government. Why is [Taliban leader] Mullah Omar any worse than these guys?” Ashraf Ghani, the country’s finance minister from 2002 to 2004, explained: “The core threat we all face is the Afghan government itself. About two-thirds of revenue is lost to abuse. This isn’t like corruption in Indonesia, where money is stolen but things still get built; here it is all looted, because the warlords are insecure about what may come next in Afghan politics.” Even as American officers talk publicly in bland clichés about partnering with and improving the performance of the Karzai government, the grim reality of Afghan public life is distinguished by corruption, criminality, and poverty.

I knew and wrote about Karzai in the 1980s, when he was a representative in Peshawar of the pro-Western mujahideen faction of Sibghatullah Mojaddedi. Mojaddedi had very little military presence inside Afghanistan; he and Karzai were no threat to anybody. Karzai had impressed me as personable, enlightened, sensitive, and, now that I think about it over the distance of time, weak. I genuinely liked him. But alas, he is said to be bored by actual governance. As Ghani points out, “He is not an organization man with the requisite management abilities,” and thus he lacks the skill to build a popular power base like the one the late Afghan Communist leader Babrak Karmal was able to build in the late 1970s and early 1980s, or even like the one the Soviet puppet Najibullah built later on. And without a power base of his own, and with the Americans distracted since 2003 by Iraq, Karzai has had few others to rely on but the warlords and his own knee-deep-in-graft family.

And on ethnic and tribal loyalties:

What does it mean to work with the tribes, Churchill-style; what does it take to overcome the geographical and human terrain here? The story of Colonel Chris Kolenda, of Omaha, Nebraska, is instructive. Kolenda, a West Point graduate with the sharp-eyed, comforting manner of a family physician, commanded the 1st Squadron of the 91st Cavalry from May 2007 to July 2008 in northeastern Afghanistan, on the border with Pakistan. When Kolenda’s 800-soldier battalion arrived, armed violence was endemic. Coalition headquarters in Kabul blamed a Pakistan-based insurgency. “The conventional wisdom was wrong,” Kolenda told me. “Almost all of the insurgents were locals who fought for a whole variety of reasons: they were disgusted with ISAF, as well as the government in Kabul; their fathers had fought the Soviets and now the sons were fighting the new foreigners.”

Then there was the “psychodrama of interethnic and clan frictions,” abetted by the fractured mountainous landscape. The area was populated by Nuristanis, Kohistanis, and Pashtuns, all of whom harbored disdain for the Gujars, migrant farm workers from over the border, who, in their eyes, were “not real Afghans.” (So much for the argument that there is no Afghan national identity.) The Nuristanis, in turn, were divided into the Kata, Kom, Kushtowz, and Wai clans. The Kom were split into hostile and well-armed groups whose current divisions stemmed from the war against the Soviets in the 1980s, when some of the Kom backed the radical forces of Gulbuddin Hekmatyar, known as the HIG, or Hezb-i-Islami-Gulbuddin, and other Kom sub-clans were loyal to the moderate National Islamic Front of Afghanistan. The Kata, meanwhile, were generally loyal to the Lashkar-e-Taiba (“Army of the Righteous”), which carried out major attacks against India from bases in Pakistan. The Pashtuns themselves were divided in some cases, on account of blood feuds, into five elements.

Kolenda apologized to me for “getting down in the weeds,” but explained that until he’d learned who was who, and who was fighting whom, his battalion couldn’t make progress and escape the cycle of ferocious firefights that had characterized the first three months of its deployment. “People were often giving us tips about bad guys who weren’t really bad guys, but simply people from another faction with whom the tipster had a score to settle.”

Interesting and thoughtful article throughout.

Sunday, May 23, 2010

A financial blog post round up

A round up of some blog posts I had been sitting on and racking my brains on how to intelligently discuss them but unable to come up with anything so I thought I'd just list them here with some short comments:
1. I had previously wondered whether the U.S. would experience a lost decade here and here and Krugman asserts that this is a looming possibility:

Recent data don’t suggest that America is heading for a Greece-style collapse of investor confidence. Instead, they suggest that we may be heading for a Japan-style lost decade, trapped in a prolonged era of high unemployment and slow growth.

Tim Duy:

To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with. But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy. At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly, and inflation continues to trend downward.

All of which together suggests that the Fed's policy stance is seriously out of whack with policymaker's interpretation of actual and potential economic developments. And I have trouble explaining the disconnect.

One of the things we tried to do a few months ago was to rebalance our portfolio based on what we thought the likley outcome in the next 10 years would be. Our thought was that the Fed/Treasury would try to inflate its way out of debt (somewhat) and inflation would rise. Even if it did not, the increase in debt would place upward pressure on interest rates. As such we moved most of our savings out of equities into TIPS. Where does the current commentary leave us?

As Krugman points out, interest rates have actually fallen due to the Greek crisis and the deflation is now a possible scenario (again!). While my longer term outlook for interest rates remains the same, the likelihood of this happening is decreasing - in other words, I have to revise downward my prior on the probability of inflation being likely in the medium term. Unfortunately, with the battering the equity and bond markets are taking there doesn't seem to be any safe sanctuary for our retirement savings.

2. That ratings agencies amplify crises and really have no role in regulation was something I had not thought about before:

During the boom, early rating downgrades would help to dampen euphoric expectations and reduce private short-term capital flows which have repeatedly been seen to fuel credit booms and financial vulnerability in the capital-importing countries. By contrast, if sovereign ratings had no market impact, they would be unable to smooth boom–bust cycles. Worse, if sovereign ratings lag rather than lead financial markets, but have a market impact, improving ratings would reinforce euphoric expectations and stimulate excessive capital inflows during the boom whereas during the bust, downgrading might add to panic among investors, driving money out of the country and sovereign yield spreads up. If guided by outdated crisis models, sovereign ratings would fail to provide early warning signals ahead of a currency crisis, which again might reinforce herd behaviour by investors.

The clincher: Rather than to establish yet another rating agency, the appropriate policy response will be a thorough revision, in fact exclusion, of the role of sovereign ratings in prudential regulation and even in internal industry guidelines.

3. However, the fact that derivatives can be destabilizing is something that I had been aware of and is now part of the popular culture thanks to Michael Lewis in the Big Short. Ideally, the existence of CDS would have allowed the shorts to make markets more efficient by signalling that they thought the underlying mortgage securities were over-priced. The fact that the shorts were able to make billions by buying so many CDSs (in effect taking the opposite side of the securitization) without affecting the price of the CDOs that were being sold to investors seem to me to be a failure of information transmission - the markets aren't transparent enough. If I knew that someone was willing to take a large position on the opposite side of my transaction then this would give me pause.

Perhaps the problem is so much derivatives per se but the lack of understanding in the markets and how they are interlinked as well as largely the fact that these transactions are not transparent. Could the existence of a more liquid and transparent market in CDSs and CDOs/mortgage securities been able to prevent the bubble? Hardly - the existence of put options for S&P and other stocks have not been able to prevent a bubble and it's hard to believe that this might be a self-regulating mechanism.

