Tuesday, 17 September 2013

The Economic Crisis Within

On a visit to the London School of Economics in 2008, the Queen asked a simple question to all the economists gathered there; why did no one see the crisis coming? This question reflected a widely held view that economics as a subject had something to answer for. For a proportion of economists (and their models), the crisis struck out of a cloudless sky in a world that had grown to believe that such events were a thing of the past; that modern economics had finally rid the world of “boom and bust”, that we would never witness anything like the Great Depression ever again.

This complacency was borne out of models that were created without including the possibility of endogenous crises or for only including crisis that attributed purely to exogenous, unidentifiable shocks. The failure of these economics models and in particular in the under-pricing of risk was central to collapse of global financial system in 2007. These models have continued to under-perform post-crisis, consistently predicting strong and swift recoveries. The last five years have seen growth forecasts consistently revised and downgraded in-fact in line with current forecasts the EU will be almost 8% smaller in 2015 than was forecast just two years ago.

A central reason for the recent failures has been the misunderstanding of the two forms of response to the crisis widely used in the developed economies. The immediate response to the collapse of credit was for Central Banks around the world to flood money markets with liquidity, formally known as Quantitative easing (QE).  The effect of this policy was heavily diluted by the banking system thirsty for liquidity and eager to repair their own balance sheets before exposing themselves to more risk in such volatile conditions. This prevented the increased availability to credit from trickling down to the wider real economy. Analysis of QE shows that much has been spent on bond purchases, seen as a relatively safe investment. QE has thus inflated bond prices, maintained gains in stock markets and boosted the profits of financial institutions, but achieved little for the real economy. Moreover as Central Bank balance sheets reach all-time highs (as of last week the Fed’s balance sheet had reached $3.7tn, compared with about $1tn before the recession), the effectiveness of monetary policy alone to stimulate demand and growth effects has continually been questioned. While further unconventional ideas could potentially have positive growth effects, such as negative interest rates and “helicopter money” policies such as Overt Monetary Financing, the discussion within policy circles of these alternative ideas only demonstrates further the failure that previous models and policy has served policymakers.

While monetary policy was entering uncharted territory, fiscal policy was moving sharply into the other direction with policymakers having seemingly ‘forgotten’ the lessons learnt in the 1930s. A key result of the financial crisis was the transfer of debt from the private to public balance sheets. Sovereign debt sky-rocketed, creating a desire for policy makers to reduce public spending in an attempt to bring total public debt back to pre-crisis levels. The effect of this contractionary fiscal policy was again vastly misinterpreted due to the gross underestimation of the fiscal multiplier, a topic this blog has previously discussed. In short cutting government spending was far more damaging than estimated.

Looking specifically at the modelling techniques used, the emphasis on individual rationality, underpinning these models generally is something which has been increasingly questioned due to advancements in the field of behavioral economics, which has suggested that the assumption of rationally is grossly wrong. An example of this is the basis of modern financial theory, the Efficient Market Hypothesis (EMH). The theory which was adopted on the basis of analytical and ideological reasons, states that it is impossible to "beat the market" as shares prices reflect all relevant information and are therefore ‘efficient’. However events have proved that EMH does has not accurately reflected human decision making, due to irrational human behaviors such as our compulsive nature and herd mentality. Therefore these models, which are presented as scientific and accurate, are in fact fundamentally flawed as they ignore the available empirical evidence.  Unbelievably there have even been calls of frustration from some economists that if only agents had acted in rationally, like in their models, then there would have been shallower and less destructive crisis or even no crisis at all!

Despite the financial crisis drawing attention to these short comings in the subject, there has been little or no movement to adjust the way economics is taught in academia, an increasingly important issue which has not been addressed at all. A central reason behind this is the influence of all those who have vested interests in the current setting who have reaped the rewards and thus are incentivised to prevent the subject progressing. Indeed those who received the highest quality in economics teaching were those often found to be those most responsible for the crash.  There has been some calls albeit small from students themselves for change in the way the subject is taught, with dozens of Harvard University undergraduates walking out of the school’s famous introductory economics course, Economics 10, pointing at its failure to prevent the financial crisis and that it offered nothing to narrow the gap between rich and poor. They have since called for a more diverse introductory course that includes exposure to more progressive economic frameworks. For the credibility and usefulness of the social science itself, let us hope more of those within economics begin questioning and demanding more of models and theory before applying them to decide crucial policy decisions.

By Andrew Whitehead and Thomas Viegas

Wednesday, 15 May 2013

The Field of Market Design: Its Advances, Uses and Importance (Wonkish)

The relatively new field of Market Design, which examines why markets and institutions fail while additionally considering the properties of alternative mechanisms, in terms of efficiency, fairness, incentives, and complexity[1], has seen increased research and development in the past decade. The topic, which uses economic theory, experiments, and empirical analysis to design market rules and institutions, has seen its importance grow significantly. This resulted in the Nobel Committee in 2012 awarding the leading contributor to the area, Alvin Roth, the Memorial Prize in Economic Sciences jointly with Lloyd Shapley "for the theory of stable allocations and the practice of market design”[2]. Roth has applied ‘Matching theory’ to a number of real life situations, these include; Medical labour markets, the public school systems in New York and Boston and the New England program for Kidney exchange. The latter application is the one which this paper shall focus on, describing the creation process and assessing both its recent and future success.

