IPE at UNC

It's Earnings Season!

2009-07-14T20:10:00.005-04:00

Goldman Sachs, the investment bank, today announced that its second quarter earnings rose to $3.44 billion, and that it had put aside $11.4 billion for salaries, bonuses and benefits in the quarter, up by nearly half from a year ago.

At that rate, Goldman employees could, on average, earn roughly $770,000 apiece this year — or nearly what they did at the height of the boom.

Senior Goldman executives and bankers would be paid considerably more. Only three years ago, Goldman paid more than 50 employees more than $20 million apiece. In 2007, its chief executive, Lloyd C. Blankfein, collected one of the biggest bonuses in corporate history -- nearly $70 million. The latest headline results — $3.44 billion in profits — were powered by earnings from the bank’s secretive trading operations and exceeded even the most optimistic predictions.

Many analysts were surprised that Goldman posted such hefty prospects, especially since it was only last month that Goldman repaid the $10 billion that it received from the U.S. Treasury Department in October. Although it is widely believed that Goldman was required to take the funds, even though they probably didn't need the extra capital.

Megan McArdle comments on why these profits shouldn't have come as such a surprise:

This is not actually hugely surprising, given that three of their biggest competitors went out of business or were acquired in the last year; as financial markets unfroze, Goldman, which had one of the cleanest balance sheets, was bound to see a hefty increase in their profits.

Goldman's stock price has also rebounded nicely, up about 77% since the beginning of the year. (Dammit, should've bought it!) It also turns out that by paying back the TARP monies last month, Goldman also freed itself from any government interference into their compensation practices, thus allowing Goldman to freely pay its employees these nice little bonuses.

Many are up in arms about paying these people so much money, even if they did as well as it seems they did this past quarter; McArdle addresses a bit of this in her post. But what are we supposed to do? Have the government intervene again, this time to cap pay inside a private corporation that made record profits, just because they made record profits while the rest of the economy is still tanking and unemployment is about to cross 10%?

I don't think that'd be a good idea; we already set a pretty bad precedent by bailing out the banks in the first place, even though it was probably needed to restore market confidence and recapitalize institutions that were in trouble. Further meddling, especially into the compensation practices of a financial firm not under government ownership, would be setting another bad precedent.

Thomas Schelling on Climate Change

2009-07-14T17:29:00.003-04:00

Conor Clarke interviews the old master of game theory and Nobel Prize winner. Part one here. Part two here. Some excerpts:

I think they ought to drop the idea that there are going to be enforceable commitments. There have never been enforceable commitments on anything of that magnitude. And I think they should try to negotiate not what emissions level they will seek in 20 or 50 years, but what they will actually DO. And when they've arrive at what looks like an understanding they hold a big conference and publicize it. If they can't quite reach an agreement among themselves, then they might see they if they can get the heads of state to come together. But I don't think this kind of work is being done right now. ...

I don't worry much about enforcement. I think that if the major countries reach an agreement they'll do their best to do what they said they would do. But if you say what you're going to do is get emissions down by 15% in 20 years, none of them knows what that means. That's not a commitment to something they're going to do; that's a commitment to some vague aspirational goal or something. ...

So if we can double our GDP in the next 70 or 80 years, even if we lose some of our GDP from climate change -- even if we lose 10% of our GDP from climate change -- we're still ahead so much that the effect of climate change wouldn't be noticed. But it would be pretty disastrous in a lot of the less developed parts of the world. And that's why I think it's crucially important not to demand anything of China, India and so forth that will significantly impede their economic progress. ...

[T]he developed countries -- the OECD or something like that, plus Japan -- if they are really serious, they'll tell India and China and Brazil, "we're going to provide enormous assistance to help reduce your dependence on fossil fuels. And we don't expect you to pay for it yourselves. We will pay for it because we're rich and you're not."

The whole thing is worth reading, of course. At different points Schelling advocates scaring the bejeezus out of citizens of the rich world (using "exaggerations" if necessary), more pollution in the developing world, and considers the irrational morality of helping future generations in China and India at the expense of present generations of Americans.

UPDATE: Wilkinson comments.

The State of Banking

2009-07-14T16:46:00.002-04:00

The Banker has released its annual report of the world's top 1000 banks. Despite the fact that profits collapsed over 85% from 2007 to 2008, the ranks are mostly unchanged from previous years. The Tier 1 capital rankings have also changed little as banks have raised massive amounts of public and private capital to off-set capital losses from the crisis, and aggregate Tier 1 holdings by the top 1000 actually increased in 2008. Perhaps more surprisingly, when government injections of capital are subtracted the rank order still changes very little, indicating that many of the top banks were not actually insolvent in the worst days of the credit crisis, but rather illiquid (this was Robert Rubin's argument back in September). Government-provided liquidity gave banks a window to raise more capital, unwind some of their positions, and make it through the crisis relatively unscathed. Now that the worst is (hopefully) past, banks are paying back the TARP money as fast as the government allows them.

This massive worldwide effort to raise capital has been largely successful: in aggregate, new capital has almost exactly off-set writedowns and losses for the year. In Europe and Asia, new capital is actually greater than the total losses. This is not to say that there haven't been significant losses; there have been, and they've been disproportionately concentrated in the U.S. and U.K. But the public and private efforts to recapitalize the international banking system appear to have been largely successful.

IR Theory and Rap Music

2009-07-13T22:19:00.003-04:00

(Great song, but some explicit lyrics, so NSFW. You've been warned.)

Marc Lynch watches the beef between Jay-Z and The Game and ponders the lessons from IR theory:

See, Jay-Z (Shawn Carter) is the closest thing to a hegemon which the rap world has known for a long time. He's #1 on the Forbes list of the top earning rappers. He has an unimpeachable reputation, both artistic and commercial, and has produced some of the all-time best (and best-selling) hip hop albums including standouts Reasonable Doubt, The Blueprint and the Black Album. He spent several successful years as the CEO of Def Jam Records before buying out his contract a few months ago to release his new album on his own label. And he's got Beyonce. Nobody, but nobody, in the hip hop world has his combination of hard power and soft power. If there be hegemony, then this is it. Heck, when he tried to retire after the Black Album, he found himself dragged back into the game (shades of America's inward turn during the Clinton years?).

