This book serves as a counterweight to books that laud free markets and capitalism such as Thomas Friedman's Lexus and the Olive Tree (missed that one) and The Commanding Heights. There is very little to disagree with in the book and if the current financial crisis has not given pause to the virtues of free markets then this book might.
His main concern is that these books have rewritten history in such a manner that trumpets the successes of free markets without considering the evidence that countries such as England, Germany etc. engaged in heavy protection of its industries in order to become industrialized and thus rich. (His interpretation of history, that is.) His support of tarriffs is so unwavering that I wonder how he feels about Smoot-Hawley.
The major problem with this book is that it lacks any solid advice. Unlike the pro-free market books that dispense advice easily and freely - deregulate! privatize! - this book makes a more nuanced case for deregulation and free trade. This means that it is harder for a book that calls for a more balanced approach to give any practical advice.
Chang is a defender of infant industry protection using tariffs and government subsidies that are typically more "patient" then foreign capital or direct foreign investment. He believes that industrialization is the only way for any country to get rich by acquiring higher level skills which then feeds into a virtuous circle of higher education, skills, and high technology industries. This is a biased reading of the successes of the East Asian "miracle" countries. Malaysia has tried to develop a heavy-industry base using its automobile Proton. As far as I can tell it has not been very successful even though it has been more than 20 years in existence. Perhaps its failure is due to it not being sufficiently export-oriented but in any case Chang does not give any attention to the industries that countries have tried to use import substitution but had to abandon them eventually because it became a drain on its budget.
Unfortunately, the weakness with any prescription that calls for industry targeting is: which industry? I have no problem with industry targeting nor with government targeting a wide array of industries but there are no guarantees of success nor that the benefits of targeting and subsidies will exceed the costs.
There is no disagreement with me on the fact that calls for free trade is based more on ideology than evidence. However his references to the "unholy trinity of IMF, WB and WTO" is sometimes a little rankling - no doubt this is intended but the IMF has learned some lessons from the Asian financial crisis and the failure of Doha has actually been considered positive by economists such as Dani Rodrik. If the IMF and WB are guilty of anything it is that they respond too favorably to "trends" and "fads": education, corruption, privatization, liberalization without much apparent consideration of other factors of the country.
Likewise, his accusation that deregulation results in corruption e.g. Russia, is true there is also some evidence that regulations also promote corruption. It is true that in some cases corruption greases the wheels of capitalism (as he notes) but isn't the existence of corruption in these cases prima facie evidence for less regulation?
While "getting the balance right" which is a subtitle in one of the chapters is easy to say putting it into practice is a lot harder and dispensing this little statement as advice borders on flip. As such, I view Dani Rodrik et. al's attempts to put growth into practical terms using diagnostics of binding constraints as being a little ahead of its time. See here for some implementations as well.
Finally, the cheer of free markets have been dampened somewhat by the following books (including this one):
1. Charlton and Stiglitz's Fair Trade, Stiglitz's Globalization and its Discontents - criticism of free trade and globalization.
2. Jaffee and Lerner's Innovation and its Discontents which Chang cites which criticizes the patent system.
3. Michael Heller's Gridlock Economy which challenges that property rights is good for growth.
Saturday, January 31, 2009
Friday, January 30, 2009
Some new proposals on the future of financial regulation were on VoxEU:
1. Luigi Zingales calls for, among other things regulation of the CDS and CDO market.
2. Charles Wyplosz summarizes The ICMB-CEPR Geneva Report: “The Future of Financial Regulation”. Some excerpts:
You can’t make the system safe by making each bank safe
The current approach to systemic regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks, and other highly leveraged financial intermediaries, can behave in a way that collectively undermines the system.
As a result, risk is endogenous. Selling an asset when the price of risk increases, is a prudent response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing institutions to take yet further steps to rectify the situation. Responses of the banks to such pressures lead to generalised declines in asset prices, and enhanced correlations and volatility in asset markets.
Busts usually follow booms
Financial crashes do not occur randomly, but generally follow booms. Through a number of avenues, some regulatory, some not, often in the name of sophistication and modernity, the role of current market prices on behaviour has intensified.
