Designed Economics

Currently a student studying Economics and Management, these are my thoughts and ideas on current economic affairs, books and theories. Feel free to comment and suggest topics for discussion.

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Happy Holidays!

Hi All,

This is just a quick happy holidays from me, hope everyone is having a nice break. Also just a preview of what's to come, I have a review of Thaler and Sunstein's Nudge in the works, as well as a discussion of some ideas I came across during a Keynes Society Lecture. Stay tuned!

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A Conference

Recently I attended an IEA conference, where three topics were discussed: Market Failure, Poverty in the UK, and The Eurozone Crisis. Here, I would like to share my thoughts on the topics discussed.

The first talk on market failure, given by Dr.Steve Davies (originally supposed to given by Professor Mark Pennington, who due to unforeseen circumstances, could not attend. I was looking forward to hearing about his work on bounded rationality and imperfect information, unfortunate, will research in my own time) was rather interesting, it started off with the acknowledgement that humans aren’t ‘Econs’ (perfectly rational, perfectly informed beings); hence prone to falling short of theoretically ‘optimal’ solutions. He went on to discuss the familiar problem of informational asymmetries and the cost of information, and how they contribute to market failure. It was upon the idea of market failure itself that Dr.Davies disagreed with the most, he argued that having a mindset of failure in the case of not being able to achieve a theoretical ‘optimal’ solution is not helpful. Especially when one considers the dynamic nature of equilibriums, and ever-present uncertainty. To an extent, I agree with his views. We should not get discouraged if a perfect solution is not met, indeed, it may never be met in the real world. However, my concern is that this view of ‘close enough’ will cause us to set aims lower and lower, it gives us an excuse to do less, try less. I still believe that imperfect solutions should be considered exactly what they are, failures, and not a ‘close enough’ success.

Dr.Davies then proceeded to outline disadvantages of government intervention, touching on producer capture, public choice theory, vested interests, and the inefficiency of government in gathering information. Indeed, government intervention is not without its faults, in some cases however, it is a required action. During deep recessions, for example, the government’s role in providing spending is vital to recovery. Even though there may be inefficiencies plaguing the policy, it is definitely better than doing nothing at all. This talk has made me more skeptical of government intervention, it is not the ‘always correct’ answer I was led to believe, but rather one of many ways to tackle market failure. Dr.Davies identified supply side policies, enforcing and increasing property rights, decentralisation and reducing informational blocks to be alternatives. I particularly agree with any efforts to reduce informational blocks, due to its role in improving efficiency.

The second talk, centred on Poverty in the UK was given by Dr.Kristian Niemietz, he raised the misleading statistics that can arise from using relative poverty as a measure of poverty. Specifically that the reaction upon hearing that poverty rates have increased may be that the public have the illusion of conditions now being worse than previous years; when in fact living standards may have increased just not universally. Dr.Niemietz then highlighted the importance of improvements in the housing market (through lowering planning regulations)  in reducing the economic burden of those in poverty. He stated the effects to be threefold: firstly, the increase in supply of housing would reduce rent, and lower pressure on council housing. Secondly, commercial building prices should similarly decrease, lowering the cost of firms, thereby leading to lower price of goods and services, thus increasing the purchasing power of those in poverty. Finally, it increases work incentives, since housing benefits are scaled to house prices, the lowering of house prices would increase the gap between minimum wage and benefits, therefore leading to a greater work incentive. Labour mobility should also increase due to the lowered cost of housing, therefore decreasing structural unemployment. I suggested increasing the flexibility of wage contracts as a way of reducing cyclical unemployment, an idea that Dr.Niemietz agreed with. Of course there are issues with this solution. Firstly, efficiency wage theory argues that firms will offer above labour market equilibrium wages in order to give labour incentive to work. Secondly, completely flexible wage contracts will decrease the job security of labour, and may indeed disincentivise people from working. Overall, I felt that this talk was an interesting take on poverty, and the solution through housing market improvements was a refreshing one.

The final talk was once again given by Dr.Steve Davies, regarding the Eurozone crisis. He echoed views of the Eurozone not being a optimum currency area. Concentrating on the criteria of labour mobility, and fiscal union, both of which the Eurozone fail to meet to an adequate degree. Despite there being no need for work permits in the Eurozone, it is difficult for labour to emigrate due to cultural differences such as language, and the difficulties in purchasing property. Indeed, many economists did not agree with the establishment of the Eurozone in the first place, in my opinion, it was more due to political reasoning than economic rationale. We were then split into groups and asked how we would solve the current crisis, with suggestions ranging from separating the Euro back into their original currencies, to forcing the exit of core countries (to reduce the competitive gap between core and peripheral countries). Indeed, structural reforms in peripheral countries are a necessity if they are to continue to be part of the Eurozone. Inflation in core countries will help this policy, since it temporarily decreasing the relative costs of these peripheral countries. I believe this to be the prudent path to take.