4. A very articulate response from Kocherlakota on why macroeconomic models failed us. The thrust is that macro models and the act of modeling are very segmented. Labor market frictions, price frictions and financial and asset market frictions are features of some macro models and not all models. In other words, it is hard to build a coherent macro model with all the frictions in at once. A model like this would be more realistic.

However, incorporating the financial sector is extremely hard. Perhaps it is made all the more harder by the fact that economists rarely try to work together to build these models and they rarely share code. Perhaps this is because of the publish or perish mentality - that if I share my code with you, you may be able to beat me to getting published just by tweaking my code a little. I don't know how relevant this is but the fact that different economists are working on different aspects of economic frictions and not coming together to try to build a large scale model says several things:

a) They do not believe that all frictions are created equal - my friction is bigger than your friction
b) Large scale DSGE models are impossible perhaps due to computational constraints and perhaps it is somewhat related the stigma attached to large scale macroeconometric modeling that took place in the 1970s (and its subsequent failure)
c) Economists actually believe that it is better to compete amongst themselves to build better models than to cooperate to build better models.

Friday, May 21, 2010

What I've always wondered about convergence

But was afraid to ask until it was asked for me: Why does anyone care about the distinction between convergence in probability and almost sure convergence?

Some answers:
1. "Suppose a person takes a bow and starts shooting arrows at a target. Let Xn be his score in n-th shot. Initially he will be very likely to score zeros, but as the time goes and his archery skill increases, he will become more and more likely to hit the bullseye and score 10 points. After the years of practice the probability that he hit anything but 10 will be getting increasingly smaller and smaller. Thus, the sequence Xn converges in probability to X = 10.Note that Xn does not converge almost surely however. No matter how professional the archer becomes, there will always be a small probability of making an error. Thus the sequence {Xn} will never turn stationary: there will always be non-perfect scores in it, even if they are becoming increasingly less frequent."
Also, almost sure convergence implies convergence in probability.

2. The most useful intuitive understanding I've been taught is that almost sure convergence guarantees that X_n be far from X (ie. further than any epsilon) only a finite number of times. Convergence in probability leaves open the possibility that X_n will be far from X an infinite number of times.
The best example I have to illustrate that is if you take Y_n as a Bernoulli(1/n) random variable. Clearly Y_n converges to 0 in probability, but it doesn't converge almost surely. Y_n will always be 1 for an infinite number of n's. You can see this from the second Borel-Cantelli Lemma.
Of course, I've got no idea if the distinction has any practical relevance for econometrics.

3. Convergence in probability is a form of weak convergence. Your students should understand the difference between convergence and weak convergence -- the difference is huge. If you have a sequence x_n, then weak convergence means that f(x_n) --> L for some f. This does not mean that x_n converges, but only that some attribute converges.
For example, you can ask, given N asset prices, if the sum of these prices converges to 1, does that mean that each individual asset price converges to something? No. Here f is the operation of taking the sum. It could be average, variance, integration against a test function, the infimum of a large set of integrations against test functions, whatever. ... Weak convergence, point-wise convergence, and uniform convergence are different concepts and useful ideas to understand, and they appear over and over again in different forms whatever branch of math you are studying.

Is Eichengreen the next Stiglitz

Certainly sounds strident enough:

European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. Greece will restructure its debt. This point is no longer controversial; the only controversy is why a restructuring was not part of the initial IMF-EU rescue package. Only the delusional can believe that, when everyone else is taking swingeing cuts, Greece's creditors can continue receiving 100 cents on the euro. It beggars belief that Greek government debt can top out at 150% of GDP, as the IMF envisages. ... debt restructuring is complex, and neither the IMF nor the Greek government had worked out a plan. If true, this is the most damning explanation of all, for it means that the Fund went into negotiations unprepared. ... The IMF botched its rescue.

Fortunately, he also has some remedies for how the IMF can redeem itself:

First, the IMF and the European Commission can encourage Greece to reach a social consensus on restructuring and reform by showing that the creditors will also contribute.

Sure, the IMF has all the power in the world to do this. And does the IMF really have the power to renegotiate debt with investment banks?

Thursday, May 20, 2010

How useful have growth regressions been?

Not very much especially after reading the following paper by Jan Hanousek, et. al. (2004):

Replication of two recent studies of growth determinants shows that results are sensitive to the choice of data from which growth rates are calculated, especially with respect to whether economic convergence has occurred. Previous warnings against using data that has been adjusted to increase cross-country comparability to study within-country patterns over time (growth rates) have been largely ignored at the cost of possibly contaminating the conclusions.

In other words using data from Penn World Tables is incorrect. From the paper:

Heston and Summers themselves state:
PWT has been used by many researchers to measure countries’ growth rates, unaware that the rates they obtained are not the same as the rates implied in the countries’ own national accounts. Both sets are weighted averages of the growth rates of GDP components, but the weights are different.... When told this, a number of growth researchers reacted in a predictable way: since they were indifferent as to [which] growth rate they were using..., this clarification was entirely disregarded..

Nuxoll (1994):
The growth rates in the Penn World Tables do differ from national accounts. International prices are useful for adjusting GDP estimates for differences in price level; they are certainly preferable to using exchange rates. However, using domestic prices to measure growth rates is more reliable, because those prices characterize the trade-offs faced by the decision-making agents, and hence they have a better foundation in the economic theory of index numbers. Probably the ideal is to use Penn WorldTable numbers for levels and the usual national accounts data for growth-rates.

From Hanousek et. al.:
As an indication of the lack of impact of the series of articles pointing out the problems with growth rates derived from the PWT data, although Nuxoll’s paper appeared in the leading professional journal in economics, it was cited in only five of the literally hundreds of empirical cross-country growth studies between 1994 and 2002.

Predictably, this paper was not published in a "leading" journal. Folks like Barro, MRW, etc. really don't like to be told that they have been wrong all along.

While there is some concern for comparability across countries, economists have not really paused to think (or perhaps they over-thought the problem) - If I live in a country in the economists' sample would I be interested in knowing what factors cause my GNP to grow in terms of my local currency or some abstract price-comparability exchange weighted terms? The obvious answer (to me, at least) is that I don't really care about my GNP denominated in some abstract way - I care about it on my terms, i.e. local currency.

How can we predict political transformation

The previous day's post on the political crisis in Bangkok reminds me how little we can say on outcomes:

1. Why did some color revolution see little violence: e.g. the Rose Revolution or the Orange Revolution while others end more violently e.g. the Tulip Revolution or the Tiananmen Square protests? Is it that the opposition in some cases show cohesiveness and unity while in others there were internal opposition divisions?

2. The opposition divisions in the Thai political crisis were well documented: the more militant faction were more aggressive and advocated violence and use of armed resistance while the more moderate ones could not control these right wing extremists. How many extremists does it take to destabilize a political movement? Or the corrollary, how aggressive do the moderates have to be to restrain the extremists?