But the limits on his ability to use this power recalls the debates about U.S. primacy. Should he use this power to its fullest extent, as neo-conservatives would advise, imposing his will to reshape the world, forcing others to adapt to his values and leadership? Or should he fear a backlash against the unilateral use of power, as realists such as my colleague Steve Walt or liberals such as John Ikenberry would warn, and instead exercise self-restraint?

Rappers have never shied from IR themes. In fact, Tupac Shakur studied Niccolo Machiavelli while in prison and took the nom de plume "Makaveli" as tribute. The concept of anarchy is central to both IR theory and the rap world, as is the realist doctrine of "might makes right" (or, as Thucydides said, "The strong do what they can, the weak suffer what they must").

The recent history of rap follows some IR themes as well. In the 1990s, the West Coast rappers balanced against the East Coast rappers, touching off the feuds that led to the murders of Tupac Shakur and Biggie Smalls. Following these deaths the rap community sought to put a permanent end to large-scale violence, instead seeking economic arrangements from which they could mutually benefit. This L.A./N.Y. Consensus made rap into a very big business, and in the past decade the scene mostly repudiated violent turf wars in favor of embracing commerce.

While this new cooperation has certainly been Pareto-improving, there have been some distributional concerns that have led to minor squabbles (like the present one between The Game and Jay-Z). But even these have often led to new cooperations; see, e.g., Jay-Z's past feud with Nas that led to multiple collaborations (one example is the song posted above). While there has been some shifting of standing in the new system, the locus of power has remained with the Def Jam/Rocafella coalition, which has provided stability and security to the system.

The new era of cooperation has led some to worry about the homogenization of rap culture as the reach of the L.A./N.Y Consensus spread. In reality the opposite has been true. The growth of rap culture and commerce has created new space for regional and international movements to thrive, from the ATL scene and reggaeton to the Bay-area Anticon collective and favela blasts. Rap now comes in every language and flavor.

In other words, there's more to the IR/rap nexus than just the recent spat between Jay-Z and The Game. These roots run deep.

Now that I think about it, this sounds like a good topic for a dissertation.

FDI, Regulation, and Shifting Power Centers: China and Rio Tinto

2009-07-13T07:42:00.003-04:00

On July 5th, without warning or explanation, Chinese officials arrested four Rio Tinto employees, one of them an executive and Australian citizen. Later, China's state run media reported the arrests were connected with allegations that Rio Tinto obtained confidential documents revealing China's bargaining strategy for negotiating iron ore prices with the multinational mining firm. Australian officials are particularly concerned since the detainees were given no access to outside communication and Chinese officials did not divulge any information about their whereabouts or the charges they face to Rio Tinto or the Australian government.

The ensuing diplomatic breakdown between China and Australia illustrates two points about the nature of foreign direct investment (FDI) today.

1) Power asymmetries are shifting.

Most academic work on FDI treats developed (read OECD) countries as price makers and developing countries as price takers. In other words, highly developed countries act on behalf of their multinationals by securing legal protection for multinationals' FDI in other countries. This is mainly done through the use of Bilateral Investment Treaties (BITs). The literature treats developing countries (China included) as grateful for whatever FDI they can get, and therefore willing to submit to OECD standards of legal protection for businesses.

The problem with this view is that FDI sourcing patterns are shifting. As the Chinese economy can support regional trade and FDI growth as well as export FDI to Africa and elsewhere, China doesn't need to cower to western demands for business protection. Indeed, China never really has.

Bottom line: predictions of convergence towards one standard of FDI legal protections depends upon the preferred regulatory level of key players. China's rise underscores the possibility of multiple and competing regulatory regimes.

2) The link between home country and multinational must be tested:

The focus on regulatory regimes like BITs assumes that home countries act as agents for their multinationals and that home countries discriminate against multinationals based on the multinational's home countries. Talk that the recent events in China will lead to a backlash against Chinese multinationals looking to directly invest abroad depends upon the idea that countries will retaliate against Chinese-owned firms as well as the Chinese government. And, the Chinese experience is an easy test of this link because many Chinese firms are in part owned by the Chinese government. It is not entirely clear that this link holds more generally or consistently.

How Not to Conduct Diplomacy

2009-07-12T18:12:00.002-04:00

Via Ackerman, I see that the foreign minister of the new Honduran government has some opinions of President Obama:

"I have negotiated with queers, prostitutes, leftists, blacks, whites. This is my job, I studied for it. I am not racially prejudiced. I like the little black sugar plantation worker who is president of the United States."

Well, there went that coup. Zelaya will be back in power within a month.

The Pope on Development

2009-07-11T17:15:00.004-04:00

[Ed.: This is a guest post by Christopher R. Dittmeier, a fellow graduate student at UNC]

Two weeks ago, Pope Benedict XVI released his latest encyclical, Caritas in Veritate (Charity in Truth), his first high-level document on social doctrine since becoming Pontiff in 2005. The theme of this encyclical is development, particularly "integral human development." While the bulk of Caritas in Veritate had been completed by 2007 (the 40th anniversary of Paul VI's treatise Populorum Progressio, which focused social doctrine away from European industrialization and toward global development issues), Pope Benedict revised it to take into account the current economic crisis. Here are a few key points from the encyclical that have bearing on IPE:

- Inequality is a systemic risk. "Through the systemic increase of social inequality, both within a single country and between the populations of different countries (i.e. the massive increase in relative poverty), not only does social cohesion suffer, thereby placing democracy at risk, but so too does the economy, through the progressive erosion of `social capital': the network of relationships of trust, dependability, and respect for rules, all of which are indispensable for any form of civil coexistence." Development, if it contributes honestly to the betterment of a state's poor, is connected to democratization, pacification, and global integration.