These avenues include mark-to-market valuation of assets; regulatory approved market-based measures of risk, such as credit default swap spreads in internal credit models or price volatility in market risk models; and the increasing use of credit ratings, which tend to be correlated, directionally at least, with market prices.
In the up-phase of the economic cycle, price-based measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increases. Most financial institutions spontaneously respond by (i) expanding their balance sheets to take advantage of the fixed costs of banking franchises and regulation; (ii) trying to lower the cost of funding by using short-term funding from the money markets; and (iii) increasing leverage. Those that do not do so are seen as underutilising their equity and are punished by the stock markets.
When the boom ends, asset prices fall and short-term funding to institutions with impaired and uncertain assets or high leverage dries up. Forced sales of assets drives up their measured risk and, invariably, the boom turns to bust.
My previous thoughts were here, here, and here. I am surprised that none of the proposals address the fact that increased regulation produces incentives to avoid regulations such as SIVs and SPVs that invested in subprime backed securities. The prohibition of off-balance sheet investment vehicles should be one element of the new regulatory regime. This would lead to armies of lawyers and financial engineers trying to circumvent this prohibition. Further regulation to prohibit these lawyers and financial engineers from trying to circumvent this problem should then be introduced which would then lead to ... well, you get the idea.
Part of Brad Setser's post on capital inflows mentions this:
I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system. ... It was a largely unregulated system. And it was largely offshore, at least legally. SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing.
My notes on CDS and CDOs are here and the use of VAR numbers to reduce aggregate risk are here. Trying to manage macroeconomic risks using individual bank VARs is essentially the same as trying to safeguard individual banks. It doesn't really work well.
1. Luigi Zingales calls for, among other things regulation of the CDS and CDO market.
2. Charles Wyplosz summarizes The ICMB-CEPR Geneva Report: “The Future of Financial Regulation”. Some excerpts:
You can’t make the system safe by making each bank safe
The current approach to systemic regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. This sounds like a truism, but in practice it represents a fallacy of composition. In trying to make themselves safer, banks, and other highly leveraged financial intermediaries, can behave in a way that collectively undermines the system.
As a result, risk is endogenous. Selling an asset when the price of risk increases, is a prudent response from the perspective of an individual bank. But if many banks act in this way, the asset price will collapse, forcing institutions to take yet further steps to rectify the situation. Responses of the banks to such pressures lead to generalised declines in asset prices, and enhanced correlations and volatility in asset markets.
Busts usually follow booms
Financial crashes do not occur randomly, but generally follow booms. Through a number of avenues, some regulatory, some not, often in the name of sophistication and modernity, the role of current market prices on behaviour has intensified.
These avenues include mark-to-market valuation of assets; regulatory approved market-based measures of risk, such as credit default swap spreads in internal credit models or price volatility in market risk models; and the increasing use of credit ratings, which tend to be correlated, directionally at least, with market prices.
In the up-phase of the economic cycle, price-based measures of asset values rise, price-based measures of risk fall and competition to grow bank profits increases. Most financial institutions spontaneously respond by (i) expanding their balance sheets to take advantage of the fixed costs of banking franchises and regulation; (ii) trying to lower the cost of funding by using short-term funding from the money markets; and (iii) increasing leverage. Those that do not do so are seen as underutilising their equity and are punished by the stock markets.
When the boom ends, asset prices fall and short-term funding to institutions with impaired and uncertain assets or high leverage dries up. Forced sales of assets drives up their measured risk and, invariably, the boom turns to bust.
My previous thoughts were here, here, and here. I am surprised that none of the proposals address the fact that increased regulation produces incentives to avoid regulations such as SIVs and SPVs that invested in subprime backed securities. The prohibition of off-balance sheet investment vehicles should be one element of the new regulatory regime. This would lead to armies of lawyers and financial engineers trying to circumvent this prohibition. Further regulation to prohibit these lawyers and financial engineers from trying to circumvent this problem should then be introduced which would then lead to ... well, you get the idea.
Part of Brad Setser's post on capital inflows mentions this:
I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system. ... It was a largely unregulated system. And it was largely offshore, at least legally. SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing.
