Danny Quah's Blog

I have to recommend -in the strongest way there is- Danny's blog. In particular this post about how Economics is a Martial Art. Danny Quah has been a sort of seal of quality in the MSc Economics at LSE in at least 10 years. He is not every other economist as he has been referenced in one of the most difficult text books one can find in the profession. Check the references in Hamilton's Time Series and you'll know what I'm trying to get across.

Danny is a world class economist, not because Tom Sargent was his PhD advisor, but because he can understand, comunicate and teach the most difficult topic, just as if he were talking about apples and oranges. I was lucky enough to be his student in both Macroeconomics and Time Series. I can only say that the amount, clarity and quality of the material presented is outstanding.

Moreover, while listening his lecture one can be able to grasp more than a few things, however, after doing some reading and serious studing of the material and listen the lecture recorded again, you can feel that you actually learned a lot, and I mean a lot. If any one knows about VAR and Error correction Form Time Series, probably will find it hard to believe that Danny taught those topics in less than two hours. By following the methodology I described above, he did it with outstanding quality and intuition. No, I'm not kidding, he can squizze intuition out of the VAR and Error Correction Form topics.

Finally I must say that I used to fear the Time Series analysis. Now I find it exciting.

Recent Readings II

I had to change the readings I planned. Now I'm reading for the second time Alan Greenspan's book along with the 2009 interviews of the Region (the Minneapolis Fed´s magazine). I have to say that the former Fed Chairman is not among my favorite policy economists. The book however, is quite enjoyable and has the narrative of very interesting moments in both the economic history of the U.S. and the personal development of Greenspan's thoughts.

There is one particular paragraph that has caught my attention. If you look at chapter 6 “The Fall of the Wall“, towards the end, you'd find the following: “Black markets, with their unregulated prices and open competition, seemingly replicate what goes on in a market economy. But only in part. They are not supported by te rule of law. There is no right to own and dispose property backed up by the enforcement power of the state. There are no laws of contract or bancruptcy, and no opportunity to take disputes to court resolution.“

While reading this paragraph, is hard not to think about countries with a weak power of the law. Particularly thinking of Mexico, it seems like the end of our Revolution War provided with weak institutions for the foundation of free markets. At present, Mexico fits -sadly- the paragraph above with ever larger black markets for all kinds pf goods and with citizens defenseless against monopolies, mobs and criminals. The bancruptcy part is an important one, as is presented in the top of the list of reasons why comercial banks lend so little and focus on making profits with charges for other uses of the payment system.

From the reading of the Rajan´s interview in the link above, another idea that would be worthy of exploring is the fact that fierce competition among banks in the U.S. caused instability in the system. This would be so because competition forces banks to look for alternative investments in order to keep up the profit rates they present to their shareholders. This is a partial view of course, the set up given by regulation is also to blame for reckless lending and investment, the idea however remains interesting. Mexico has had a less-than-competitive financial system that is endlessly "consolidating" for over a decade, and the claim that competition should be enhanced has been in the top of the priorities of the policy makers. Now, in light of Rajan's comments, should they still push for more competition accepting a tradeoff with stability? Further thinking is needed.

Recent Readings

I recently finished two books: Superfreakonomics and Freefall. Very different of course, but both have interesting things to say. About the Levitt and Dubner's the one chapter on global warming its very interesting. The book overall is better than the first one. At least is more relevant in its topics and less anecdotic.

The Stiglitz's Freefall has interesting thoughts on what went wrong in the U.S. before and during the crisis, but is rather repetitive. Each chapter goes on and on how bankers and policy makers abused taxpayers with the bailouts. On the bright-side however, it explains really well all the informational problems that financial markets have. And all pending regulations to overcome this informational issues. In particular the chapter on reforming economics is interesting as a summary of how the macro science developed in the last thirty years and places over the table that frictions in financial markets should play a central role in modelling.

Superfreakonomics relies on the modern techniques of econometrics for empirical micro. I must say that even though there are updated references on the topic like the Angrist and Pishke's book causality issues are far from well developed as I see them. I'm no fan of econometrics anyway but at least economists are increasingly happy with the answers the counterfactual approach yields, that means that progress has been made (I'm not sure if current state of affairs is good enough).