3. The Thai government has also labeled the extremists "terrorists". If it weren't for the U.S. global war terrorism this would not have been so. It's hard to say if they have made the situation worse but it remains to be seen what their next moves will be. Certainly, the U.S. goal of promoting democracy seems to contradict some aspects of its global war on terror. My sense is if democracy were a U.S. export, it would still sustain a deficit.

Tuesday, May 18, 2010

What if the French Revolution happened today?

According to Wikipedia:

Paris was soon consumed with riots, chaos, and widespread looting. The mobs soon had the support of the French Guard, including arms and trained soldiers.

... By late July, insurrection and the spirit of popular sovereignty spread throughout France. In rural areas, many went beyond this: some burned title-deeds and no small number of châteaux, as part of a general agrarian insurrection known as "la Grande Peur" (the Great Fear). In addition, plotting at Versailles and the large numbers of men on the roads of France as a result of unemployment led to wild rumours and paranoia (particularly in the rural areas) that caused widespread unrest and civil disturbances and contributed to the Great Fear.

This could be the scenario for Bangkok and Thailand.

Some highly abbreviated speculations on how it got this way:
1. The yellow shirts (PAD) seized the airport in 2008 and forced the collapse of a pro-Thaksin government. The yellow shirts were hardly punished for their actions.

2. The red shirts are now doing to Bangkok what yellow shirts did to the airport.

3. The current pro-PAD government believe that the yellow shirts are negotiating from bad faith. From WaPo: "Red shirt demonstrators, it seemed, had forced the Thai government to call an early election. But that deal foundered on last-minute demands from leaders of the red shirts."

4. This has hardened the current government's stand. From the BBC: "Thailand's government has rejected an offer of mediated talks with red-shirt protesters aimed at ending an increasingly violent confrontation." They have begin ominously to label the more militant faction as terrorists: "The situation has escalated and become violent with armed groups and terrorists attacking the government, officers in the field and civilians," cabinet minister Satit Wonghnongtaey said in a televised news conference. ... The government accuses hard-liners within the red camp of using women and children as shields. At a news conference on Tuesday the military showed footage of what it said was a protester holding a baby over a barricade.

5. It has also hardened the government's response. From the same BBC link: The red-shirts, meanwhile, accuse government troops of firing indiscriminately on them, although the army said troops were firing live rounds only in self-defence. They have also been accused of assassinating Maj Gen Khattiya, known as Seh Daeng (Commander Red). Moreover, they have also rejected UN mediated talks.

6.Meanwhile, the conflagration spreads: Protesters roaming the lawless streets of a strategically important neighborhood near the protest zone threatened to set fire to a gasoline truck as bonfires, some from piles of tires, sent large plumes of black, acrid smoke into the sky. .... Security forces armed with assault rifles were deployed in greater numbers across the city after many firefights, including a nighttime grenade attack on the five-star Dusit Thani Bangkok Hotel, a landmark in the city. The attack and a subsequent prolonged gun battle suggested that Thai security forces were up against more than just protesters with slingshots and bamboo staves. Protests have spread outside the capital with a military bus set afire in the northern city of Chiang Mai and demonstrations in two north-eastern towns in defiance of a government ban.

7. While some may see this the eclipse of the influence of the king, I find it hard to believe that the current government actions do not have the tacit and implicit support of the Privy Council.

What may happen:
1. Both sides ratchet up:
The government declares Thaksin a terrorist and makes a "with us or against us" speech. Elite military troops fan out across the country to target red-shirt leaders. Thaksin is also targeted. Heavy artillery and the air force are used to target red-shirt encampments. Rank and file who are pro-red shirts abandon the military and fight an insurgency within Bangkok and the country. They target the elite and the members of the Privy Council including ransacking and looting their property. A civil war breaks out and given the numbers this is a war that the current government will eventually lose on the international public relations arena but can only win domestically with sufficient violent force. A autocratic government is established.

2. The best outcome for the red-shirts:
A compromise is reached where some UN monitoring is accepted. The UN will monitor the November elections originally proposed as well as hold an inquiry into the events of April 2010 where red-shirts died in a demonstration. The outcome of this election is a forgone conclusion.

3. The best outcome for the yellow-shirts:
Continued use of force to arrest red-shirts and imprison agitators is successful enough to tamp down revolutionary fervor. Thaksin is branded a terrorist and all financial assets are frozen. All his advisors currently in Thailand are arrested, tried and jailed. An election is held where the result is favorable to the yellow-shirts. The results are known prior to the election being held. Red-shirt leaders continue to be arrested and jailed.

4. Is there a compromise solution?
Red shirts withdraw from Bangkok and the current government ceases police and military action. The original November election is held as originally proposed. Some UN monitoring is allowed for the elections but no UN investigation into the demonstrations is initiated. Both sides agree to abide by the outcome of the elections but with a lot of pre-conditions with regards to the candidates that parties are allowed to field. The result will be candidates that no one really likes and some kind of hung parliament that muddles along for years. Think Phillipines.

In cases 1 and 2, we will see capital flight from the urban elite as well as private investors.

Are there lessons for Thailand from:
1. Sri Lanka? The majority Buddhist Sinhalese finally defeated the Tamil Tigers after almost 30 years of civil war. Both sides have been accused of human rights abuses despite the fact that Buddhism has been characterized as a largely peaceful religion. Is such a civil war and human rights abuses in the future for Thailand? Alternatively, consider what the current Sri Lankan government is doing in reconciliation with the northern Tamils. Is the same rapproachment toward the Northern and Northeastern Thais from Bangkok possible?

2. Italy? Will a return of Thaksin Sinawatra be possible? If so will he be another Silvio Berlusconi - essentially a corrupt government official using the state to line his pockets? The sale of Thaksin's Shin Corp has already proven beyond a shadow of a doubt that he is not above using the state for personal purposes. In line with Berlusconi, he had curried favors with politicians using money and he had promoted loyalists with whom he has done business with into government positions. (See this for a legacy of Thaksin's rule.)

This is the end of Thailand as we know it.

Update (5/27): Looks like Thaksin has been declared a terrorist.

One scenario that I did not consider above was that the red-shirts are being used by Thaksin's group in a bid to bring him back to power - in which case, see the Italy comparison. In this scenario, any reconciliation attempt by the current government whether it continues to hold power or not will be undermined by the Thaksin loyalists. Even a yellow shirt government that tries to spread the distribution of wealth more equally would not be trusted. Even as it tries to gain the trust of the red-shirts, its attemps will be undermined by propaganda. The Thanksin loyalists may carry out insurgent attacks which will then be blamed on the current government.

Some other ruminations here.

Is there a hopeful solution?
Perhaps the best outcome would be the "charismatic" leader outcome. Some one incorruptible (and Thai politics has always been corrupt) that rises above the yellows and the reds and lays down the law Lee Kuan Yew style. It had been my hope that Abhisit would be the one (and he still could be the one) but right now he strikes me as a bureaucrat.