- Given global interdependence, getting out of the economic crisis will require not only restructuring of the market in terms of regulation, but also a rethinking of the nature of the state. "Today, as we take to heart the lessons of the current economic crisis, which sees the State's public authorities directly involved in correcting errors and malfunctions, it seems more realistic to re-evaluate their role and their powers, which need to be prudently reviewed and remodelled so as to enable them, perhaps through new forms of engagement, to address the challenges of today's world." Several important issues, including social security, labor mobility, and migration, are no longer national issues, but require transnational attention. Benedict appears to support a more vibrant interpretation of the theory of responsibility to protect, to include endowing states positive (and not only negative) humanitarian responsibilities.

- International organizations are key to the international stability and development, but current institutional arrangements lack effective agency and have strayed from their intended purpose in practice. "In the face of the unrelenting growth of global interdependence, there is a strongly felt need, even in the midst of a global recession, for a reform of the United Nations Organization, and likewise of economic institutions and international finance, so that the concept of the family of nations can acquire real teeth." The Church has for most of the twentieth century been a proponent of subsidiarity (now most well-known as the operating principle of the European Union's organization), so the proposal of investing both authority and power to supranational entities indicates skepticism of both state-centered and market-centered methods of development. The encyclical points to the role of civil society at local, national, and international levels as the primary innovators of development.

- There is no one right methodology of development. "Technologically advanced societies must not confuse their own technological development with a presumed cultural superiority, but must rather rediscover within themselves the oft-forgotten virtues which made it possible for them to flourish throughout their history." This attack on the Washington Consensus is part of Benedict's larger opposition to the ideology of technology. He specifically attacks the effects of austerity measures on social security, noting that in committing to foreign lenders, governments in developing countries often sell their own people short, weakening the long-term sustainability of their development.

- The Pope gave official blessing to microfinance. "`Ethical financing' is being developed, especially through micro-credit and, more generally, micro-finance. These processes are praiseworthy and deserve much support." Traditional banking has tended to shy away from ground-up development projects in favor of larger (and supposedly more sound) top-down projects, which are nonetheless more prone to corruption and the creation of dependency. Microfinance, on the other hand, establishes firm links between capital in developed countries and entrepreneurship in developing countries, allowing for internal capacity-building, institutionalization, and sustainable economic development.

While a Papal encyclical is unlikely to make waves in the IPE community (at least outside of Italy), the Church's position--one that transcends normal academic and partisan schools of thought--provides a fresh perspective on development theory that can prompt greater discussion on how to approach economic and political development in the 21st century.

[Ed.: For more on the encyclical, see Tyler Cowen in the WSJ. The text of the encyclical itself is here.]

Some Things Get Better, Some Things Get Worse

2009-07-10T21:46:00.003-04:00

Some interesting data came out recently. First, the U.S. trade deficit is declining, mostly because imports have declined faster than exports, but also because exports have fallen at a lower pace than many expected. This is a partial win. Still, unemployment continues to rise and wages earned have continued to decline, once again giving reason to guard against deflation.

Despite that, it looks likely that the economy may be technically out of the recession:

Now that we have the May trade figures, the modal forecast is (i) an economy that was flat in the second quarter relative to the first quarter, (ii) an economy that starts to grow relatively slowly in the third quarter, and (iii) an unemployment rate that keeps rising for another one and a half to two years--like it did in 1992 and 2002--as the old-fashioned business-cycle productivity-employment pattern is broken once again. Bob Hall's NBER committee is likely to proclaim that recovery began sometime in the second quarter, but it won't feel like a recovery to workers (as opposed to asset owners) for quite some time to come.

How is this happening? It's partially because employers are laying off their least productive workers first, and hoarding the top talent. Therefore, measured productivity has jumped:

With labor input falling at a rate of 6% per year in the second quarter, that suggests a productivity growth rate in the economy as a whole of some 6.2%--which is really weird. It used to be the case that businesses hoarded labor in recessions because they did not want their skilled workers to wander off and to have to train new ones....

Now it is really beginning to look as though businesses take recessions as opportunities to greatly slim down their workforces without making the workers they retain too angry and depressed. We saw this in 2002-2003. We saw it before in 1992-1993. The fact that productivity is no longer strongly countercyclical in recessions is good news in the long run--it means that our average long-run rate of productivity growth is higher than we used to think.

So we now face a "jobless recovery" in which the economy technically moves into the black, but job growth lags for a year or two. In exchange we get higher productivity in downturns which can help keep recessions somewhat short. This is a mixed blessing at best, but the outlook is certainly better than it was in January.

In other news, Krugman thinks that all economists that disagree with him are motivated solely by ideology. I guess if you are convinced of your own infallibility then that is the only possible conclusion.

Obama's Summer Vacation

2009-07-09T19:50:00.003-04:00

There is no doubt that Obama is media-savvy, so when he chooses a somewhat curious venue for a major speech, it is worth examining why. His speech at the New Economic School in Moscow on Tuesday is no different. A professor at that university speculates about Obama's reasons for choosing NES over more high-profile sites:

First, it is important that NES is a new institution, founded in 1992. Similar to the way Obama represented a new political paradigm for Americans who voted for him, NES also represents a new paradigm for the modern study of economics.

Second, Obama is the first U.S. president in many years to have built his political career not by dividing voters into separate ideological camps, but by searching for pragmatic and nonpartisan solutions. After 70 years of ideological domination by the state, the NES is continuing the traditions begun by such great Russian economists as Yevgeny Slutsky, Nikolai Kondratyev and Nobel Prize winner Leonid Kantorovich, whose work rose above ideological or national boundaries, as it should be in any scientific field.