If you read the Freefall book and you are interested in the new ways the macro should expand you will find valuable ideas. Just be patient while professor Stiglitz unload his fury on the "pure-market-believers". One thing I really dis-like about the book is its continuous reference to an unfair wealth redistribution from taxpayers to bankers. Is not that he is wrong. There was indeed a redistribution in the named direction. It is also true, however, that the U.S. economy has been living beyond its means. That is true for all economic activities and all income levels. My guess is that Raghuram Rajan's new book addresses the same topic from a more centered perspective.

It would be interesting to see if at some point in history taxpayers did not pick the tab after a banking crisis. I'm trying to learn about this in Reinhart and Rogoff's recent book. Mexico had its own episode of banking crisis in the second half of the 90's decade. And yes, taxpayers paid bankers' lack of care on credit allocation. Citizens lost their mortgaged homes. Credit card interest rates hit new historic ceilings. Long-story short, after fifteen years of the banking crash there is still outstanding debt issuance from the official entity on charge (IPAB). But just as true is the fact that there was no other way to fix the problem.

I'm a bit puzzled by the saying of Reinhart and Rogoff: the "This time is different" syndrome. Today Spanish banks are under pressure to get funds in international markets. This is a direct result from the fiscal deficit that Spain faces and the problems that Greece faced recently. Spanish banks are debtors of more than 50 per cent of Mexican savers. Whenever someone asks whether or not there will be problems for the Mexican subsidiaries the prompt answer is: this time is different. It may be so. In fact this banks may well manage to separate their business in each country they operate. The truth is nobody knows because there is no acces to their (full) balance sheets.

After serious thinking I find that is not possible to continue learning macroeconomics without looking at the financial crisis. Not only the current one, but to have a comprehensive view of them. To complement Reinhart and Rogoff's reading I choose Roubini's about the economy at crisis, he was one of the few that saw the crisis coming.

Central Banks and Objectives

In the last fifteen years the role of monetary policy has converged to be a matter of rules. In particular, rules on inflation and this has the name of Inflation Targeting (IT). While successful in keeping inflation low through a clear mechanism that aims to control expectations, IT has been blamed to cause an excess of liquidity in the world. I think criticism overstates the weaknesses of IT. In particular let me discuss the mindset rather than the IT per se that drives the criticism. A disclaimer is in order, I think IT has its days counted as the sole objective of a Central Bank. This however, does not make its achievements irrelevant.

The mindset of the critics bluntly blames IT for an excess of liquidity before and during the current financial crisis. They forgo in the process that inflation is at least as painful as unemployment. In their mindset they still have a negative-sloped-Phillips-Curve. Moreover, they disregard any important role of expectations (and thus the vertical-Phillips-Curve). There are many opinions around this subject and the consensus of the forward-looking Phillips Curve is facing a real challenge.

Behind any criticism is the underlying notion of a non-taken path that would have yielded a better outcome. Interestingly this is just an assumption. Is there any guarantee whatsoever that taking the non-IT path back in early 90's would have delivered a lower unemployment rate and avoided the financial crisis? I think the best answer is: we will never know. Counterfactual outcomes (the path non-taken) are as fictitious as any army that Quijote fought. They are based in a number of assumptions. Many of this assumptions are based, in turn, in the path taken, thus violating the counterfactual nature.

It is my believe that economist should take more seriously the optimality principle: any policy decision made today must be optimal taken as given the state of affairs. To argue that the non-taken path was better and flawless hardly helps a better understanding of reality. Furthermore, our training as economists has not helped us to acknowledge that some policies are inherently finitely lived. That is, maybe IT's was the best policy to follow and now is not. That does not mean that we were wrong all along in following IT prescription.

This is not to say that history should be neglected. If a policy yields bad results it should be replaced, but, at the same time, it should be evaluated against itself and according to its reality.

Having said this, I think that IT contributed to a low inflation level that is remarkable. Sadly it is not enough to help the economy grow. Central Banks should put a lot more attention to developments in financial markets. In particular, market concentration and excessive trading should be closely observed and corrected. By excessive trading I mean a large number of intermediaries in the financial market. It is clear now that there are at least two ways to make money in the financial market 1) the traditional one where resources are lent to profitable investments and gains are shared by investors. 2) By intermediating. This second form has been criticized for not creating wealth, but only redistribute it.

This is part true. Think of a corn producer. In order to put the corn in the hands of the final consumer, the producer has to go in to the city and spend valuable time selling the corn. If there exist an intermediary who can work full time selling corn there are gains for the three individuals (producer, intermediary and final consumer). What happens if I add a fourth individual, a second intermediary? If this individual is identical (in its functions) to the other intermediary then profits for the producer go up along with consumer surplus, and the identica intermediaries see how their profits go down. Now, further assume that the second intermediary is not identical to the other, but he is between the latter and the final consumer, now profits of the producer and consumer surplus are lower. What is going on is a redistribution of wealth from consumers and producer to intermediaries.