Monday, May 17, 2010

Regulating proprietary trading

Mark Thoma alerted me to the difficulties in regulating proprietary trading. What confused me a little was the fact that the post does not say what the differences are between the Volcker rule and the Merkley-Levin amendment:

The Volcker Rule, if you'll recall, is a ban on proprietary trading at banks and bank holding companies (BHCs). If you ask Merkley and Levin's offices, they'd no doubt tell you that their amendment significantly strengthens the existing Volcker Rule language in the Dodd bill (Section 619 of S.3712). Don't be fooled — it does nothing of the sort. I spent the majority of my career as a lawyer for a big investment bank, and my first thought after reading Merkley-Levin was: "Wow, this would be cake to get around." Wall Street is scared of the Volcker Rule, but believe me, they're not scared of Merkley-Levin.

What I did learn from the post was that under Merkley-Levin BHCs are allowed to trade as market makers just not on a proprietary basis. This aspect simply allows banks to try to hide proprietary trades under market making trades which seems to be the start of another shadow finance sector.

Like Mark Thoma, I'm not too convinced that this cannot be regulated but it's always a problem that when we hire a watchdog we also have to hire a watcher to watch the watchdog and so on. Perhaps we should allow competition in regulation - keep the disparate non-performing agencies that we have now and allow them to compete in regulation. To motivate the agencies, let the winner keeps the spoils. The fines or settlement go to the budget of the winning agency

Do we invest into a fad?

By some accounts, the love affair over cupcakes is just a fad. My view: How can it not be? How many cupcake places can Washington support? And if it were a fad (and if I believed it to be a fad) would I expand? What does it imply when Georgetown Cupcake expands into Bethesda?

1. It makes sense because there aren't as many cupcake eateries in Bethesda?
2. It is a fad but GC isn't too heavily in debt and hopes to cash in on the fad while it can?
3. Geez, if it isn't rational then they wouldn't be doing it, would they? (The Chicago school of cupcakes.)

Monopoly without monopoly power?

I see Jerr Dan as the only game in town (here in Washington, DC). They seem to be the only company that outfits tow trucks.

Hoovers lists Peterbilt and Mitsubishi as some of its competitors which seems to my untrained eye to be non-existent. My question: Are they a monopoly? If so do they exert monopoly power via high prices, etc.?

Friday, May 14, 2010

Revival of free markets?

The stock market crash last week exposed me to the world of algorithmic trading. Silly me, I thought free market economics had triumphed and that the Chicago school of efficient markets implied that there is no strategy better than a buy and hold. Perhaps, efficient markets only exists in academics and regulatory agencies and not in financial markets - which must be true since according to Rajiv Sethi (emphasis mine):

they have become increasingly common recently, and now account for three-fifths of total volume in US equities:

Algorithms have become a common feature of trading, not only in shares but in derivatives such as options and futures. Essentially software programs, they decide when, how and where to trade certain financial instruments without the need for any human intervention... markets have come to be dominated by “high-frequency traders” who rely on the perfect marriage of technology and speed. They use algorithms to trade at ultra-fast speeds, seeking to profit from fleeting opportunities presented by minute price changes in markets. According to Tabb Group, a consultancy, algorithmic and high-frequency trading accounts for more than 60 per cent of activity in US equity markets.

This is a recipe for disaster:

[In] a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise.

Under such conditions, algorithmic strategies can suffer heavy losses. They do so not because of "computer error" but because of the faithful execution of programs that are responding mechanically to market data.

But the fact that the market gained in the next fifteen minutes is a triumph for free market economics - that the market was mispriced and participants acknowledged it.

So, how could something like this happen? An insight from Kid Dynamite (HT: MR):
... one possible explanation is that an algorithm gets into a "sell loop," where it is sending out a sell order which, for some reason or another doesn't get immediately acknowledged, or doesn't get acknowledged within the threshold for the algorithm. So, the algo, thinking its order didn't make it, spits out another order, which doesn't get acknowledged, and it spits out another, etc etc etc. Why would the algo be coded to send out a new order before it had an "out" on the prior order? I don't know - that seems odd to me, (any algo writers out there? please share your knowledge in the comments section) but I remember a great story that my boss used to tell on our trading desk about how in the old days, when they sent a program trading order to sell a basket of stocks, the old dot-matrix printer behind them would loudly whir to life and print up a confirmation that the basket went. One day, trying to sell a basket, they got no confirmation. Silence. So they hit the button again. And again... and again... Until finally someone shouted - "THE PRINTER IS OUT OF PAPER," as they watched the market fall under the cascade of sell orders that had just been sent.

The recent news is now that this may in fact be the case (no, not that the printer was out of paper):

Regulators examining the causes of the brief stock market free fall last Thursday are looking closely at heavy selling in the market for stock-index futures by a single trader, beginning 10 minutes before stock prices began to plummet.

Gary Gensler, the chairman of the Commodity Futures Trading Commission (CFTC), said at a congressional hearing on Tuesday, May 11, that during that crucial time period, the futures trader, whom he would not identify, accounted for about 9% of trading volume in the most actively traded stock-index derivative contract, known as the 500 e-mini futures contract.

All of the trader’s orders were to sell, Gensler said, while most of the other 250 traders who were active in the same market that day were both buying and selling securities.

As the trader’s orders went through, the futures index on the Chicago Mercantile Exchange (CME) began to plummet.

What surprised me was how long it was taking the SEC to reconstruct the trades until I read this (emphasis mine):

We now have more than 50 market centers, which has brought added competition. Today, algorithmic trading interests are wired across markets -- equity, fixed income, futures and options; the market is the network -- and yet our regulators work in silos. Responsibilities are divided between the SEC and CFTC. Within equities markets, we have multiple Self Regulatory Organizations setting rules -- more silos: New York Stock Exchange, NASDAQ, FINRA, National Stock Exchange, and more. All too often, those rules have been watered down and eliminated in the absence of the SEC establishing these and other regulatory controls across equity markets. We created a "National Market System" but we forgot to create a "National Regulatory and Surveillance System" to go along with it. ‬‪ ... The Commission does not yet collect by rule the data it needs efficiently to reconstruct unusual market activity.

Yet, Jim Hamilton has the most insightful comment:

Let's take a look at one of the amusing examples of trading on Thursday. Exelon is a perfectly sound utility. The stock started and ended the day at about $42, yet at one point allegedly changed hands for a penny a share. If you are the owner of 100 shares of this stock on Wednesday May 12, the company will send you a dividend check for $55. They'll send you another $55 (and likely eventually even more) every 3 months thereafter, as long as you own the stock. What rational person would possibly prefer to have $1 on Thursday May 6 in preference to owning 100 shares of the stock, say, for at least another week?

No sane person ever would. I wonder how many of the sell orders came not from actual humans, but instead from instructions programmed to execute automatically by computers. Anybody following such a strategy is obviously not a subscriber to my theory of fundamental value, but instead seems to be playing Keynes' beauty contest game, having persuaded themselves, based on the historical correlations, that when the crowd starts to sell, if you can instruct your computer to sell at the "market price" faster than a human can even think, you'll come out ahead.