More at the link, but maybe a more simple explanation is that Obama wasn't invited to a more prominent stage. After all, Obama has not shied away from grandiose settings for past speeches, and the Russians didn't seem interested in attracting a wide domestic audience for Obama.

Via Joshua Tucker at The Monkey Cage, who has more reactions to and context for Obama's trip to Russia.

Link Dump

2009-07-08T18:51:00.004-04:00

-- Reconsidering Asia's inevitable takeover of the world.

-- IMF says things are getting better, but are still very, very bad.

-- Capital adequacy requirements under Islamic banking law [pdf].

-- Anil Kashyap's research page.

-- A Boston Review forum on Paul Collier's newest book -- Wars, Guns, and Votes -- featuring Krasner, Easterly, Birdsall, Diamond, McGovern, Miguel, and Collier himself. The debate spills over onto Easterly's turf.

-- Asking the dumb questions about financial reform:

No G-8 Climate Change Deal

2009-07-08T18:33:00.002-04:00

They couldn't even reiterate what they decided last year, when Bush was negotiating for the U.S. and the Waxman-Markey had not yet been thought of: to cut emissions by 50% by 2050. Why? Because the entire developing world opposed the plan:

The failure to establish specific targets on climate change underscored the difficulty in bridging longstanding divisions between the most developed countries like the United States and developing nations like China and India. In the end, people close to the talks said, the emerging powers refused to agree to the specific emissions limits because they wanted industrial countries to commit to midterm goals in 2020, and to follow through on promises of financial and technological help.

“They’re saying, ‘We just don’t trust you guys,’ ” said Alden Meyer of the Union of Concerned Scientists, an advocacy group based in the United States.

Why don't they trust us? Hmm:

China, India and the other developing nations are upset that commitments to provide financial and technological help made during a United Nations conference in Bali, Indonesia, in 2007 have not translated into anything more tangible in the interim.

Mr. Meyer estimated that the United States, Europe and other industrial nations need to come up with $150 billion a year in assistance by 2020 to help develop clean-energy technology for developing countries, reduce deforestation that contributes to rising temperatures and help vulnerable nations adapt to changes attributed to greenhouse gases.

In other words, the developing world is saying "show us the money".

I thought Waxman-Markey was supposed to make it easier to get international cooperation. Instead, the richest countries in the world can't even re-commit to the plan that President Bush signed on to last year, which had no direct requirements but rather a vague target 40+ years in the future. Imagine what actual negotiations would be like.

The Data Do NOT Show the Paradox of Thrift

2009-07-08T14:54:00.006-04:00

I'm seriously beginning to think that Krugman doesn't care about making sense any more. Instead, he'd rather use vaguely economic-sounding arguments and cherry-picked statistics to support his normative priors, and then scream "Treasury View! Treasury View!" whenever somebody questions him. Earlier this week, Krugman willfully misread a graph in order to argue in favor of a second stimulus. In today's example, Krugman misreads the graph below and says that it shows incontrovertible proof that the Paradox of Thrift is real, therefore Keynes was right, therefore Krugman is right, therefore we should have a second stimulus. Look at the graph:

What does it show? It shows that net national saving has gone down since the recession began. This is what an advocate of the paradox of thrift would predict. But why has it gone down? Because the government has spent a ton of money! Personal savings is way up, and corporate savings are only down a small amount (likely due to reduced investment caused by excess inventories and the credit crunch; this could reverse within the next few quarters) and not nearly enough to off-set the rise in personal savings. If you take the government out of the picture, then net national saving has gone up and the paradox of thrift is wrong.

Of course that's a huge "if". It's not clear what the personal savings rate would be if the government were not spending in deficit. But Krugman rejects the rational expectations story (Treasury View!) that individuals react to government deficits by saving for future tax increases. If that is true, then the reverse must be true as well: individuals should not react to fiscal neutrality by lowering savings. And if that is true, then the above graph actually shows that in the absence of government deficits net savings would still go up, so the paradox of thrift is wrong, Keynes is wrong, Krugman is wrong, and the case for a second stimulus is weakened*.

Krugman can't have it both ways: either people alter their behavior in response to government deficits or they don't. If they do, then the stimulative effects of deficit spending are at least partially off-set by reduced demand from individuals (Treasury View!). If they do not, then the paradox of thrift does not exist in the present situation.

Like the Laffer Curve, the paradox of thrift is definitionally true at some margin. But it is not clear that we are at that margin or even anywhere near it.

*Though not destroyed; personal consumption is still negative, so Krugman could still argue that stimulus is needed to boost aggregate demand. This demand-side argument is the crux of Keynesianism. But the supply-side argument doesn't support his case, and actually works against it since some of the demand-side effects will be negated by supply-side responses.

Iran Organizational Chart

2009-07-07T15:05:00.006-04:00

I wanted to pass along this chart courtesy of Nathan Gonzalez, author of Engaging Iran: The Rise of a Middle East Powerhouse and America’s Strategic Choice, by way of the Monkey Cage's Joshua Tucker. The chart shows the organizational structure of the Iranian government and society. I wish I would've had this in my hands a couple of weeks ago when I kept hearing about the Expediency Council, Assembly of Experts, Guardian Council, Basij and a host of others without knowing where they stood relative to each other.

Art Imitates Social Science

2009-07-06T17:35:00.004-04:00

Last night my wife and I watched The Treasure of the Sierra Madre, the classic Bogey film about prospecting for gold in Mexico. Although it was meant as a morality play, I was surprised by how much economics and international relations theory there was in the film. A partial list:

1. Game theory, game theory, game theory: The whole film was textbook game theory. The gains from cooperation, the costs of defection, credible commitment problems, security dilemmas, the role of signaling, it's all there (and more). There is one-thousand times as much game theory in Sierra Madre as there is in A Beautiful Mind. Interestingly, though the film was made several years after von Neumann and Morgenstern's classic book, the novel the film was based was published twenty years prior.