It is at this point that I would like to thank Dr.Steve Davies, and Dr.Kristian Niemietz, they gave very interesting talks, ones that provided a refreshing view on topics that I thought I was familiar with.

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Globalisation and Its Discontents

I apologise for the lack of posts lately, I've been rather busy lately, nevertheless, I have read Stiglitz’s ‘Globalisation and Its Discontents’, an account of how unsuitable free market ideologies have impacted countries. Stiglitz critiques the IMF, not from an ideology standpoint, but rather from a pragmatic stance, a view that I find rather refreshing.

One point that Stiglitz highlights is the trade-offs during the process of privatisation, although in the long run, there may be efficiency gains, in the short run, there will be increase in unemployment. Compounding this problem, in rather undeveloped countries, the loss of employment imposes additional social costs. As children may be taken out of school to work on farms, it could also lead to protests and violence. This tradeoff emphasises the importance of prioritising objectives in the process of globalisation, is it a matter of improving living standards? Or a matter of increasing output? If the latter is the aim, one has to consider additional scenarios. For example one cannot guarantee that the newly privatised firm will not be used as a base for asset stripping, or indeed be a private monopoly. In the first situation, a negative effect will instead be felt, in the second, the monopoly could result in higher prices for the people, both prove detrimental to the aim. Indeed, as Stiglitz argued it is important to have a social climate that encourages growth, and not asset stripping. If instead, improving living standards is the aim, then it may not be prudent to only concentrate on growth. There are those that believe in ‘trickle-down economics’ the idea that growth in income of higher income groups will filter down to those at lower income levels. I do not believe in this idea, I believe that it is more important to concentrate on schemes such as improving education, utilities, and healthcare to lower income groups.

  Central to the book is a debate about the role of the government in steering economies, specifically how emerging economies should approach globalisation. Trade market liberalisation is an important part of globalisation. For example, trade market liberalisation has increased the amount of opportunities that more undeveloped countries have for trading. With most of these countries having cheap labour available, their goods should exhibit price competitiveness, and lead to growth. The problem is the reverse, that developed countries have more opportunities for trade. Large firms exporting to these less developed countries will have products that are more advanced and may even be at a lower price, this makes it extremely difficult for local firms to compete. In turn, unemployment could result, reversing the process of increasing living standards all together. Therefore, I argue that it is important for the government to play a role in how liberalisation occurs. The speed at which liberalisation is done should be managed, making sure that local firms are competitive needs to be a priority. Conversely, developed countries need to lower their barriers, with trade tariffs in place, it makes it even harder for exports from less developed countries to compete. More importantly, it seems rather hypocritical for developed countries to take advantage of these less developed ones by selling to them while refusing to buy. If globalisation is to be done right, the more advanced west should set an example. Yet another example of government steering the economy to an advantageous outcome is the case of China; specifically partial-privatisation. The two-tier price system, I felt worked very well. It insured a certain level of price stability while also allowing the rather inexperienced public to get an idea of price setting within a free market. Moreover, the success that the program on the small scale led to the public actually wanting to adopt it. This circumvents the problem of a negative social climate as the public is eager to partake in this new system.

A final point to pick up on is Stiglitz’s emphasis on IMF’s failures; policies such as privatisation, capital and trade market liberalisation are not inherently harmful to the economy. The order in which they are done though, is very important. In the case of Russia, rapid privatisation was implemented before fundamental structural elements such as policy rights enforcement were set up properly. Indeed policies only work as well as the system it is being implemented on allows it to be, sequencing is key. Another problem is the IMF’s ‘cookie cutter’ approach to helping economies. Rather than understanding the specific issues that a country has to deal with, the IMF applies the ‘free-market doctrine’ to all; a mixture of privatisation, trade and capital market liberalisation. Though it may work well for some economies, these are not universally beneficial, as I have discussed with trade market liberalisation and privatisation. Capital market liberalisation is not exempt from this trend, the main issue is hot money. Hot money flows into and out of a developing country can have detrimental effects; it could cause asset bubbles to form, or cause volatile exchange rate movements, both are not particularly helpful to growth. It is important, therefore, for IMF to understand particular situations before a solution. To me, it seems to be a matter of luck whether or not this ‘cookie cutter’ approach works out. It also troubles me that the IMF takes a firm free market approach, and does not even consider other theories, such as those proposed by Keynes. There should be dialogue in order to allow for the most prudent growth strategy.