Economists and financial engineers seem to approach stock markets differently. The financial engineers often see the game as figuring out whatever the historical predictability has been and trying to get ahead of it. Economists tend to ask what the equilibrium in the market would look like if everybody played the game the way the financial engineers do. The answer to that second question is, if momentum-chasing algorithms come to rule the financial world, those who try to follow them will be the biggest losers.

Another notion that's popular with many financial gurus these days is the claim that you can eliminate certain risks to your portfolio with the right strategy of automatic trading and stop-loss sell orders. Again that claim invites an economic question-- if you are getting an insurance policy, who is selling it to you? I believe the implicit answer is, you are counting on the market-maker to insure you by taking the other side of your escape transactions. But the curious thing about such an insurance policy is that the market-maker gets to decide what premium to charge you after you ask to collect on the policy. You just might find that the state of the world when you and your buddies all most desperately want to cash in on your insurance is exactly the time when the premium proves to be ruinously expensive.

Or if I haven't persuaded you with these arguments, let me try a more modest suggestion-- those of you whose computer programs sent an order to sell Exelon even if you only get a penny a share might want to consider tweaking the code just a bit.

Costs of business cycles

It all began when Lucas (1987) argued that the welfare cost to eliminating business cycles is extremely small: "Eliminating all the fluctuations from a person's consumption path (i.e. eliminating the business cycle entirely) is worth only 1/20 of 1 percent of average annual consumption."

This finding was confirmed by Chris Otrok and yet it is so counter-intuitive that something has to be wrong. Otherwise, why would we implement any kind of stabilization policy at all. Krusell and Smith (1999) wondered if a heterogeneous agent model would help:

We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity arises from uninsurable and idiosyncratic uncertainty in preferences and employment, where regarding employment, we distinguish among employment and short- and long-term unemployment. We calibrate the model to match the distribution of wealth in U.S. data and features of transitions between employment and unemployment. Unlike previous studies, we study how business cycles affect different groups of consumers. We conclude that the cost of cycles is small for almost all groups and, indeed, is negative for some.

However, there are other ways to establish that the welfare effects are larger than Lucas' estimate. For instance, Barlevy (2003): " cycles can have a deleterious effect on the rate at which the economy grows over the long run. The reason is that cycles lead to volatile investment, reducing the efficiency of investment. Essentially, the fact that investment activity is concentrated in booms rather than spread out uniformly over time creates congestion effects that lower the productivity of investment. I estimate that eliminating the cyclical fluctuations that prevailed during the post-War period would have increased the growth rate of real GDP per capita in the U.S. from 2.0% per year to 2.5% per year. The cost of reduced growth from macroeconomic volatility is computed at a rate of 10% of consumption expenditures per year, over 100 times."

At the worker level Mukoyama and Sahin (2005) show that under market incompleteness: "Unskilled workers are subject to a much larger risk of unemployment during recessions than are skilled workers. Moreover, unskilled workers earn less income, which limits their ability to self-insure. We examine how this heterogeneity in unemployment risk and income translates into heterogeneity in the cost of business cycles. We find that the welfare cost of business cycles for unskilled workers is substantially higher than the welfare cost for skilled workers."

More recently, Krusell, et. al (2009) find:
We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity arises from uninsurable and idiosyncratic uncertainty in preferences and employment status. We calibrate the model to match the distribution of wealth in U.S. data and features of transitions between employment and unemployment. In comparison with much of the literature, we find rather large effects. For our benchmark model, we find welfare effects that, on average across all consumers, are of a bit more than one order of magnitude larger than those computed by Lucas (1987). When we distinguish long- from short-term unemployment, long-term unemployment being distinguished by poor (and highly procylical) employment prospects and low unemployment compensation, the average gain from eliminating cycles is as much as 1% in consumption equivalents. In addition, in both models, there are large differences across groups: very poor consumers gain a lot when cycles are removed (the long-term unemployed as much as around 30%), as do very rich consumers, whereas the majority of consumers---the "middle class"---sees much smaller gains from removing cycles. Inequality also rises substantially upon removing cycles.

This is an example of progress in economic model building - the idea that what is intuitive is hard to model mathematically. Heterogeneity matters but not at first (see Krusell-Smith 1999) Yet, do all these models really jive with what we observe anedoctally? And what are the costs not considered?

Lisa Kahn, an economist at Yale, has studied the impact of recessions on the lifetime earnings of young workers. In one recent study, she followed the career paths of white men who graduated from college between 1979 and 1989. She found that, all else equal, for every one-percentage-point increase in the national unemployment rate, the starting income of new graduates fell by as much as 7 percent; the unluckiest graduates of the decade, who emerged into the teeth of the 1981–82 recession, made roughly 25 percent less in their first year than graduates who stepped into boom times.

But what’s truly remarkable is the persistence of the earnings gap. Five, 10, 15 years after graduation, after untold promotions and career changes spanning booms and busts, the unlucky graduates never closed the gap. Seventeen years after graduation, those who had entered the workforce during inhospitable times were still earning 10 percent less on average than those who had emerged into a more bountiful climate. When you add up all the earnings losses over the years, Kahn says, it’s as if the lucky graduates had been given a gift of about $100,000, adjusted for inflation, immediately upon graduation—or, alternatively, as if the unlucky ones had been saddled with a debt of the same size.

... Mossakowski has found that people who were unemployed for long periods in their teens or early 20s are far more likely to develop a habit of heavy drinking (five or more drinks in one sitting) by the time they approach middle age. They are also more likely to develop depressive symptoms. Prior drinking behavior and psychological history do not explain these problems—they result from unemployment itself. And the problems are not limited to those who never find steady work; they show up quite strongly as well in people who are later working regularly.

... Glen Elder, a sociologist at the University of North Carolina and a pioneer in the field of “life course” studies, found a pronounced diffidence in elderly men (though not women) who had suffered hardship as 20- and 30-somethings during the Depression. Decades later, unlike peers who had been largely spared in the 1930s, these men came across, he told me, as “beaten and withdrawn—lacking ambition, direction, confidence in themselves.” Today in Japan, according to the Japan Productivity Center for Socio-Economic Development, workers who began their careers during the “lost decade” of the 1990s and are now in their 30s make up six out of every 10 cases of depression, stress, and work-related mental disabilities reported by employers.

... Till Von Wachter, an economist at Columbia University, and Daniel Sullivan, of the Federal Reserve Bank of Chicago, recently looked at the mortality rates of men who had lost their jobs in Pennsylvania in the 1970s and ’80s. They found that particularly among men in their 40s or 50s, mortality rates rose markedly soon after a layoff. But regardless of age, all men were left with an elevated risk of dying in each year following their episode of unemployment, for the rest of their lives. And so, the younger the worker, the more pronounced the effect on his lifespan: the lives of workers who had lost their job at 30, Von Wachter and Sullivan found, were shorter than those who had lost their job at 50 or 55—and more than a year and a half shorter than those who’d never lost their job at all.