My notes on CDS and CDOs are here and the use of VAR numbers to reduce aggregate risk are here. Trying to manage macroeconomic risks using individual bank VARs is essentially the same as trying to safeguard individual banks. It doesn't really work well.
Why neuroeconomics is not yet a science
Jeff Goldberg undergoes an fMRI which reminds me as to why neuroeconomics has been overselling itself:
Bin Laden, I was pleased to learn, stimulated predictably negative brain activity, but the neuroscientists were flummoxed by my reaction to the sight of Ahmadinejad, who apparently stimulated, in a most dramatic way, my ventral striatum. “Reward!” Iacoboni said. “You’ll have to explain this one.”
When I couldn’t, Joshua Freedman, who is a practicing psychiatrist, offered a possible explanation: “Perhaps you believe that the Israelis or the Americans have the situation under control and so you’re anticipating the day that he’s brought down.” He asked me some questions about my view of Jewish history, and then said: “You seem to believe that the Jewish people endure, that people who try to hurt the Jewish people ultimately fail. Therefore, you derive pleasure from believing that Ahmadinejad will also eventually fail. It’s very similar to the experiment with the monkey and the grape. It’s been shown that the monkey feels maximal reward not when he eats the grape but at the moment he’s sure it’s in his possession, ready to eat. That could explain your response to Ahmadinejad.”
He paused. “Or it means that you’re a Shiite.”
Andrew Gelman addresses the problems of multi comparisons and the overhyped "voodoo" correlations of neuroscience in the press.
It's hard for me to believe that the approach based on separate analyses of voxels and p-values, is really the best way to go. The null hypothesis of zero correlations isn't so interesting. What's really of interest is the pattern of where the differences are in the brain. ...
I think the way forward will be to go beyond correlations and the horrible multiple-comparisons framework, which causes so much confusion. Vul et al. and Lieberman et al. both point out that classical multiple comparisons adjustments do not eliminate the systematic overstatement of correlations.
Bin Laden, I was pleased to learn, stimulated predictably negative brain activity, but the neuroscientists were flummoxed by my reaction to the sight of Ahmadinejad, who apparently stimulated, in a most dramatic way, my ventral striatum. “Reward!” Iacoboni said. “You’ll have to explain this one.”
When I couldn’t, Joshua Freedman, who is a practicing psychiatrist, offered a possible explanation: “Perhaps you believe that the Israelis or the Americans have the situation under control and so you’re anticipating the day that he’s brought down.” He asked me some questions about my view of Jewish history, and then said: “You seem to believe that the Jewish people endure, that people who try to hurt the Jewish people ultimately fail. Therefore, you derive pleasure from believing that Ahmadinejad will also eventually fail. It’s very similar to the experiment with the monkey and the grape. It’s been shown that the monkey feels maximal reward not when he eats the grape but at the moment he’s sure it’s in his possession, ready to eat. That could explain your response to Ahmadinejad.”
He paused. “Or it means that you’re a Shiite.”
Andrew Gelman addresses the problems of multi comparisons and the overhyped "voodoo" correlations of neuroscience in the press.
It's hard for me to believe that the approach based on separate analyses of voxels and p-values, is really the best way to go. The null hypothesis of zero correlations isn't so interesting. What's really of interest is the pattern of where the differences are in the brain. ...
I think the way forward will be to go beyond correlations and the horrible multiple-comparisons framework, which causes so much confusion. Vul et al. and Lieberman et al. both point out that classical multiple comparisons adjustments do not eliminate the systematic overstatement of correlations.
Thursday, January 29, 2009
My CFL died and I'm about to poison the earth
After about a year one of our compact fluorescent bulbs stopped working - emitting a foul odor as it fizzled and died. I've placed it into a non-recycleable (at least in our county) plastic container and am thinking of giving it a decent burial. I will mourn its passing since it died well short of its expected life span.
Unfortunately, burial is not an option since it contains mercury. I guess I'll try our local recycling and wasted center.
Unfortunately, burial is not an option since it contains mercury. I guess I'll try our local recycling and wasted center.
Wednesday, January 28, 2009
Crime and Section 8
The Atlantic article on crime and the spread of Section 8 vouchers to the suburbs which in turn also spreads crime was compelling though not entirely convincing. For those who believe that you can take the poor out of the crime ghettos but not the crime out of the poor ghettos this article provided the ammunition.