Matching is generally considered to be an integral part of markets and institutions. The ability to match one market participant to another smoothly, such as a willing buyer to a willing seller, is crucial to a well functioning market. This idea was explored by David Gale and Lloyd Shapley (hereafter GS) in a, now classic, 1962 paper “Collage Admission and the Stability of Marriage’. In this they proposed the ‘deferred acceptance algorithm’, which has contributed greatly to the advancement of ‘Matching theory’[3]. The problem constructed to explain the algorithm was a simple model of two-sided matching, the marriage of a man and a woman. GS proposed that their algorithm resulted in a “stable” matching, in which no man or woman is matched to an unacceptable mate and that no man and woman, who are not paired to each other, would both prefer to be. The process began with one set of agents making proposals in order of preference (men offering marriage proposals) to another set of agents, the receivers (women receiving the proposal).  Those agents that receive more than one proposal than accept the most preferred offer and reject the rest. However the acceptance is not immediate and deferred until the end of the algorithm. In the meantime, the process continues until there are no rejected agents who are able to make more proposals. It is only at this point that all proposals held are finally accepted resulting in a matching[4].

This insight by GS that there existed a process when preferences by agents are strict, there always exists for each side of the market a stable matching that is optimal for agents on each side was ground-breaking. By stable we mean a matching when no set of agents that can organise a matching among themselves that they all prefer and am matching is optimal when for a set of agents if there is no stable matching that all agents in the set prefer. Both properties are seen as extremely desirable within a market and consequently resulted in the application of the deferred acceptance algorithm in several ‘failed’ markets in which matching effectively is problematic. The algorithm has been built upon by Alvin Roth to great effect in both the market for matching new doctors to hospitals and the matching of children to public schools in Boston and New York.

It was first in a 2004 paper “Kidney Exchange” that Roth, along with Tayfun Sӧnmez and M. Utku Ünver, discussed the inefficiency of the existing kidney transplant system in the USA and proposed that a centralised exchange system, using matching theory, could be structured to facilitate the transplantation of many more kidneys than was already possible[5]. They paper emphasised the inefficiency of the current kidney transplant system claiming that ,using data from the United Network for Organ Sharing , there are over 55,000 patients on the waiting list for cadaver kidneys in the USA, of whom 15,000 had been waiting more than three years. Furthermore in 2002 there were over 8,000 transplants of cadaver kidneys performed; while about 3,400 patients died while on the waiting list, and another 900 became too ill to be eligible for transplantation. There were also over 6,000 transplants of kidneys from living donors in the same year, a number that has been increasing annually[6].

The figures they claimed highlighted the failure of the existing market in kidney exchange because of the substantial shortage in the supply of kidneys, relative to demand. Roth has described this characteristic of a market as a lack of thickness, which is a failure of a market to bring together an ample amount of potential buyers and sellers to produce satisfactory outcomes for both. He claimed that this was due to existing process of if a kidney patient brought forward a donor and testing revealed incompatibly between the two, then the donor was just sent home. No medical record of the donor was kept thus inhibiting the opportunity of a compatible patient receiving that kidney. Thickness along with safety (incentives for agents to reveal confidential information) and overcoming congestion (giving market participant enough time to make satisfactory choices if faced with a variety of alternatives) are the three criteria, Roth claims, which must exist in a market for it to function properly. Moreover when creating a market, all three must be adhered to in order for the market to be sustained over a period of time.

Roth, Sӧnmez and Unver noticed that in a small number of cases, there had been exchanges between two or more incompatible patient-donor pairs. One being a paired exchange, which involved two patient-donor couples for each of whom a transplant within the pair was infeasible but such that the patient in each couple could feasibly receive a transplant from the donor in the other couple. The other being an indirect exchange, this involved an exchange between one incompatible pair and the cadaver queue. In this exchange, the patient in the couple receives high priority on the queue in return for the donation of the pair’s donor’s kidney to someone else in the queue. Both exchange system were declared ethically acceptable and improved the welfare of couples involved.

In the 2004 paper, they built on these concepts and gave consideration into which type of exchange system would prove most efficient. Roth, Sӧnmez and Unver modeled patient-donors pairs as agents and gave them strict preferences over compatible kidneys and allowed exchanges among any number of agents. They excluded list exchange, as used in the “housing market” example of Shapley and Scarf (1974) from Gale’s method of Top Trading Cycles (TTC) which produced efficient, core allocations. They called this set of procedures top trading cycles and chains (TTCC) and identified a version which would be Pareto efficient and incentive compatible.

The distribution of the paper to numerous Kidney surgeons resulted in Roth et al. (2004) convening with Frank Delmonico, the medical director of the New England Organ Bank. The resulting discussion regarding the system proposed in the paper, led to the creation of the New England Program for Kidney Exchange (NEPKE) in 2004[7]. This united the fourteen kidney transplant centers, with regards to data and medical records, in the region to allow incompatible patient-donor pairs to find exchanges with other such pairs.