2. Division of labor: While the two younger prospectors had the start-up capital and energy, the old-timer had the necessary knowledge.

3. The tragedy of the commons: Technically, the prospectors were trespassing and the gold they found didn't belong to them. Because of that they are constantly under threat from bandidos, federales, indigenous populations, and other prospectors. They had to extract as much gold as they could in a short amount of time, hoarding all the gains for themselves before they were forced to share. True, this isn't the classic "tragedy of the commons" because the gold is not reproducible as are fish stocks or grazable land, but the applications to modern resource extraction (and accompanying security dilemmas) are even greater for that fact.

4. The scarcity of resources: The only reason they were searching for gold, of course, is because its relative scarcity makes it a valuable commodity. But even beyond that, the scarcity of gold led the prospectors to race against time to extract as much as they could before their operation was found out. There's also a bonus for conservationists: after they had drained the vein dry, the prospectors clean up their operation to leave the mountain as they had found it (less a good amount of gold, of course), despite the fact that it cost them valuable time and energy. Interestingly, this lost time may have been their downfall but I think that is coincidental.

There's more, including gains from trade, the necessity of strong institutions for economic development, the political economy of immigration, and the role of incentives in shaping behavior. The film must be viewed as essentially realist (I can't say why without spoiling it), but there is a heavy dose of institutionalism and constructivism as well.

Drezner and his Foreign Policy pals ran their lists for best films about International Relations several months back, and none of them included Sierra Madre. After watching it, I think it is a notable omission.

Basel's Revenge

2009-07-06T16:44:00.003-04:00

Takafumi Sato, the commissioner of Japan's Financial Services Agency (the main regulatory agency in Japan) argues that stricter capital adequacy requirements for banks would not have prevented the present crisis. Indeed, he argues, they may have caused it:

I share the determination to prevent a repeat of the financial crisis. I also believe capital adequacy regulations have a key role in our prevention efforts. Medicine, however, should be prescribed properly, as any effective medicine has side-effects as well. Suppose stronger regulations make banks issue more equity. Then the capital market will expect greater profits in return, and bank management may be tempted to meet such profit pressure by taking more risks. Was this, however, not the cause of the catastrophe?

Also, bigger capital requirements may induce complex risk-taking. If bankers add simple risks, regulators will notice and request more capital. In order to satisfy both regulators’ demand for a high capital-to-risk ratio and investors’ demand for return on equity, bankers may want to take risks in a sophisticated manner, inventing exotic products and creating a darker shadow banking system. It would be too optimistic to presume that we can stop this completely.

The most elaborate shadow banking system flourished in the US, the jurisdiction with the world’s most demanding capital requirement – 5 per cent of so-called “tier 1” capital over total assets. “Excess is as bad as shortfall,” said Confucius. Shortfall in bank capital indeed destabilises the financial system. Many banks’ capital bases need to be strengthened and we should fortify capital adequacy regulations. However, excessive capital requirements can result in a big banking system making big profits by taking big complex risks, defeating the whole purpose.

This follows a common theme at IPE@UNC: the exotic financial instruments at the root of this crisis were created to give banks opportunities for risk-taking. There is no other reason for their existence. The general response to this observation is to advocate even stricter regulations to prevent this sort of regulatory arbitrage from recurring. But as Sato says, "it would be too optimistic to presume that we can stop this completely". Nor is it even obvious why we should. Capital adequacy standards were created to strengthen systemic stability, not to weaken it. If strict capital adequacy ratios incentivize bankers to take less transparent risks, then perhaps our regulatory system should focus on improving transparency rather than mandating a higher number.

Prescience

2009-07-06T02:04:00.004-04:00

So, a couple weeks ago I wrote (regarding an Ezra Klein post): "Undoubtedly, this will lead [Klein] to suggest that what we really need to do is abolish the Senate."

Just two days ago Klein writes: "The main thing we could do to improve the functioning of the legislative process would be to dissolve the U.S. Senate."

Cool.

The U.S. Plays Chicken with the BRICs

2009-07-05T14:53:00.006-04:00

A few days ago, Dr. Oatley wrote about the attempt by the U.S. House of Representatives to cap greenhouse emissions and coerce other countries into doing the same:

This time it is the Waxman-Markey cap and trade legislation. The intent of the legislation--reduce greenhouse gases--addresses concerns of the Democrats' median voter, who cares deeply about climate change. Producers, however, are concerned that the higher energy costs generated by cap and trade will disadvantage them relative to Chinese firms who are not facing higher energy costs because China does not regulate greenhouse gases. The solution, added late to the legislation, is to impose tariffs on goods from countries that do not regulate GHG (i.e., China). Nobody really wants to impose tariffs, but the hope is that the threat of tariffs will be sufficient to induce China to agree to international regulations on CO2 emissions.

This realist view is often borne out in the politics of international regulations. But in this case it is difficult to see whether the U.S. has the muscle to coerce China (and others) into adopting the U.S.-preferred strategy. Krugman loves it, but the push-back from China and India has already begun:

The Chinese government also said it believed the carbon tax proposal violated the principle set out in the Kyoto protocol that developed and developing countries should respond to climate change together but with different responsibilities. “[It] severely harms developing countries’ interests,” Mr Yao said.

The WTO report, which gave a cautious nod to carbon tariffs, was prepared by the organisation’s secretariat, which can advise and facilitate discussion among the WTO’s members but does not set the rules itself. If a government such as China’s challenged such taxes, the case would be decided by the WTO’s dispute settlement system – panels of independent trade experts and lawyers.

Some trade lawyers point out that past WTO decisions have permitted governments to restrict trade in order to protect natural resources. But others say the case law is patchy, and it is hard to prove that such measures are being applied in a fair and consistent manner – a necessary condition for meeting WTO rules.