On a theoretical level the idea is that as more poor people with Section 8 vouchers move out of the inner city and as they begin locate closely to one another again they form a new pocket of crime. While one or two househoulds with a Section 8 voucher in a suburb may not result in an increase in crime, maybe ten or more households might be sufficient to increase crime because it is more likely that at least one or two households have a criminal past and are more likely to vicitimize one another and others in the new neighborhood. I actually have a strong prior on this though it is only theoretical.
This paper by Jeff Kling and Jens Ludwig ("Is Crime Contagious") uses data from MTO randomization/demonstration program finds results that I would characterize as mixed. I called MTO a demonstration program because the HUD site indicates this is what it was although the analysts who ran it call it a randomized trial. I hestitate to call this a randomized trial because if memory serves they had difficulty recruiting households to participate.
The authors conclude:
Our results are not consistent with the idea that contagion explains as much of the across neighborhood variation in violent crime rates as previous research suggests. We do not find any statistically significant evidence that MTO participants are arrested for violent crime more often in communities with higher violent crime rates. Our estimates enable us to rule out very large contagion effects, but not more modest associations. This general finding holds for our full sample of MTO youth and adults as well as for sub-groups defined by gender and age, and it also holds when we simultaneously instrument for neighborhood racial segregation or poverty rates.
I don't know how this translates into rising "local" crime rates that are more of interest to police in the Atlantic article. The article is concerned that crime rates rise in suburbs and the Kling and Ludwig do not test that crime rates rise in the neighborhoods in which the MTO participants move into. The definition of "neighborhood" is one difficulty althought it may be possible to test for the significance of whether MTO participants are arrested for violent crime more often in communitites with lower violent crime rates. It is possible that there was not enough variation in the data to perform this test.
On a theoretical level the idea is that as more poor people with Section 8 vouchers move out of the inner city and as they begin locate closely to one another again they form a new pocket of crime. While one or two househoulds with a Section 8 voucher in a suburb may not result in an increase in crime, maybe ten or more households might be sufficient to increase crime because it is more likely that at least one or two households have a criminal past and are more likely to vicitimize one another and others in the new neighborhood. I actually have a strong prior on this though it is only theoretical.
This paper by Jeff Kling and Jens Ludwig ("Is Crime Contagious") uses data from MTO randomization/demonstration program finds results that I would characterize as mixed. I called MTO a demonstration program because the HUD site indicates this is what it was although the analysts who ran it call it a randomized trial. I hestitate to call this a randomized trial because if memory serves they had difficulty recruiting households to participate.
The authors conclude:
Our results are not consistent with the idea that contagion explains as much of the across neighborhood variation in violent crime rates as previous research suggests. We do not find any statistically significant evidence that MTO participants are arrested for violent crime more often in communities with higher violent crime rates. Our estimates enable us to rule out very large contagion effects, but not more modest associations. This general finding holds for our full sample of MTO youth and adults as well as for sub-groups defined by gender and age, and it also holds when we simultaneously instrument for neighborhood racial segregation or poverty rates.
I don't know how this translates into rising "local" crime rates that are more of interest to police in the Atlantic article. The article is concerned that crime rates rise in suburbs and the Kling and Ludwig do not test that crime rates rise in the neighborhoods in which the MTO participants move into. The definition of "neighborhood" is one difficulty althought it may be possible to test for the significance of whether MTO participants are arrested for violent crime more often in communitites with lower violent crime rates. It is possible that there was not enough variation in the data to perform this test.
An alternative to nationalization
Ricardo Caballero has an alternative to nationalization which is for the government to act as an insurance against uncertainty:
... there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.
A little background:
There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely. (From Part I of the column)
(From Part 2)
... I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.
... Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events (Caballero and Krishnamurthy 2008b).
A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.
Of course real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.
I am uncertain whether the pricing of the insurance is possible given the uncertainty. I am still in favor of wholesale nationalization as a way to reduce uncertainty quickly. In Part I of his column he said:
Worsening the situation, until very recently, the policy response from the US Treasury exacerbated rather than dampened the uncertainty problem.