The discussion between Delmonico and Roth et al (2004) also allowed for some modifications of the original proposals presented in the latter’s paper. To solve one feature of the incentive problem and for other reasons, all surgeries were to be done simultaneously as to avoid complications if part of a patient-donor suddenly became unwilling[8]. A two way exchange between agents would involve four synchronized surgeries, a three way exchange would involve six and so on. Despite evidence suggesting that large exchanges would be infrequent, it posed difficulties to the program. Discussions with surgeons concluded that while two-way exchanges would be feasible, there would be constraints to a three-way exchange or more (due to the difficulty in performing six simultaneous or more surgeries). Therefore it was decided that the New England system’s matching software would initially only attempt to find two-way matches, while keeping record of any potential three-way exchanges the software found.

The extent, to which ‘Matching theory’ has improved the kidney transplant system, since the NPKE’s inauguration, has been huge. Since 2005, the number of Kidney Paired Donations has increased each year with 3 matches/7 transplants in 2006; 4/10 in 2007; 4/9 in 2008; 6/16 in 2009; and 5/12 through May 2010. This has in turn resulted in the number of transplant centers working with NEPKE increasing from 14 to 21 in 2010, with the NPKE running searches for matches every two weeks. Furthermore the success of the program has led to the consideration of a national kidney exchange clearinghouse by the United Network for Organ Sharing (UNOS)[9].

However Roth has stated there further challenges still remain to total kidney exchange, related to thickness, congestion and incentives. To address thickness, progress has been made with the passing of legislation in the US Senate in 2007 to remove potential legal obstacles to a national system. But expanding the market to allow compatible patient-donor pairs to exchange with each other would also help the thickness problem. With regards to congestion, the reduction in the time it takes for the testing of compatibility between patients and donors would aid massively. While the growth in co-operation between transplant centers has resulted in a new incentive issue. This being how the system should be organised to give centers’ incentive to always inform the central exchange of all incompatible patient-donor pairs.

Overall the use of ‘Matching theory’ by Alvin Roth has helped transform the kidney transplant system in the US, specifically New England, by addressing the main problem of a lack of thickness in the market prior to 2004. The designation of a system in which incompatible patient-donor pairs could interact with another pair and result in an efficient market transaction is one example of many, which have shown the growing importance of the field of Market Design, to both consumers and producers across a variety of market interactions.


[1] National Bureau of Economic Research (2013) NBER Working Group Descriptions: Market Design

[2] Nobelprize.org (2013) The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2012

[3] Roth, A.E. (2008) Deferred acceptance algorithms: history, theory, practice, and open questions: International Journal of Game Theory

[4] Gale, D. and L.S. Shapley (1962) “College Admissions and the Stability of Marriage” The American Mathematical Monthly, 69(1): 9-15.

[5] Roth, A.E. (2007) The Art of Designing Markets: Harvard Business Review, October: 118-126

[6] Roth, A.E. Sӧnmez, T. and Unver, M.U. (2004) Kidney Exchange: The Quarterly Journal of Economics, May 2005: 457-488

[7] Roth, A.E. (2007b) What have we learned from Market Design?: National Bureau Of Economic Research, Working Paper 13530

[8] Roth, A.E. Sӧnmez, T. and Unver, M.U. (2005) A Kidney Exchange Clearinghouse in New England: American Economic Association, May 2005: 376-380

[9] Al Roth's Game Theory, Experimental Economics, and Market Design Page (2013)

Friday, 26 April 2013

The changing face of the IMF

For decades the IMF has been synonymous with the failed policies of a neo-liberal agenda pushed upon developing countries. Set up with the mandate of fostering global growth and economic security successive interventions into crisis proved counterproductive notably in the 90s East Asia Crisis, for which they were widely criticised. The reason for the controversy is the fact that while the Fund does not require collateral for its loans, they are instead conditional on the imposition of policies that have proved exceedingly unpopular. These policies were aptly described by economist Jeffry Sachs as 'belt tightening to countries who are much too poor to own belts'. Further distrust of the Fund has been caused by the influence held by the US, who receives the greatest share of votes, with ‘Special Drawing Rights’ giving undue weight of voice to the larger economies.  As the fund seemingly moved further and further from its mandate, set out as part of the now extinct Breton-Woods system, questions over its legitimacy were raised, characterised by the former chief economist at the World Bank stating that while the Fund was set up to provide Keynesians reflations it was instead ‘reflecting the interests and ideology of the Western financial community.’

This time around things didn’t look like they would be any different. As the fall-out from the 2008 financial crisis took hold of Governments balance sheets the IMF was one of the first and strongest supporters of the austerity measures pushed forward by many governments in the developed world. In 2010, here in the UK, the Fund praised Chancellor George Osborn’s ‘essential’ deficit reduction plan describing it as ‘strong and credible’ and stating that the plan ‘supports a balanced recovery.” Words described by chief economics commentator at the Financial Times Martin Wolf as ‘a love letter’.