Overall, Stiglitz's ‘Globalisation and Its Discontents’ has given me a good understanding of the workings of the IMF, and the problems that unsuitable policies bring. It is definitely a book I recommend reading.

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Animal Spirits

The idea of animal spirits which was brought forth by Keynes has always interested me, I’ve always felt that not all economic decisions are made based on pure economic rationale, psychology and behaviour patterns surely play a part. To better understand the concept of animal spirits, I recently read Animal Spirits: Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller, a fascinating read. There are of course points that I would like to discuss.

The main issue addressed is the state of mainstream economics, the authors feel that modern economics has not allowed for the incorporation of animal spirits, which the authors stated to be made up of confidence, money illusion, corruption and bad faith, stories and fairness . One good example of this is their critique of natural rate theory. The theory was developed by Milton Friedman and Edmund Phelps, they believed that the original Phillips curve was incorrect, due to the fact that it allowed for money illusion. Both Friedman and Phelps believed in rational expectations and believed that wage contracts would change to reflect inflation expectations. This would mean that real wages would hold constant, meaning that unemployment should only deviate slightly from a ‘natural rate’ the NAIRU (non-accelerating inflation rate of unemployment). The policy implication of this is very important, any attempt by the government to intervene by demand side policies would only lead to accelerating inflation under this theory, while not actually impacting unemployment. The authors critique this idea with the use of money illusion, showing that wage rates do not respond to inflation rationally. For example only 19% of wage contracts of Canadian workers from 1976-2000 had COLAs (cost of living adjustments), which would adjust wages according to current inflation. However, even then, COLAs only adjust after a threshold has been reached, in fact, only a third of these contracts experienced levels of inflation that reached their thresholds. This to me, is a good example of money illusion, there are of course others stated in the book, but needless to say at the moment I am very much in favour of the view that animal spirits should be incorporated into mainstream economics.

One interesting point was a discussion of a confidence multiplier by the authors, they argued that alongside the usual fiscal and investment multiplier, that should also be one that relates to confidence. This is not to say that it should be quantified, but the idea that there could be one was important to note. In my opinion what is most important about this concept is that the fiscal and investment multiplier could change drastically according to the confidence multiplier, perhaps it is more accurate to say that the confidence multiplier would have an add-on effect on the others. This has intriguing policy implications, as mentioned before, stimulus would be more effective if first the issue of confidence is addressed. Therefore perhaps the most important role of stimulus at anytime is to restore confidence, the value of the stimulus should be a secondary concern. Collapse of confidence is argued to be the cause of recessions by the authors, interesting the upswing of the economy seems to lay the seeds for this to happen. The authors argue that during the upswing overconfidence leads to investments being made that ultimately will lead to economic losses, similar to the idea of malinvestment, except overconfidence instead of excess increases money supply being the cause. The authors also argue that due to the abundance of investments being made there is greater incentive for corruption, which combined with the eventually economic losses will result in collapse of confidence. To me there is irony in this situation, under this view recession are when the confidence multiplier is the lowest, hence when fiscal stimulus is the least effective, yet most needed.

Fairness is the last element that I would like to discuss. The authors’ idea of fairness has given me a new perspective on the process of setting wages. Previously I had been of the view that employers will always look for a way to employ at the lowest wage possible as to decrease the costs of the firm. However, I neglected to consider the effect that wage has on the productivity of labour, this of course would lead employers to employ at a higher wage than the market clearing wage. This, known as efficiency wage theory, is suggested to be a reason why involuntary unemployment exists. Indeed, it is not that the unemployed is not prepared to accept a lower wage, but employers not prepared to give a lower one. The authors further develop this idea, employers not only have to give a wage that will ensure labour productivity, but a ‘fair’ one. There are therefore, many factors to consider in wage setting, whether the employee will feel motivated or not, whether other employees at the firm feel that the wage is ‘fair’, whether the employee will feel loyalty towards his/her tasks. I agree with this proposal, it seems to me that there are real problems when it comes to setting wages, and it is not a matter of freely setting a wage. There are restrictions that employers must abide by in order to ensure the smooth running of a company. The ‘fair’ wage, the authors argue is also one of the main reasons why there is involuntary unemployment, the fair wage will simply be higher than the  market clearing one, allowing there to be a demand gap in the labour market, thus inducing unemployment.