... unemployed men are vastly more likely to beat their wives or children. More common than violence, though, is a sort of passive-aggressiveness. In Identity Economics, the economists George Akerloff and Rachel Kranton find that among married couples, men who aren’t working at all, despite their free time, do only 37 percent of the housework, on average. And some men, apparently in an effort to guard their masculinity, actually do less housework after becoming unemployed.

... joblessness corrodes marriages, and makes divorce much more likely down the road. According to W. Bradford Wilcox, the director of the National Marriage Project at the University of Virginia, the gender imbalance of the job losses in this recession is particularly noteworthy, and—when combined with the depth and duration of the jobs crisis—poses “a profound challenge to marriage,” especially in lower-income communities.

... “We already have low marriage rates in low-income communities,” Edin told me, “including white communities. And where it’s really hitting now is in working-class urban and rural communities, where you’re just seeing astonishing growth in the rates of nonmarital childbearing. And that would all be fine and good, except these parents don’t stay together. This may be one of the most devastating impacts of the recession.”

Many children are already suffering in this recession, for a variety of reasons. Among poor families, nutrition can be inadequate in hard times, hampering children’s mental and physical development. And regardless of social class, the stresses and distractions that afflict unemployed parents also afflict their kids, who are more likely to repeat a grade in school, and who on average earn less as adults. Children with unemployed fathers seem particularly vulnerable to psychological problems.

... Communities with large numbers of unmarried, jobless men take on an unsavory character over time. Edin’s research team spent part of last summer in Northeast and South Philadelphia, conducting in-depth interviews with residents. She says she was struck by what she saw: “These white working-class communities—once strong, vibrant, proud communities, often organized around big industries—they’re just in terrible straits. The social fabric of these places is just shredding. There’s little engagement in religious life, and the old civic organizations that people used to belong to are fading. Drugs have ravaged these communities, along with divorce, alcoholism, violence. I hang around these neighborhoods in South Philadelphia, and I think, ‘This is beginning to look like the black inner-city neighborhoods we’ve been studying for the past 20 years.’ When young men can’t transition into formal-sector jobs, they sell drugs and drink and do drugs. And it wreaks havoc on family life. They think, ‘Hey, if I’m 23 and I don’t have a baby, there’s something wrong with me.’ They’re following the pattern of their fathers in terms of the timing of childbearing, but they don’t have the jobs to support it. So their families are falling apart—and often spectacularly.”

Wal Mart versus Whole Foods

In general I found Corby Kummer's column interesting. What was more interesting was how we behave when what we expect isn't what we want it to be:

... the tasters were surprised when the results were unblinded at the end of the meal and they learned that in a number of instances they had adamantly preferred Walmart produce. And they weren’t entirely happy.

Yet, I have to applaud Wal Mart's efforts - whether it is sustainable is yet to be determined.

... buying local food is often harder than buying organic. The obstacles for both small farm and big store are many: how much a relatively small farmer can grow and how reliably, given short growing seasons; how to charge a competitive price when the farmer’s expenses are so much higher than those of industrial farms; and how to get produce from farm to warehouse.

... To get more locally grown produce into grocery stores and restaurants, the partnership is centralizing and streamlining distribution for farms with limited growing seasons, limited production, and limited transportation resources.

Walmart says it wants to revive local economies and communities that lost out when agriculture became centralized in large states. (The heirloom varieties beloved by foodies lost out at the same time, but so far they’re not a focus of Walmart’s program.) This would be something like bringing the once-flourishing silk and wool trades back to my hometown of Rockville, Connecticut. It’s not something you expect from Walmart, which is better known for destroying local economies than for rebuilding them.

... Michelle Harvey, who is in charge of working with Walmart on agriculture programs at the local Environmental Defense Fund office, summarized a long conversation with me on the sustainability efforts she thinks the company is serious about: “It’s getting harder and harder to hate Walmart.”

Can technology help us adapt

To sex offenders living among us that is. Consider a bracelet or implant that will allow us to constantly track their whereabouts. Consider also a web site or iPhone app that will tell us their location at all times. Would this make us feel better about having sex offenders in our neighborhood?

Alas, most likely not. Personally, despite close monitoring my comfort level would be very low with kids in our household. If it were a neigborhood without kids then perhaps, yes.

... a better solution would be to establish housing in industrial areas—for instance, Young suggested that a major orange-juice company could hire sex offenders to pick its oranges on the condition that they live in corporate housing.

“A good law would be figuring out where they could live,” rather than where they can’t, said Rodstrom. “But no politician would ever do that, because that’s the death of your career.”

Saturday, May 8, 2010

What Paul Theroux thinks of Africa

He looks back on his time in the Peace Corps:

It would be easy, but misleading, to list all the things my students and their families didn't have. This is what celebrities do when they visit villages in Africa: Out of a guilty, grotesque, almost boasting self-consciousness, these wealthy visitors enumerate the insufficiencies. That's because they don't stay very long. If they stayed longer, perhaps a few years, they would see what I saw in Africa: the resiliency of the people. Africans knew neglect, drought, flood, bad harvests, hunger, disease, and—more insidious than any of these—tyrannical government; and yet in the face of these adversities they had developed survival skills, and prevailed. For more than forty years I've heard outsiders lamenting the plight of Africans—and, given AIDS and Darfur and Zimbabwe, sometimes justly; but I seldom hear, except from someone who has lived closely among them, how Africans, ignored by the world, have managed to save themselves, often in the bitterest of circumstances.

My teaching had its uses for them, but what I taught was negligible compared to what I learned. Yes, after two years my students spoke and wrote English well, and some of them went on to college. But today, despite forty years of volunteer efforts, Malawi is probably worse off than it was back in 1963.

... Like many people who have been affected by such an experience in a distant land, I did not come all the way home; nor did I leave that experience behind. It stayed in my mind, it informed my decisions, it made me strong. To all of this, there are people who will say, "What's the point?" But those are the same people who'll say what's the point of writing a poem, or learning a language, or going for a hike, or lingering on a wooded path to watch a bird flash onto a branch.

A look at Millennium Villages Project from Conde Nast

Amy Wilentz sounds a skeptical (?) tone:

Toya's villagers stand around in groups, watching as Sachs and his entourage inspect the community. A few hundred of the more than 5,000 people who live here have come to welcome us. The wind whips over the sand, luffing the men's robes like sails. A rice farmer tells Sachs that the yield is very low but that if they could just grow a windbreak of some kind, they could have mangoes, bananas, dates, and oranges. The Millennium Villages Project is hoping to double or triple the rice harvest with new rice seeds and fertilizer that are better adapted to the local climate. The windbreak, too, sounds like a good idea to Sachs and his entourage. Under a beating sun, he tells a circle of village elders that he wants them to start nurseries and fisheries. To me, it seems as if he must be hallucinating: fruit trees and fish? All around us is sand and wind. I ask a woman standing outside the circle what she thinks of Sachs.