Since then however there has been a change of heart within the IMF, its growth forecasts for the UK have been consistently downgraded as the economy slipped back into recession in 2012 and has just narrowly escaped a ‘triple-dip’, according to the most recent figures. Early signs of this shift in consensus came in the October 2012 World Economic outlook which stated that austerity has caused far more damage than IMF experts had assumed. This was shown by the fact that countries implementing austerity underperformed their growth forecasts while those providing fiscal stimulus grew by more than the Fund had anticipated. As has been well documented this was due to the under-estimation of the multiplier effect. In certain situations, especially in downturns, the multiplier effect is high enough that cutting growth leads to a higher deficit because of the negative effect it has on growth. In a meeting last week between the IMF, World Bank and G20 the Funds managing director Christine Lagarde emphasised this new approach saying "We need growth, first and foremost" and stressing the dangers of overemphasizing deficit reduction with growth still fragile. The IMF's economic report called on both the United States and Britain to scale back there deficit reduction plans in the near-term, calling on both nations as well as Europe, China and Japan to adjust their policies in order to boost struggling global growth.

So as the IMF plans its up-coming visit to the UK its Chancellor may well be apprehensive, once among his strongest allies they now join those calling for plan B, their chief economist saying "it may be time to consider adjustment to the original fiscal plans" and warning that the UK was “playing with fire”.  With the IMF jumping the sinking ship austerities intellectual foundations were eroded further by a student in Massachusetts who discovered ‘miscalculation, data errors and unsupportable statistical techniques’ in a paper by two Harvard economists linking debt and growth rates that was previously praised by George Osborne as well as fellow fiscal conservative Paul Ryan.

With these recent events in mind it may be that austerity has reached the beginning of its end - ‘Austerity has reached its limit’ recently declared the European Commission President. However it is clear that the policy many fought so hard to implement will not go down without a fight, according to an aid of Mr.Osborne “If they recommend we loosen fiscal policy, we won’t do it. We think they are wrong.” However with UK unemployment and growth proving as stubborn as its Chancellor, pressure may grow to heed the Funds advice.    

Tuesday, 12 March 2013

(Central Bank) Independence Day

Stagnant growth, painfully high unemployment levels, depleted consumer confidence, substantial deleveraging and reduced investment by businesses are all documented effects that have lingered from The Great Recession and have been witnessed to varied degrees throughout the global economy. However there is one consequence of the financial crisis that is now only becoming apparent, this being the undermining of central bank independence. With fiscal consolidation being the dominant (albeit tremendously wrong) policy prescription of the day, greater onus has been put on central banks by their respective governments to revive growth and return to the path of prosperity. This has forced central bankers to become more innovative with regards to monetary policy creation and challenged the long established view of the importance of an independent central bank.

But let’s first look at how this independence came about and why it is was widely employed. Economies in the 1970s were characterised by a unique problem: contractions in growth coupled with increasing inflation. A problem, that according to Walter Phillips’ famous original analysis in a 1958 The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957’ , could not exist. The one country who managed to achieve relatively low inflation levels in this harsh economic environment was West Germany, where inflation averaged around 5% during the decade while comparably US inflation rate reached highs of 13% and averaged at around 7%.

Policy makers put the country’s success down to the fact that the Bundesbank was independent from the German government. This, coupled with the rise of Monetarism led by Milton Friedman, triggered a global movement in which countries increasingly adopted legislation to increase the independence of their monetary authority. The main argument put forward for independence is that a central bank would be free from political pressure and the numerous difficulties arising from the dual-mandate that a government had of sustaining high output (resulting in low unemployment levels) while also keep the price level relatively low and stable. It was shown by the use of game theory that with both policy goals, the government would have the incentive to ‘cheat’ the public into believing that the inflation would be a certain level and change it to increase their own pay-off . Thus by giving central bank independence and assigning them to oversee one of the policy goals, sustained output or low inflation, then their actions would be deemed credible by the public thus allowing policy to work effectively.

So what policy goal to give an independent central bank? Inflation or employment targeting? Well Friedman in his famous 1968 paper ‘The Role of Monetary Policy’ claimed that monetary policy could not successfully target employment as a criterion of policy , it could not peg real quantities but only nominal ones and that by following a steady course of action, a monetary authority could promote economic stability. Thus the prospect of unemployment levels being the mandate of monetary policy was ended and instead the rules-based inflation targeting became the economic norm. First initiated by the Reserve Bank of New Zealand in 1988 and now currently used by a number of central banks including those in  Australia, Brazil, Canada, India, South Africa and the United Kingdom.

However due mainly to The Great Recession, this established view is being fiercely challenged across the developed world. With interest rates at the zero-lower bound and no help (with regards to expenditure) from the state forthcoming, monetary policy is being pushed to its limits when trying to accommodate other goals than just price stability. For example in the US, the Federal Reserve is buying $85bn of bonds a month until the US jobs market sees a substantial improvement and plans to keep interest rates at close to zero at least until the US unemployment rate falls below 6.5%. While in the UK, incoming governor of the Bank of England, Mark Carney, has already sparked debate by suggesting that economic output could be targeted instead of inflation and it appears that Chancellor or the Exchequer, George Osborne, plans to grant Carney greater powers to revive growth in the Budget later this month.