Unfortunately, there aren’t many ideas that I disagree with in this book, it’s always hard to critique something that you agree with. On the other hand, the book proposes a very strong case of how animal spirits should be incorporated into mainstream economics, which I am very supportive of. Looking into the future, I have begun reading Joseph Stiglitz’s Globalisation and its Discontents, look forward to a discussion of that next.

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Creditors and Debtors: A Discussion of Paper Promises

Following the rather bright and optimistic look at the crisis through the lens of Krugman’s ‘End the Depression Now!’ , it was time to be brought back to earth by Coggan’s ‘Paper Promises’, it offers a look at significant historical events that still hold economic relevance today, while giving a thorough analysis of our current predicament and potential solutions. It has been a refreshing, if somewhat depressing look at things to be, of course there are many points of discussion.

Debt is the main subject of this book, and Coggan thoroughly explores how it was developed throughout history up until the events of the recent crisis. One thing that I’d like to pick up on is the role of government debt. I myself have seen government debt as relatively risk-free, since I’ve always seen the governments as being able to depreciate their currency to pay their debts, and even though this can be considered a partial default it is still able to meet the debt obligation. Coggan instead argues that although defaults are rare in the developed world, they are by no means impossible, Greece is a good example. One problem that Eurozone countries have, not just Greece, is that depreciation isn’t an option available to them. Meaning for countries such as Greece, where there is lack of competitiveness (indicated by current account deficits that have been run for consecutive years), costs can only be lowered through austerity. This of course makes it harder to raise tax revenue due to increased unemployment and decreased labour wages, making it even harder to pay off debts. Even though the ECB has helped Greece out, even harsher austerity measures were imposed, I question when the cycle will end. Indeed it seems more prudent to me for Greece at this time to instead address supply side problems while the ECB gives financial aid. On the other hand this would mean increased spending, which for Greece has to be financed at a high rate, and I do not think the ECB would be willing to let that happen, since it represents the interests of creditor nations such as Germany, which would of course discourage further spending. Perhaps less drastic measures could be taken, at this point anything that helps restore confidence in the Greek government would help, although the options are few. For example, I do not think fiscal stimulus would be an option, neither is the less conventional monetary policy of QE (since the ECB cannot pick political favourites by choosing a specific country’s bonds). Even though I don’t agree with the policy of austerity, it seems to be the only option, it seems cruel in my mind, however, to see Greece suffer through a long period of stagnation. Greece is a candidate for default, the problem is, if it does, it could cause a domino effect. If Greece defaults, couldn’t Spain do the same? Or Italy? If one country defaults confidence in others may collapse, indeed it could spread like a contagion. If that does happen, then it may be a long time before creditors are willing to trust governments, which would have large repercussions on the nature of government spending to come.

One aspect that I found rather interesting is the discussion of the moralities behind debt. Throughout history, creditors have lent in the hopes that their debtors won’t default, and interest payments will lead to an increased income. Of course, debtors have always borrowed to facilitate investment or immediate consumption. It is very interesting then, that Coggan makes an effort to introduce the moralities behind this act. Making the distinction between productive (where the loan is used to invest, for example start a company) and consumptive (where loans are made for the sole purpose of purchasing goods now rather than later) loans, an idea introduced by Adam Smith. Arguing that productive loans are moral, while consumptive ones aren’t. He takes this idea further, in the modern world, how can one distinguish between the two? Consumptive loans will lead to the purchase of goods, which should encourage these firms to invest, leading to, of course a productive outcome. Should one act be considered more moral than the other? In my opinion, it is rather hard to draw these lines, the argument made by Adam Smith is one based on intention, unlike the second which is based on outcome. Being rather pragmatic myself, I believe that the answer should be based on the outcome, as even the best intention could lead to a detriment.

Yet another issue discussed is ‘odious debt’, if debt is incurred for the sole uses of a dictator, for example, should the people of said country bear the burden? It seems extremely immoral to do so, it is not the people that is at fault here, only the dictator himself. To this end the debt of some countries are being considered for cancellation or reduction, which seems to be the 'moral' thing to do. Yet this action in itself created the possibility of moral hazard, what makes one country eligible and not the next? Speaking of moral hazard, this book also brought the interesting idea of QE as a form of the 'Greenspan Put' forward, based on the fact that QE leads to increased speculation in the financial markets, thereby allowing the prices of shares and such to rise. This can therefore been seen as a form of helping banks out, when they need it. I for one, disagree with this notion, QE is a much subtler way of helping these institutes out, moreover, QE tapers, and is done in rounds. One cannot be certain that QE will be undertaken, and in what amount, which I think should lower the role of moral hazard quite a bit.