"I've heard of him," Aïssata Amadou Maïga answers quietly. "He came to help us." A farmer who cultivates rice with her hands, the 45-year-old has five children, ages 30, 25, 14, 8, and 3.

"He came to bring us happiness," another villager adds. In other words, hopes are high—which is always dangerous, because high hopes must be fulfilled or anger and desperation can result.

... When Sachs gets up to speak ("President Jeff Sex," Toya's mayor announces), he has to explain the project to his listeners; a Malian translates the speech into Bambara, the nation's lingua franca. "I bring many partners who are interested in Toya," Sachs tells the silent crowd. "A movie star—you can see him on television, his name is Matt Damon." Around him the faces are blank. "The Secretary-General of the UN sends his good wishes." More blank faces: Damon and Ban Ki-moon, equally unknown quantities here. "And many international businesses want to help you," Sachs tells them. "A company called Sony, which makes computers, wants to give them to you." But what do they know of Sony or computers? He tells the crowd that there are "many exciting things we'll do together in the coming years." Among these he includes introducing new seed varieties, better irrigation, veterinary health care, fishing, a new ambulance, computers for the school, and even the development of tourism as a source of revenue. These are things the people understand better.

As President Sex continues, children on the sidelines sit in the sand near their mothers, and skinny-legged boys run with sticks and hoops. The sunlight plays across the lenses of Sachs's eyeglasses as he speaks from beneath the huge architecture of his turban. Jeffrey of Arabia, I think.

Some paragraphs that caught my eye:

When he deals with hardened power brokers and manipulative politicians, author Naomi Klein writes in The Shock Doctrine, Sachs often seems "like a Boy Scout who has stumbled into an episode of The Sopranos."

... The Millennium Villages may score impressive results during the five years in which they get funding. But after the quick fix, if the changes are not grafted onto the local culture, they may not endure. As Norman Rush writes in Mating, his novel about development in Africa, "If you know in your heart something is in essence or origin charity you act differently toward it than if it's utterly your own creation."

Thursday, May 6, 2010

What happened to the "As if" defence

This post which attacks utility maximization reminded me of the argument in defence of utility maximization models: While we do not actually believe that consumers equate their marginal rates of substitution across goods we think that they act as if they do. We certainly do not believe that compute their MRS as they are staring at the grocery store shelves.

The analogy that is usually made is that of a game of billiards or pool. The player certainly does not make momentum and angle computations as he is about to take a shot. The outcome of the shot is that he acts as though he does. Sometimes he makes mistakes. This is the flaw in the theory of utility maximization - it does not account for deviations or mistakes. Why does the consumer not maximize utility - is it the cost or complexity of the calculations. What situations is she most likely to make mistakes - consumer choice or career choice? What are the consequences of these deviations for social welfare.

Unfortunately, my reading of the evidence in favor of utility maximization is that it is weak. Empirical research does not focus on MRS directly but on the implications of utility maximization, i.e. demand curves and demand systems. Alternatives are tests of whether the Generalized Axiom of Revealed Preferences are violated.

P.S. What I find a little contradictory is that economists who have no problems with utility maximization and models of consumer behavior criticize representative agent models and DSGE in general. While I agree that the latter are not the best models, it is also the case that utility maximization may not be the best paradigm in economics.

Wednesday, May 5, 2010

Is there higher inflation for the future?

Econbrowser's analysis of the Fed balance sheet seems to indicate that inflation is going to be an outcome from having to unload all the assets that it has acquired in trying to flood the market with liquidity and subsequently aquiring equity stakes in the bailout. Slate sees a more benign outcome:

... As it guaranteed debt and swapped cash for all sorts of assets, the Fed's balance sheet grew—from about $850 billion in assets before the crisis to about $2.3 trillion this spring. ... Each week, the Fed's H.4.1. publication gives a snapshot of the Fed's balance sheet. Table 10 provides the headline number: $2.334 trillion on April 28, down $7.1 billion from the week before. ... as I [Daniel Gross] documented in a recent column, that's all on a glide path to going away. The closing of the sales of Alico and AIA will return $50 billion to the Fed, and the Maiden Lane vehicles are generating sufficient income to pay down the debt extended to them—and then some.

Meanwhile, many of the market and asset guarantees that the Fed put into place in '08 are expiring. At its peak, the commercial paper funding facility, which guaranteed short-term corporate debt, held more than $300 billion. Now its balance is down to zero. The Term Asset-backed Lending Facility, or TALF, which was started in late 2008 to revive the market for loans backed by assets like car loans and credit card receivables, is closing to new business in June. TALF's balance stands at $45.3 billion, down from more than $48 billion in March. Why? Some of the three- and five-year loans guaranteed by TALF have already been paid off. This balance should shrink to zero by 2013.

... The largest single item on the Fed's balance sheet is the $1.1 trillion in mortgage-backed securities it has acquired since the meltdown began. These are bonds issued by Fannie Mae and Freddie Mac and guaranteed by the U.S. government. The Fed has signaled that its buying campaign is over. And while the mortgages backing these bonds don't mature for 15 to 30 years, many of them will be disappearing from the Fed's balance sheet in the near future as people pay down, prepay, refinance, and sell homes. An informed analyst might presume that some $200 billion of that portfolio will mature or be paid down by the end of 2011. And as those bonds disappear, the Fed is not replacing them with new ones.

The bottom line? The Fed wants to get the junk off its balance sheet and return to a situation in which it has about $1 trillion in assets, the lion's share of them in the form of government bonds. To do so, it will need to rid itself of about $1.3 trillion in assets. That's a lot. But when you add up the components of the balance sheet that are shrinking, the task doesn't seem quite as daunting. By the end of 2011, by my rough calculations, at least $300 billion of the Fed's current assets will be gone with a substantial additional amount on the way out—and all without the Fed having to stage a huge sale of assets. The Fed will be left with a large portfolio of government-guaranteed mortgage-backed securities and the difficult chore of weaning the economy off its diet of rock-bottom interest rates.

Nouriel Roubini disagrees (not with Daniel Gross) - he still sees inflation as a problem not from the Fed's balance sheet but from public debt:

... we are seeing a massive "re-leveraging" of the public sector with budget deficits on the order of 10 per cent of GDP. The IMF and OECD are projecting that the stock of public debt in advanced economies is going to double and reach an average level of 100 per cent of GDP in the coming years.

... If you are a country like the US, the UK or Japan that can monetise its fiscal deficits, then you won't have a sovereign debt event but high inflation that erodes the value of public debt. Inflation is therefore basically a capital transfer from creditors and savers to borrowers and dissavers, essentially from the private sector to the government.

While the markets these days are worrying about Greece, it is only the tip of the iceberg, or the canary in the coal mine of a much broader range of fiscal crises. Today it is Greece. Tomorrow it will be Spain, Portugal, Ireland and Iceland. Sooner or later Japan and the US will be at the core of the problem, shaking the global economy.