The most vigorous attack on Central bank independence however is occurring in in the Land of the Rising Sun, Japan. Newly elected Prime Minster, Shinzo Abe, has pledged to use both fiscal and monetary expansion to stimulate growth and defeat the persistent deflationary problem the country has faced for years. When running for office, Abe said he would set a ‘policy accord’ with the Bank of Japan for a mandatory inflation target of 2%, backed by unlimited monetary stimulus. So far he has got he wish, under increasing political pressure the Bank of Japan changed its inflation target from 1 to 2% and nominated Haruhiko Kuroda, a fierce advocate of past BoJ policy, to be the next head of Japan's central bank. Kuroda has since promised aggressive steps to raise inflation to 2%, which has only reinforced the Yen’s continued rapid decline. Focus on this radical shift in policy has only increased with the Yen’s decline in value and the riskiness of this policy shift has already been discussed at great length. The Bundesbank President Jens Weidmann has claimed that the BoJ's independence is under threat and warned against government interference in monetary policy.

Some may ask so what? So what if the central bank is being forced under political pressure to focus on output and inflation too, surely that is a good thing? In some sense yes. There is a case that monetary policy should focus more on output, as unemployment is not just a problem that has economic consequences but also massive social implications as well (as is being seen in Spain and Greece). Furthermore there is the argument that greater flexibility and openness in monetary policy circles, along with greater debate into monetary tools and their effects can only be beneficial for the improvement of our knowledge on both central banking and monetary policy.

In other ways however caution must duly be applied. Greater burden on Central Banks for creating growth reduces the responsibility on governments. Especially on those already pursuing destructive austerity measures which have increasingly being proven to be doing much more economic and social harm than good. With most noticeably an article, written by IMF chief economist Olivier Blanchard and Daniel Leigh, stating that fiscal multipliers in the advanced economies are considerably larger than had been previously assumed and thus austerity is much more damaging to output in the near term than was anticipated. Furthermore the lack of effectiveness of monetary policy in certain economic times, such as the liquidity trap situation that most developed countries are currently in, means that greater responsibility on central banks will not necessarily lead to the desired outcome to revive growth. As John Maynard Keynes proclaimed to President Roosevelt, using monetary expansion to create growth is “like trying to get fat by buying a larger belt”.

One thing seems certain for the independence of central banks, it is being severely challenged. It remains to be seen whether the long-established central bankers will coordinate a counterattack to save central bank independence and policy as we know it.

Monday, 18 February 2013

What I Learnt From The Coin.

Last month saw Congress pass yet another measure to raise the debt ceiling, the latest measure delays the date the debt will reach its limit until May the 19th. This sets up another round of political wrangling and drawn out negotiations over deep cuts in social spending and defence. As the debt level approaches the level raised by Congress, Republicans will dig their heels in, holding both the US and global economy to ransom by using the threat of economic crisis as leverage in their quest to reduce Government spending and re-establish an America with a small state . On one hand President Obama has previously said he will refuse to play games with regards to the debt ceiling, however Republicans have stated in response that these negotiations are ‘necessary’ for the country. So as agonising as it is, the games will go on.

The reason that the debt ceiling puts the President in such a predicament is the confusing way in which power is divided between Congress and the President. Congress sets the budget, if this involves a shortfall of tax revenue relative to public expenditure, then the President is forced to borrow the difference. What makes this situation different from other countries is that Congress also has the power to limit the amount of debt the country can have. As this level approaches, they put pressure on the President to halt the levels of borrowing, created by their budgets. The President could stop borrowing past the amount Congress needs to implement its budget, but this would result in the Government spending money which it has not been financed. This would have dramatic consequences for the US and global economy, especially with regards to confidence in the dollar as a means of payment, which would be extremely dangerous for global stability and consequently has never been allowed to occur. This raises the question - for what reason does the Debt Ceiling actually exist? Part of the reason is that Congress benefits from creating a problem that only it can solve, allowing it to use the threat of economic destabilisation as leverage to fight against any changes in Government spending or taxation that it opposes.

As for the so called deficit hawks in Congress Obama may reason that they are not in fact deficit hawks at all. Many of the Republicans demanding that the Government deficit be reduced were supportive of the previous President quickly turning large surpluses into deficits with tax cuts to the wealthy and massive military outlay, which together, according to estimates from the Congressional Budget Office, account for a staggering $600 billion of the current deficit today. To put this in perspective according the Office’s estimates by 2019, if current policies are sustained, almost 50% of the total government debt will be accounted for by these two Republican policies. The economic downturn instigated by the burst of the housing bubble along with the failure of adequate recovery measures that attempted to fill the substantial hole in total spending left by the private sector, account for the majority of the current deficit. Clearly in principle therefore Republicans have no problem with sustained deficits. A more appropriate term for them would perhaps be Spending hawks or Welfare hawks, who use self-created deficits to demand the current President cut programs they deem to have no value, these being mainly welfare and health provision which the GOP have wrongly claimed are the main reason for the current deficit.