And the Indians have quite a point:

With 1.1bn people – roughly a sixth of the world’s population – India has one of the lowest per capita emission levels, with 1.2 tonnes per head, about 4.6 per cent of total global emissions. “India has not polluted – we are bearing the brunt of global climate change caused by the developed countries and we are being asked to curb emissions,” he said. “I find this ludicrous.”

However, India’s carbon emissions are expected to rise sharply in the future, especially as the country tries to meet its power deficit through the rapid development of generating capacity. India uses about 450m tonnes of highly-polluting coal for power generation each year, a figure that Mr Ramesh said would rise to about 1bn tonnes in less than a decade.

“There is no running away from our karma – without coal, we have no economic future,” he said.

That last sentence is the crux: India and China will not yield because they cannot. They can credibly commit to hurt U.S. consumers and producers in retaliation (in this case, retaliation could be as simple as accepting reduced economic gains from trade; of course, they could also slap retaliatory tariffs or simply stop buying U.S. bonds). So the question is whether the U.S. thinks that the environmental gains from carbon tariffs will out-weigh the economic costs of a trade war during a nasty recession. More specifically, does the president and the 60th most-progressive senator think so? So far, Obama has indicated that he is not interested in playing chicken with the Chinese.

From my seat (nowhere near the table), it appears that the provision will be stripped from the Senate version of the bill, and/or the bill will not pass. The costs to American consumers of challenging China and India (and Canada) have already become too great. That could change if the U.S., E.U., Japan, and others make a concerted stand against the BRICs, but that would allow the BRICs to accuse the rich world of preventing the development of some of the world's poorest people in order to fulfill their pet preferences. And they would be right.

Addendum: China may have actually started the trade war over a month ago.

We Hold These Truths to Be Self-Evident

2009-07-04T19:56:00.002-04:00

Short July 4th reading list:

-- The Declaration of Independence.

-- The least free places on earth.

-- Benjamin Franklin plagiarizes Captain America.

Straight Outta Lagos

2009-07-03T16:18:00.004-04:00

This was probably inevitable:

It probably seemed a good idea at the time. But Russia's attempt to create a joint gas venture with Nigeria is set to become one of the classic branding disasters of all time -- after the new company was named Nigaz.

That, of course, being a mash-up of "Nigeria" and Russian energy company "Gazprom" rather than a tribute to "the world's most dangerous group".

I so want to post some YouTube vids here, but alas: this is a family-ish blog. Instead, here's a link.

Via Blattman.

More Musings on Climate Change

2009-07-03T14:43:00.001-04:00

I've recently had a couple of posts on climate change that have focused on what the U.S. can and should do to prevent climate change from occurring, and how much it would cost. While I didn't actually come out and say that it would be foolish for the U.S. to act unilaterally, I expressed skepticism that there are positive economic benefits from doing so (while acknowledging that there may be strong normative reasons that outweigh the dollars and cents). Matt Rognlie has also been blogging on this topic, and ends a recent post with an audacious claim:

It's easy to dismiss carbon policy because it "won't make a difference." But I have never seen anyone making this argument appropriately deal with the economic, moral, and political issues I've discussed here.

I think he's completely wrong about that; following the release of the Stern report there was a lot of talk in the blogosphere and elsewhere about the economic and moral concerns, and the international and domestic political aspects are a common topic. Still, if Rognlie thinks there is a void, perhaps I can fill it. Rognlie's economic, moral, and political claims can be summed as follows:

1. Economic: Demand curves do not slope downwards outside the U.S.

2. Moral: The U.S. will be guilty of mass murder and planet rape if it does not act, unilaterally or otherwise.

3. Political: International cooperation (including the BRICs and other developing countries) will be easier to achieve if the U.S. takes the first step without reciprocation.

Let me first say that I don't completely disagree with Rognlie's argument, but I enjoy playing Devil's Advocate and I don't think the case is quite as straightforward as he makes it out. I'd like to start with the claim that the U.S. has a moral responsibility to curb its emissions. This judgment is supported by Arthur Pigou's concept of externalities, wherein some economic actions have costs that are not directly borne by the party engaging in the economic activity. The classic example is of a firm that pollutes as it manufactures its goods: the benefits of production are captured by the firm, but the costs of the pollution are spread throughout the whole society. At a glance, this framework seems to capture climate change perfectly: the industrialized world enriches itself by emitting carbon into the atmosphere, but the costs of those actions are spread throughout all of the world.

The narrative gets murkier when we look at specifics, however. The logic of externalities depends on being able to identify the offenders and the victims. After all, who are the polluters in this case? Historically, it has been the entire industrialized world. And who are the victims? The unindustrialized world. In other words, every country that has the means to pollute does pollute, because pollution is a by-product of economic growth, and the countries without the means to pollute are desperately trying to gain them. So all that we can say is that the industrialized world is more efficient at doing what everyone is trying to do: generate economic growth. But if everyone is seeking the same outcome, then is it morally appropriate to castigate the ones who achieve it more successfully? True, outcomes have diverged, but preferences have not. This suggests that the logic of externalities may not be the most appropriate way to think about climate change.

Now that China -- a developing country -- is the world's greatest polluter in absolute terms, and other developing countries are also increasing their pollution, the moral calculus shifts further. India and Russia, two other of the BRICs, are also in the top 5 emitting countries and developing countries were responsible for 73% of the increase in emissions in 2004 (and that ratio has surely increased in the last 5 years). As the developing world becomes responsible for a larger and larger share of emissions, then who are the victims? Well, all of us. But if there is a preference-choice to be made between growth and a clean environment, it seems that all countries, not just the greedy West, have made the same decision. To say it more technically, as Larry Summers did in his infamous "LDCs should pollute more" memo, the income elasticity of environmentalism is very high, so it is very unlikely that the developing world will choose conservation until they reach a high level of economic development.