This is a key question financial markets cant regulate by themselves. The number of heterogenous traders (intermediaries) grows ever larger, diminishing savings returns and available funding for investment. Here lies an important role for the central bank as the vigilant of the well functioning of the payment system. This kind of objective should be added to IT. And if it represents a conflict with it, society preferences should decide which is more important.

Young's Tyranny of Numbers

I have always thought that an important part of the explanation of rapid growth of the so called Asian Tigers (Hong Kong, Singapore, South Korea and Taiwan) was productivity. Turns out that is not necessarily the case. LSE's professor Alwyn Young has this famous paper "The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience". Young's estimates of productivity -a key feature of economic growth according to the neoclassical model- for these Asian countries is not particularly different from countries such as Mexico, Brazil or Canada.

The paper argues for a different reason why economic growth boomed in the region. A -sort of- one time shock of education, participation and investment. It seems that underlying fast growth is the laggard progress they had before World War II. So its not that they are particularly good at something. Nor it is that they are productive workers. Not even that real wages are low. These economies grew because they were far away from the needed level of capital human, investment and participation. Once they achieve these levels, employment along with exports pulled these economies.

When policy recomendations for countries like Mexico point to follow the Asian Tigers, the only thing there is to follow is the improvement of investment, participation and human capital levels, not necesarily the productivity indicators. Productivity should push prices down, but it takes more than that to increase aggregate output.

Mexican Senate organized a forum to recollect the opinion of experts to increase productivity and competition. According to Young's argument, competition should be addressed as a priority, including the increase in investment - GDP ratio. Taking official series at constant prices, the ratio's growth rate has lately fall to negative levels in Mexico. This should be a policy lesson.

Lucas talks on the Critics of the Economics Profession

Robert Lucas from University of Chicago has a strong argument published in The Economist against those dooming modern macroeconomic models. It is worth reading.

A few thoughts from Animal Spirits

After completing the Animal Spirits book I have a few thoughts that I think deserve some discussion. I sustain that the book does not provide a way to model the Animal Spirits as defined by the authors. It does provide a list of topics and questions that macro guys should address soon if it wants to contribute to decisions among policy makers.

There are some interesting examples of how generalization in markets analysis may not be the right path to think of their behavior. The book includes an interesting and revealing example from Keynes. It goes like this: Assume there is a beauty contest where judges are rewarded if they price contestants as the majority of judges does. With this simple assumption, it is farly straight to conclude that every judge chooses what he thinks every other judge will choose -maybe- instead of his true first preference. The latter illustrates perfectly how the stock market works.

I agree with a statement of Akerlof and Shiller: it is hard to believe that every single day there is an explanation for the recent stock market movements. I think that being a stock market columnist must require a vast stock of creativity, specially in days of many fluctuations.

Another example of "special" markets is a common one in Mexico. Physicians are rarely choose from the yellow pages. They get most of their patients because a satisfied patient recommends his services. Literature books are read not only because of their publicity, but because of some recommendation. So these two markets -physicians and books'- have in common that information is a strong determinant in decisions. This is not new, what is interesting is that prices may not reflect all information there is needed to make a "good choice".

The utility provided by a book -or a physician- can be explained by tastes, but the great supply makes it necessary to ask for a recommendation before making a transaction. So stock markets -books and physicians- may need a different framework to be analyzed.

Another part of the reading that kept me thinking is the efficiency wages theory and its implications in rigidities, it is indeed natural to conclude that this theory explains reality of rich countries. In poor countries the same effect of costly layoffs can be largely explained by unions.

There is another reality that can not be drawn out of the analysis: that is the skills and fairness issues in the problem of determining wages. The latter is very important in recent tax design literature, and create a major problem arguing in favor of the non-negative slope Phillips curve.

We economist must always have in mind the important difference between normative and positive economics. The former must be the target, but the latter is our reality and must be understood too. If economist can diagnose what is wrong -using normative economics- we should also know how to deal with actual problems -with positive economics.

The book tries to take away the profession from a normative to a positive fashion, but both are essential, Skidelsky goes even further asking for a change in universities' economics programs adding a philosophical background and letting math aside.