Because of these frustrations, discussion in some quarters has turned to how the President could get around the obstacles set before him by Congress. One idea was to use the constitution that protects US debt to simply ignore the deficit limit - wanting to avoid all the legal entanglements that this would involve Obama has refuted this option. Next was the infamous “trillion dollar coin” suggestion. Queue the right-wing comedy. ‘How about a twenty trillion dollar coin or even a 100 trillion dollar coin?’ was a common question amongst critics. Stephen Colbert provided probably the wittiest gag: "we should have known a coin was Obama's solution to everything - it was right there in his slogan: CHANGE”. Meanwhile news stations have kept themselves equally amused with clips Dr. Evil and Homer Simpson with a trillion dollar note.

Moving onto the serious discussion of the logistics of the plan Fox News reported that the amount of platinum needed would sink any boat used to transport it as it would weigh 17,774 tons or using their alternative unit of measurement - 89 blue whales! This clearly ignores the simple fact that there is no more reason for the coin to actually be worth one trillion dollars than the paper used to make a $20 note actually be worth $20. Meanwhile those who tried to sound more serious stated that the coin would create massive levels of inflation and destroy the value of the dollar, comparisons with the hyperinflation of Zimbabwe Dollars were especially popular. All this served to prove the point that those hired to inform the rest of us have little understanding of money creation or even basic economics. Economic theory states that in certain conditions, i.e. with depressed demand and interest rates unable to fall any lower, an increase in the money supply does not lead to inflation. Banks today create trillions of dollars by the simple act of lending, which has had very little inflationary effect, as evidenced by the rates of inflation in the US as well as other advanced nations with a highly developed banking industry. In fact in the UK, around 97% of the total money supply has been created by the financial sector and not the Bank of England.

Putting it simply, the creation of more money is not the alien concept it has been made to seem and is only inflationary under certain conditions. But even this misunderstands the central concept of the coin. The one trillion dollars credited to the treasury would be offset by selling assets or borrowing from banks so that borrowing would continue as normal. In other words this is just an accounting trick. This is not an economic solution to the debt in the longer term. Instead it is aimed to get around the political problem of the debt limit set by Congress. As the fiscal cliff showed us by claiming several points of GDP growth, political problems have economic consequences which explains the enthusiasm of some to avoid yet another messy and costly round of negotiations.

Therefore what has been revealed by this round of debt ceiling talks is that the majority of people influencing the debate in Washington either do not understand the concepts discussed or do not want to engage in serious debate about the role of money and debt in the economy. Perhaps before the next round of negotiations begins, this issue should be addressed.

Thursday, 7 February 2013

The European Integration Question: Economical or Political?

 Author: Thomas Viegas

With European nations struggling at present with the Sovereign Debt Crisis, which has engulfed the region, intense debate over the progress, desirability and future of both economic and political integration within the single market area has amplified. Originating in the aftermath of the Second World War, the creation of the European Coal and Steel Community (ECSC) in 1951 was declared by Robert Schuman, then French Foreign Minister, to be "a first step in the federation of Europe". Since then the Treaty of Rome, the Single European Act and the Maastricht Treaty have all contributed to furthering of economic and political integration between the nations of Europe. However the extensive economic problems that several countries in the Eurozone now face can only be solved with collective action and further integration. This has led to questioning whether it is possible to do this without deepening political integration within Europe as well. 

Economic integration is defined as “the elimination of economic frontiers between two or more economies’ with a frontier being any ‘differentiation over which actual and potential motilities of goods, services and production factors are relatively low”. Furthermore this type of integration refers to both market and economic policy integration, with the former however remaining the essence of economic integration. The fundamental motives for economic integration between economies are that, in theory, it will lead to increases in overall trade, actual or potential competition and growth rates within the integrated area. Moreover consumers in the area should experience lower prices, greater quality variation and choice as integration forces the allocation of resources to be more efficient.

Political integration has been defined as “the process whereby nations forego the desire and ability to conduct foreign and key domestic policies independently of each other, seeking instead to make joint decisions or to delegate the decision-making process to new central organs”. The keys features of this type of integration are its implications on sharing and delegating amongst member nations, the transfer of national sovereignty to pooled sovereignty and the creation of supranational institutions. Empirical studies have shown the consequences of increased integration include increases innovation and economic growth and the level of competition within both economic and political markets. There has been continual debate over whether political integration is a condition or a process and whether it has an ‘end point’, this is particularly important when considering the long term objectives the European ‘project’.

The current Crisis has exposed severe flaws in the economic integration process between Eurozone members, whilst also showing that political integration affects the optimality of the monetary union. The major flaw is the failure of a federal system in the zone to assist convergence in growth, as funds would be able to be allocated where they were needed in the case of asymmetric shocks (shocks to individual states). The crisis has resulted in the massive divergence of growth between ‘core’ states (Germany, France and Austria) and the ‘periphery’ (Spain, Portugal, Ireland and Greece). The argument for such a system uses the example of the US in which the federal budget redistributes income across regions, thus offsetting parts of the interregional differences in income.  