Of course, the moral argument might be swamped by more pragmatic problems. Even if we settled the question that the West should do more to curb emissions, we are left with figuring out how it can be done and the economics of energy do not support an equilibrium with lower global energy consumption. To see why, suppose the developed world reduces its energy consumption significantly to combat climate change: the reduced demand for energy will lower the price, the reduced price will cause the developing world to increase the quantity of energy demanded until the price is bid back up to equilibrium. In other words, reducing MDC demand will increase LDC demand. This may be fine in egalitarian terms -- it's essentially a wealth transfer from the richer countries to the poorer countries -- but the environmental effects will be nil. In fact, they could be negative: as incomes in the developing world increase, their demand for energy will also increase which could lead to greater overall consumption of energy.

So we're left with the political problems. Rognlie claims that if the U.S. acts now, then getting cooperation from the Chinese and Indians will be easier to achieve a few decades hence. Perhaps. Perhaps not. That is unknowable. But even if China and India (and Russia and the petrostates) are more amenable to a reduction of carbon emissions in the future, that doesn't necessarily change the economics discussed above, or the political difficulties that have always been present. In 2040 the rapidly-rising economies may be in Indochina, or Africa, or Latin America and they may be reluctant to give up their rising incomes in order to combat climate change. And at all points in this chain we are faced with the common collective action problem: enforcement is essentially impossible, so defection is highly likely. The politics of this are just as gloomy as the economics.

How to Destroy An Economy, in Five Easy Steps

2009-07-01T08:41:00.001-04:00

From an excellent article by Laura Secor in the New Yorker (published in February, well before the election), profiling Iranian economist Mohammed Tabibian (who was "forced into retirement" for criticizing Ahmadinejad's economic policies):

The current President, Mahmoud Ahmadinejad, who was elected in 2005 on a promise to distribute Iran’s oil wealth downward, has shrugged off expert economic advice in favor of grandiose gestures toward the poor. Upon taking office, he promiscuously handed out grants and subsidies; when these were not approved by the state budget office, he simply ordered the banks to issue more currency. He injected billions in oil revenues directly into the economy, dipping into the country’s savings to do so. Liquidity increased by nearly forty per cent in the space of a year. Iranians, lacking incentives for investment, used this cash to buy imports, which buried local industries and sent prices soaring. Already on the rise worldwide, inflation in Iran skyrocketed. Within a year of Ahmadinejad’s election, the inflation rate was the fourth highest in the world, after Zimbabwe, Uzbekistan, and Burma; by the summer of 2008, it topped twenty-eight per cent. Meanwhile, Ahmadinejad slashed interest rates, a move that encouraged lending, pushed the country’s fragile banking sector to the edge of ruin, and contributed to a surreal housing bubble in Iran’s cities. For each of the past two years in Tehran, real-estate prices have more than doubled.

It's never a good thing to have your economic policies mentioned in the breath as Robert Mugabe's.

Altering Incentives

2009-06-30T22:31:00.001-04:00

Much like Richard Posner, Martin Wolf is not a very big fan of Obama's proposed restructuring of the financial regulatory structure. But rather than focus on the fallibility of regulators as Posner does, Wolf focuses on the incentives at the heart of the financial system:

Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important. Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky.

In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”. ...

Profs Bebchuk and Spamann add that four features of the modern financial system make the situation even worse: first, the capital of banks is itself partly funded by debt; second, the role of bank holding companies may further increase the incentives of shareholders to underplay risk; third, managers are rewarded for aligning their interests with those of shareholders; and, fourth, some of the ways managers are rewarded – options, for example – are themselves a geared play on rewards to shareholders. So managers have an even bigger economic interest in “going for broke” or “betting the bank” than shareholders. As the paper notes, the fact that some managers lost a great deal of money does not demonstrate they were foolish to make these bets, since their upside was so huge. ...

Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives. The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis.

Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.

The classic criticism of CEOs is that their personal incentives are not aligned with the desires of shareholders. Wolf is arguing that the exact opposite is true: CEOs take massive risks because their principals demand it from them. However, this risk-taking creates systemic risk, and the events of the past year have showed that if firms are "too big to fail" they will not be allowed to fail.

This sounds a lot like moral hazard, but in truth that is only partly accurate. Shareholders do have plenty at stake, but their potential losses are bounded at zero while their potential gains have no upper bound. Simply allowing them to go out of business is not enough of an incentive to prevent risk-taking, since risk-taking is rational in this environment.

Wolf's last paragraph is unsatisfying, however. It may not be easy to see which firms are systemically important ex ante. Even relatively small firms can spread a lot of risk through counterparty obligations. But even if we could tell, how would we break them up? How would we "run them in a different way"?

We can't, says Brad DeLong, unless we publicly display managers of failed firms in the stocks:

Managers and traders are, however, where I would focus most of my attention. I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out--reduced in assets to their last two cars and their last four-bedroom house--if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don't see how we do it.

Who in their right mind would work in finance under those conditions? No, that is not the answer. Individuals and firms should be allowed to take risks without fear of punitive reprisals if it is in their rational self-interest. We cannot, and should not, attempt to change the nature of man. What we should do is find a way to link outcomes to actions in a way that minimizes externalities. But so far, that solution has proven elusive.

Altering Incentives

2009-06-30T20:49:00.000-04:00

Lucian Bebchuk and Holger Spamann of the Harvard Law School make the big point in an excellent recent paper.* Its focus is on the incentives affecting management. These are hugely important. Still more important, however, is why a limited liability bank, run in the interests of shareholders, is so risky.

In a highly leveraged limited liability business, shareholders will rationally take excessive risks, since they enjoy all the upside but their downside is capped: they cannot lose more than their equity stake, however much the bank loses. In contemporary banks, leverage of 30 to one is normal. Higher leverage is not rare. As the authors argue, “leveraged bank shareholders have an incentive to increase the volatility of bank assets”. ...