We need to recognize that we are in the next stage of financial crisis. The coming issue is not private-sector liabilities, but public-sector liabilities.

Yet there are plenty of naysayers as well. For instance, Mike Kinsley reports:

Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict. Greg Mankiw, who was George W. Bush’s economic adviser, has examined the evidence in his New York Times column and concluded that a return of debilitating inflation is pretty unlikely (although “current monetary and fiscal policy is so far outside the bounds of historical norms” that who can say for sure?). Krugman has charged that inflation fearmongering is a nefarious Republican plot. The Congressional Budget Office (usually known by its nickname, “the nonpartisan Congressional Budget Office”) projects inflation rates of less than 2 percent for the next decade. Some say the real danger is the opposite: deflation, or prices (and wages) going down across the board.

Is this an example of the failure of economics or a failure to communicate? If Mankiw and Krugman can agree then there must be something to it.

Tuesday, May 4, 2010


Andrew Gelman wonders why "fancy" financial products use the word "tranche" rather than slice. I suspected the reason was historical - perhaps related to loan tranches by the IMF post Bretton Woods. Thus, I was surprised when a Google News Search using "loan" and "tranche" turned up entries as early as 1930 referring to the Dawes Plan which was an attempt by the Triple Entente (basically Great Britain, France and Russia) to collect war reparations from Germany.

The use of tranches for securities came later. The search for "security" and "tranche" gave results as early as 1980.

Future of things to come

The NYC bomb plot makes me wonder what the future holds for this country.

1. Is Mumbai style attack in preparation? It only took two snipers to hold the city under siege for days.
2. Will there be a future of IED or why isn't it here yet?
3. Is Greece a harbinger of the future for the US? Or will the US keep spending beyond its means and ignore the lessons from the PIGS?
4. Is the Belgian political crisis the future of US politics?

Saturday, May 1, 2010

Economic models redux

There is widespread agreement that economic and statistical models have failed us. (See some old posts here here, here, here, and here.) Some recent posts in the blogosphere continue to remind us of this but have not provided any alternatives. The main point that all model users fail to remember is that ALL MODELS ARE FALSE. It is when they decide to drink their own model elixir and to substitute models for reality that instead of living in the real world they begin to live in a dream like state. (If I could substitute my spouse for a model I'd probably live in a dream like state as well.)

First off, John Cassidy is absolutely correct:
To repeat myself, the problem wasn’t so much with the models themselves, but with how they were utilized. Rather than being used to discipline individual traders and trading desks, they were used to justify bigger and bigger speculative positions, and more and more leverage.

I take exception however to the tone of the article that blames model builders without considering the incentives. What incentive is there to tell a CEO or a trader that he should not do a trade even when the payoffs are huge because even though the model may be right, there is a small chance that it could be wrong?

Another recent post attacks utility maximization. I am sympathetic to to the idea that life is not all utility maximization. My more general attack on microeconomics here - in fact, the failure of contract theory, principal-agent models and pay for performace indicates a failure of the expected utility maximization. These models typically assume that utility is unbounded from below - yet as the blogger cites Carol Graham:

"People seem to be able to adapt to high levels of adversity, poor health and all kinds of things and retain their natural cheerfulness or their natural happiness…People really can adapt to adversity."

I would also indicate that Herbert Simon's concept of satisficing has been around a long time (and surprisingly did not make it into the bloggers comments) and for all purposes appear to be a possible alternative but has not made it into mainstream economics.

While there may be a case for starting anew, it is still possible to retain the EU framework which almost all economists love. Hyperbolic discounting is one that comes to mind. Moreover, it is also possible to re-cast Carol Graham's comment into a framework of binding budget constraints. And while it is easy to talk about models in lyrical terms or using analogies, the preferred language of economists is mathematics. Whether this is restraining economists is a debate for another post, i.e. are economists constrained by their tools (mathematics) or by their lack of imagination? For instance, economists (still?) struggle to put Nelson and Winter's evolutionary approach into mathematical models.

This point is brought recently to force by Rajiv Sethi's discussion on John Geanakoplos' Leverage Cycle. Rajiv blogs:

David at Deus Ex Macchiato agreed that the work is important, but added:

What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

I would add that it is one thing for Galbraith to articulate an idea but what is more important in PhD programs these days is not exploring ideas but model-building and sometimes putting ideas into models is easier said than done. One idea dating at least to Zarnowitz tha thas been challenging is that every boom sows the seeds for its eventual bust. It is possible that economists have not been re-reading popular works as much as they should (after all these are frowned upon since they should be building models or extending DSGE models) and Rajiv agrees:

Implicit in David's question is the accusation that the training of professional economists has become too narrow, and on this point I believe that he is absolutely correct.

Econbrowser's Jim Hamilton agrees that economists think too narrowly:

We're fond of building models of rational people reacting in a predictable way to the incentives they face; if their behavior changes, we look for an explanation in terms of changed incentives. It turned out to be in the fund managers' short-term interests to go with the more aggressive strategy, with disastrous longer-run consequences. Was the manager rational before 2006 and irrational after 2006, or did the incentives fundamentally change?

One of the explanations I sometimes hear is a story about "search for yield," which appears to be a combination of the two interpretations, attributing some of the altered risk-taking strategy to the period of very low interest rates in the preceding years. If this indeed accounts for some of the changed behavior by lenders, it is a channel for the transmission of monetary policy to the economy that's left out of the Fed's standard models, and another reason to be cautious about overestimating the benefits that are practical to achieve from a stimulative monetary policy.

Finally, Sciencenews reminds us:

The “scientific method” of testing hypotheses by statistical analysis stands on a flimsy foundation. Statistical tests are supposed to guide scientists in judging whether an experimental result reflects some real effect or is merely a random fluke, but the standard methods mix mutually inconsistent philosophies and offer no meaningful basis for making such decisions. Even when performed correctly, statistical tests are widely misunderstood and frequently misinterpreted. As a result, countless conclusions in the scientific literature are erroneous, and tests of medical dangers or treatments are often contradictory and confusing.

Even randomized control trials should be viewed with skepticism:

Statistical problems also afflict the “gold standard” for medical research, the randomized, controlled clinical trials that test drugs for their ability to cure or their power to harm. Such trials assign patients at random to receive either the substance being tested or a placebo, typically a sugar pill; random selection supposedly guarantees that patients’ personal characteristics won’t bias the choice of who gets the actual treatment. But in practice, selection biases may still occur, Vance Berger and Sherri Weinstein noted in 2004 in ControlledClinical Trials. “Some of the benefits ascribed to randomization, for example that it eliminates all selection bias, can better be described as fantasy than reality,” they wrote.

Randomization also should ensure that unknown differences among individuals are mixed in roughly the same proportions in the groups being tested. But statistics do not guarantee an equal distribution any more than they prohibit 10 heads in a row when flipping a penny. With thousands of clinical trials in progress, some will not be well randomized.