Early on in the crisis, there was a nagging feeling that policy was behind the curve; then came the “exemplary punishment” (of shareholders) policy of Secretary Paulson during the Bear Stearns intervention, which significantly dented the chance of a private capital solution to the problem; and finally, the most devastating blow came during the failure to support Lehman. The latter unleashed a very different kind of recession, where uncertainty ravaged all forms of explicit and implicit financial insurance markets.
In short, I am uncertain that the reduction of uncertainty by insuring against uncertainty will not in turn result in even more uncertainty due to implementation issues.
The strongest argument against nationalization comes from this report in WAPO:
Another danger is that by taking over a substantial portion of a bank's stock and wiping out the investment of the firm's other shareholders, the government could also precipitate a sell-off across the banking system as investors flee, fearing they could be next.
Which is why nationalization must quick and broad leaving only the smallest retail banks that are very clearly not impacted by the crisis independent. Of course, post nationalization is whole other subject matter. The end of capitalism perhaps.
Currently, it is unlikely that the US will take the lead in nationalization of the sector. Perhaps France or UK will be the leaders here.
Update: Tyler Cowen points out that nationalization might not be cheaper than a bail-out. If the sector suffers a loss whether we bail it out or take it over we still suffer the loss.
... there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.
A little background:
There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely. (From Part I of the column)
(From Part 2)
... I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.
... Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events (Caballero and Krishnamurthy 2008b).
A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.
Of course real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.
I am uncertain whether the pricing of the insurance is possible given the uncertainty. I am still in favor of wholesale nationalization as a way to reduce uncertainty quickly. In Part I of his column he said:
Worsening the situation, until very recently, the policy response from the US Treasury exacerbated rather than dampened the uncertainty problem.
Early on in the crisis, there was a nagging feeling that policy was behind the curve; then came the “exemplary punishment” (of shareholders) policy of Secretary Paulson during the Bear Stearns intervention, which significantly dented the chance of a private capital solution to the problem; and finally, the most devastating blow came during the failure to support Lehman. The latter unleashed a very different kind of recession, where uncertainty ravaged all forms of explicit and implicit financial insurance markets.
In short, I am uncertain that the reduction of uncertainty by insuring against uncertainty will not in turn result in even more uncertainty due to implementation issues.
The strongest argument against nationalization comes from this report in WAPO:
Another danger is that by taking over a substantial portion of a bank's stock and wiping out the investment of the firm's other shareholders, the government could also precipitate a sell-off across the banking system as investors flee, fearing they could be next.
Which is why nationalization must quick and broad leaving only the smallest retail banks that are very clearly not impacted by the crisis independent. Of course, post nationalization is whole other subject matter. The end of capitalism perhaps.
Currently, it is unlikely that the US will take the lead in nationalization of the sector. Perhaps France or UK will be the leaders here.
Update: Tyler Cowen points out that nationalization might not be cheaper than a bail-out. If the sector suffers a loss whether we bail it out or take it over we still suffer the loss.
Animal Spirits
The Animal Spirits Page has constructed this measure using unemployment rates. I like the approach but am not convinced that unemployent rates can tell us everything. Likewise I am also skeptical of yield curve approaches and here is where perhaps psychometrics or factor analysis might lend to more insights.
I was reminded of these when Mark Thoma linked to Bob Shiller's piece on consumer confidence. Like Mark I do not believe that confidence is the cause of business cycles but I believe that it is a propagation mechanism. Once the Fed failed to contain the collapse of Lehman and AIG it began to spillover into the real sector. Until then I believed (with no evidence whatsoever) that the subprime problem could have been limited to a small sector of the economy. Perhaps an DSGE model of this might be helpful.
I was reminded of these when Mark Thoma linked to Bob Shiller's piece on consumer confidence. Like Mark I do not believe that confidence is the cause of business cycles but I believe that it is a propagation mechanism. Once the Fed failed to contain the collapse of Lehman and AIG it began to spillover into the real sector. Until then I believed (with no evidence whatsoever) that the subprime problem could have been limited to a small sector of the economy. Perhaps an DSGE model of this might be helpful.
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