The cry for common bonds, or ‘Eurobonds’, to be issued has also been mentioned to allow troubled countries to borrow at a lower rate then they currently do from international markets. Not only would this consolidation of national budgets and debt would create a common fiscal authority which would protect member states from the prospect of defaulting, it would also be a very visible and constraining commitment that should ‘convince’ markets of the long term future of the union. In addition  the call for a ‘banking union’ between member states , to guarantee deposits of any individual in the zone, was strengthened when Ireland guaranteed all deposits for customers while others nations did not. In addition the necessity of a distinct eurozone budget has become apparent to allow the union to function much better because it would smooth the impact of asymmetric shocks too.

However these potential economic policies have encountered large political difficulties. The idea of a Federal system within Europe is one with extreme complications. The main one being that the policy would result in national governments surrendering the only available economic instrument left, Fiscal policy. Furthermore it would not only mean substantial changes in individual nation’s constitutions (assuming it would get past a referendum) but it would also have to be sold to the taxpayers of the zone that they would be financially assisting their ‘fellow European citizens’. At present these drawbacks appear unlikely to overcome due to upcoming national elections and the vocalness of citizens in core countries, which have already had to subsidise large bailout packages. The call for ‘Eurobonds’ has been met with strong resistance from nations, especially Germany, who enjoy negative real rates to borrow currently, who feel that this would increase the moral hazard risk. The risk being that, now with implicit insurance, members would issue too much debt.

Discussions over a joint ‘banking union’ have begun between the zone’s finance ministers but have already run into problems. The degree to which the ECB would have supervisory control has caused divisions, with Germany claiming that the supranational body should only monitor the 60 largest banks in the area while France believing  that the  Bank should be responsible for monitoring of all such institutions. The prospect of a distinct eurozone budget looks extremely bleak due to the inability of all EU members to agree on a collective budget for 2014-2020 and agreement looks increasingly unlikely. Moreover the current 2012 budget for the EU totals 0.98% of the regions Gross National Income and an effective budget for the eurozone would need to be considerably larger.

The drive for increased economic and political integration would involve the evolution of supranational institutions in the region. As mentioned before further economic integration would mean further powers being transferred to the European Central Bank, an organisation that was built to be completely independent from national governments. The loss of financial policy, already with the monetary type, to a body that is not accountable does not appear politically desirable. The prospect of the European Commission and Parliament to have greater influence in the management of regional policy is also small. Much debate already ensues over the usefulness of the Common Agricultural Policy (CAP) and with these institutions already heavily involved in competition, trade and industrial policy making; the giving up of more powers to Brussels would question the requirement of national governments.

The process of both economic and political integration between European economies has been largely interdependent and the deepening of the former type requires an increase in the latter. The economic situation that the continent was in after 1945 forced collective political action, which resulted in furthering economic ties between nations to improve prosperity in the region. The continuing removal of economic barriers between European economies led to successful economic growth in the latter half of the twentieth century, thus reinforcing the need for the former to induce the latter. The current Sovereign Debt Crisis however threatens the continuation of both types of integration. It has become obvious that the longevity of the integration process relies on furthering economic ties between economies but whether the political integration process has reached its ‘end point’ remains to be seen.

Tuesday, 11 December 2012

Iceland: Coming in from the cold

Authors: Andrew Whitehead and Thomas Viegas

In 2008 Iceland became the first country to be hit by the ugly aftermath of the global financial crisis; the now infamous sovereign debt crisis that has now engulfed the rest of Europe. In the now familiar story the years prior to this were characterised by the embracement of unfettered capitalism and financial liberalisation that lead the newly privatised Icelandic banking industry to grow to a monstrous 1000% of GDP, economic policy described by the Chief Economist at Citigroup as “collective madness”. Although, by no means alone in the pursuit of such policies, the relative size the banking industry to a country of only 300,000 people made it unique.    

When the crash did happen it was spectacular: the stock market plummeted 90%, unemployment shot up to an all-time high and inflation rose to 18%. All the ingredients for at best, a prolonged depression and at worst the complete collapse of the economy. The situation was so dire that around 2-3% of the population immediately fled the country! This remarkable implosion not only left their economy in tatters but also resulted in the country being widely mocked. In particular the SNP leader Alex Salmond was roundly sniggered at for his previous quote that an independent Scotland could join some small nations such as Iceland to form an “arc of prosperity”, while across the water with the Irish banking system collapsing the Irish media consoled themselves by joking “at least we’re not Iceland!”