Profs Bebchuk and Spamann add that four features of the modern financial system make the situation even worse: first, the capital of banks is itself partly funded by debt; second, the role of bank holding companies may further increase the incentives of shareholders to underplay risk; third, managers are rewarded for aligning their interests with those of shareholders; and, fourth, some of the ways managers are rewarded – options, for example – are themselves a geared play on rewards to shareholders. So managers have an even bigger economic interest in “going for broke” or “betting the bank” than shareholders. As the paper notes, the fact that some managers lost a great deal of money does not demonstrate they were foolish to make these bets, since their upside was so huge. ...

Such a crisis is not only the result of a rational response to incentives. Folly and ignorance play a part. Nor do I believe that bubbles and crises can be eliminated from capitalism. Yet it is hard to believe that the risks being run by huge institutions had nothing to do with incentives. The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis.

Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.

Managers and traders are, however, where I would focus most of my attention. I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out--reduced in assets to their last two cars and their last four-bedroom house--if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don't see how we do it.

Cap, Coerce, and Then Trade

2009-06-30T13:44:00.004-04:00

I once wrote a paper in which I asserted that international agreements are a consequence of dilemmas of domestic politics. Voters pressure politicians to enact regulation (say, to protect the environment). Producers ask legislators to not pass the regulation because it will put them at a cost disadvantage in international trade. Legislators are thus forced to choose between making voters happy but losing producer support (and campaign contributions), and making producers happy but losing votes.

I argued that legislators often escaped this dilemma by using international agreements to force foreign producers to accept regulations identical to those imposed at home. As Hubert Humphrey once said, "Germans don't vote" [in the U.S., that is] and so it makes sense to push the cost of regulation onto foreigners. Sometimes, however, foreign governments are unwilling to change their regulation. In such cases, the government that wants new regulation must somehow force the recalcitrant government to do so. I suggested that one way they did so was by threatening to impose even stiffer costs onto the reluctant government if it continued to refuse to enact new rules.

Though the paper is one of my most often cited, it has not had much impact on how people think about where international regulation comes from. (Someone once told me that this reflects the paper's unfortunate focus on something nobody cares about--the Basle Accord.) Every once in a while, however, something happens that reminds me that the paper says something important.

This time it is the Waxman-Markey cap and trade legislation. The intent of the legislation--reduce greenhouse gases--addresses concerns of the Democrats' median voter, who cares deeply about climate change. Producers, however, are concerned that the higher energy costs generated by cap and trade will disadvantage them relative to Chinese firms who are not facing higher energy costs because China does not regulate greenhouse gases. The solution, added late to the legislation, is to impose tariffs on goods from countries that do not regulate GHG (i.e., China). Nobody really wants to impose tariffs, but the hope is that the threat of tariffs will be sufficient to induce China to agree to international regulations on CO2 emissions.

The Other Coup

2009-06-29T13:26:00.005-04:00

Honduras is in turmoil after the President was removed by the military after the President tried to hold a referendum that was deemed unconstitutional by both the National Congress and the Supreme Court. I know nothing about this, but these rundowns at Global Voices and The Field have a lot of information and reactions from Honduras (ht: Dish).

The impression that I get is that the President enjoys much popular support, but was prevented from seeking another term by the Honduran constitution. Hence the referendum to re-write the constitution to allow Zelaya to run for office again. President Zelaya ignored the rulings by the congress and courts, removed the top general of the Honduran army from his post, and tried to hold the referendum yesterday. At which time, the military removed Zelaya from the presidential palace and put him on a plane to Costa Rica.

I've seen a few bloggers express dismay that the Iranian uprising has garnered so much more attention than the Honduran uprising. There is a clear reason for this: Iran is a large, geopolitically important country in the most unstable region in the world and has long been an antagonist of the West. Honduras... not so much. Still, it seems clear that the referendum should have been allowed to go forward, and the removal of democratically-elected presidents by the military is pretty much never a good thing.

At least we know the U.S. government wasn't involved. We can't even get the military on the phone. From the Times:

Obama administration officials said they were working with other members of the Organization of American States to ratchet up pressure on the Honduran military to end the coup and dismissed the prospect of outside military intervention in the matter.

“We think this can be resolved through dialogue,” said the senior administration official. However, he admitted that the Honduran military was not responding to calls from the American government.

UPDATE: Sanchez wonders which side is right:

Without pretending to any expertise on the Honduran political scene, here’s what I’ve gathered to be the context: Zelaya was pushing for a national referendum on whether he should be able to seek reelection, though the constitution limits him to a single term due to end in January. The country’s Supreme Court declared this move illegal, and the congress recently passed legislation similarly barring any such plebiscite, but Zelaya was apparently undissauded. This weekend, under an order from the Supreme Court, the military spirited Zelaya off to Costa Rica. The line of succession was observed, and the president of the congress, a member of Zelaya’s own party, ascended to the presidency with the confirmation of the legislature.

Grant that this is a mess either way, that this is hardly an outcome that a liberal democrat should feel comfortable with, and that there are almost certainly aspects of this that I’m missing. Is it actually obvious that Zelaya is on the side of “democracy” here?

Yes, that much is obvious. He wanted a referendum, and nothing is more democratic than a referendum. If Zelaya won, the constitution would have been effectively modified via a democratic process and power would have been redistributed from the National Congress and Supreme Court to him (which, presumably, is why they struck the referendum down). If Zelaya lost the referendum then (again presumably) he would have stepped down.

What Sanchez means to ask, i think, is whether liberal-minded people should always and everywhere support the "will of the people" when that involves tearing down legitimate political institutions. I don't think there's an general rule that answers this question satisfactorily in all cases. I tend to side with institutions more than popular whims, but that's because I think that durable institutions can serve the polity much better than a democratic society that careens from one extreme to another every decade or so. However, if the institutions are not legitimate -- if they do not reflect the will of the people -- then they should be reformed.

In this case I don't know whether referendums of this sort are allowed by the Honduran constitution. It's quite possible that they aren't, and that Zelaya was violating the law by pushing for one. But saying that is not the same as saying that he is acting undemocratically.