However the mockery has now quickly receded. Employment levels in Iceland have fared far better than in many other European nations, even in the depths of the crisis unemployment never reached double figures while in Greece and Spain it remains above 20%. While their employment rate is the second highest in Europe, in the latest figures (78.5%) this compares favourably against economic powerhouses Germany (72.5%) and the UK (69.5%) and even more so when compared with other small nations hit by the crisis such as Latvia (61.5%) and Ireland (59.2%)

But how has Iceland fared so well despite such an economic catastrophe? The reason is part dumb-luck and part excellent management from the Icelandic Government and, for once, the International Monetary Fund (IMF). I say dumb luck because it is the very nature of the “collective madness” described earlier that makes Iceland such an excellent test of economic doctrine accepted (or forced) on the rest of us. Due to the huge magnitude of their banking crisis (the largest ever relative to GDP), they were forced to use unorthodox measures to save their economy. In the words of economist Paul Krugman “Iceland zigged when all the conventional wisdom was that it should zag”. The rest of the developed world has followed the path of huge bailouts, resulting in the shift of private debt to public balance sheets, and the slashing of public sector spending with the hope that this would restore the much needed confidence in markets to stimulate private sector spending.

These hugely unpopular policies were sold to the public on the basis that there was no other alternative. The case of Iceland however proves that this is not true. While everyone else rushed to give taxpayers money to the banks, Iceland let them fail. While the bankers at the heart of the crisis were protected and in some cases rewarded in the US and Europe, in Iceland they were jailed and while the rest of Europe embarked on a social spending slashing binge, Iceland expanded its social safety net.  At the time, the consequences of these unconventional policies were warned against by many economists, who predicted punishment from global credit markets leading to bankruptcy and economic Armageddon. This has not been the case. Compared to Ireland, which took full responsibility for its banks debt, both suffered similar drops in GDP (14 and 15% respectively from peak to trough) but credit default swaps in Iceland are now much lower than in Ireland, indicating increased confidence in the ability of the Icelandic government to service its debt. Furthermore this year has seen the Iceland successfully return to the international credit markets for the first time in five year.

A crucial part of the recovery was the relationship between the country’s government and the International Monetary Fund, who provided a $2.1 billion loan package. Just as Iceland’s economic catastrophe and road to recovery has been unique so has its co-operation with the IMF. While in the past the IMF has been severely criticised for its role in worsening crisis, most notably in Asia in the 90’s (in South Korea what we know as the “Asian Financial Crisis” they know as the “IMF crisis”), the IMF’s response in Iceland was different. They allowed the Government freedom to maintain fiscal control, altering spending and revenues how they saw fit. More surprisingly they allowed capital controls, a move normally regarded as heresy by the Fund’s free market priests. These capital controls, although controversial, prevented the collapse of the Icelandic currency as it prevented large amounts of funds leaving the country. The measures are still in place and are based not on time but on prevailing economic conditions (a lesson the US may which to observe as they approach their fiscal cliff). Another different approach used by the IMF was allowing the maintenance and even strengthening of the Icelandic welfare system. They allowed automatic stabilisers to do their job in protecting the citizens of the country from the depths of the crisis, as inflation rose and wages fell, delaying fiscal adjustment for a more stable time. A key factor in this economic salvation was the helping out of heavily indebted households, a policy recently recommended to the US by the former chair of the Federal Deposit Insurance Corporation. This freed up consumers to spend their money on other things, no surprise then that domestic demand has been a powerful aspect in the recovery. The extension of social security resulted in inequality actually falling during the crisis as the bond and shareholders as well as foreign creditors bore the brunt of the fallout from the banking collapse.

So although Iceland did experience severe economic damage and a substantial drop in living standards, the effects on its people were contained and the economy has been able to launch its own moderate recovery.  Although comparisons between a small island of 300,000 people and large dynamic economies such as the UK may seem far-fetched it is clear lessons can be learnt from the country that ‘zigged’. The case has clearly taught the IMF a lesson, explicitly shown in the recent conference set up by the fund “Iceland’s Recovery: Lessons and Challenges” in the countries capital Reykjavik. One such noteworthy lesson , outlined by the Funds managing director, is the importance of a wide range of tools for dealing with the crisis, even if such tools go against what is being practiced elsewhere. Another is the importance of the role of the welfare system in any economy’s recovery. It has long been an accepted view that more equal societies perform better on a variety of social indicators from crime to mental health but it has been extensively believed that a trade-off exists between equity and growth. But this conception is being gradually eroded and recent research undertaken by the IMF has shown that countries grow faster and more consistently when income is shared more equally. This coupled with their recent paper stepping away from the use of austerity shows a clear change of direction for the IMF, one that will hopefully see them become an increasing effective in achieving their main goal: the safeguarding of the global economy.

The message to take from Iceland’s experience is that contrary to what the majority of policy makers keep preaching to the public about austerity being the only way forward, there is a clear and credible alternative. While Iceland’s road to recovery will not necessarily be repeated to the same extent in other economies, due to the uniqueness of its crisis, its stance on several key policy decisions can be adhered to. Iceland’s policies centred on protecting its people, assisting indebted households and holding those responsible for the crisis to account and this has rescued its country from economic disaster. Hopefully Europe’s leaders will sit up and take notice of what has been achieved in the country that zigged as currently zagging has not only resulted in increased social unrests but also shows no clear signs of short to medium term improvement in growth.