What interested me the most, and contrasted with Krugman the most is Coggan’s rather bleak prediction of our future. One way that is does this is through the use of demographics. The idea is that as the world becomes more developed, birth rates have decreased, while life expectancy has increased, this will inevitably lead to a decrease in workforce, therefore for the world to maintain the current level of production, productivity must make up for the gap, which to Coggan seems unlikely. Frankly, I have to agree, as there will be an increase in the older demographic, pension payments will increase portionally, while taxes decrease progressively, the now smaller proportion of workers will need to make up for this gap. The way that productivity has increased in the past was by ways of technology, however, this doesn’t seem to be a viable option at our current time. In the past advances such as the internet have allowed us to increase our productivity, but one has to wonder what is the next big innovation. Is there even one in the future? There are some who think that the technologies we have today are all derivative of what we have invented in the past, that there are no ‘new’ breakthroughs to be had, and although I do not hold myself to this view. It does seem to me that there are now fewer opportunities for radical innovations that will lead to drastic improvements to productivity, even if there are, perhaps in fields such as nanotechnology, I wonder how long it will take to implement, and to cause an effect on productivity, not to mention the effect on productivity it will ultimately have.

Coggan also spoke of peak oil theory, where the rate of oil extraction will decline in the near future leading to rising energy costs, which without further productivity increase will reduce the profit margin of firms while raising the cost of living for household. Coggan further argues that even if rate of oil extraction doesn’t decline the difficulty of extracting from these new deposits will lead to rising costs. Adding to this are the repercussions on transportation, and existing capital, with rising oil costs, air travel may once again become a method of travel for the rich, and with existing capital being increasingly expensive to run, they too may need to be made redundant. This will result in a worsening of productive capacity, and a long period of time will be needed in order to retool current capital or to invest in new capital altogether. I have a couple of criticisms of this argument, after doing some research into peak oil theory, I found many sources that the rate of oil production is not slowing down. In fact, there are sources that state the opposite, rate of oil production is actually speeding up, with that in mind, the price of oil should not be increasing due to this factor. As for the idea that new deposits will be harder to extract from thereby increasing cost, I have to agree, oil extraction companies no doubt extract from sources that are least costly, therefore remaining deposits will be ones that are more costly to extract from. The solution to this should be alternative fuel sources, which Coggan also mentioned, but he is rather pessimistic about the possibility of these alternative fuel sources replacing oil anytime soon. I would argue that there is already an increasing amount of alternative fuel being used, furthermore with the knowledge that the rate of oil extract is increasing, we have even more time to research and implement these alternative fuel sources.

Overall the contrast between this Paper Promises and End This Depression Now! was very enlightening. There is indeed two sides to anything, and Paper Promises offers a convincing argument that the future is not as rosy as some think. Although I am still more inclined towards Krugman’s view, I now realise that there are still fundamental changes that will be made before the global economy gets back on track.

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End the Depression Now!

Sorry about the rather long wait for this book analysis. I found this book to be an overall great read, being an informative and entertaining look at the crisis, and a interesting look at the solutions at our disposal. I say an analysis, by the way, because I don’t have a clue as to how to begin a review, however, I am very excited to discuss some ideas that were raised within the book. 

Paul Krugman’s End This Depression Now! is a rather optimistic outlook on our recent crisis, he provides a very much Keynesian view of the crisis, and emphasises that lack of demand is our problem, and not so much in the structural side. One of the main arguments that Krugman makes is one regarding debt, with the application of the Minsky model and using debt deflation as the method through which the recession takes place. He argues that the high amount of leverage that consumers and corporations have undertaking have made use vulnerable to shocks, upon reading this I came to the natural conclusion that paying off the debt will be a fundamental part of our recovery. Krugman argues otherwise, he suggests the idea of using a combination of GDP growth and steady inflation to erode away at the real burden of the debt. I question the sustainability of this strategy however, since Krugman also argues fiscal stimulus is key in this process, governments will have to essentially gamble that the stimulus and its multiplier effect, coupled with the inflation will increase at a faster rate than the debt being accumulated. Perhaps in countries with a lower debt to GDP ratio this might be possible, where the spending of the government may be enough to compensate for the lack of private spending. However, I worry in the case of Japan (with debt 230% of GDP), where high growth and inflation seems unlikely. This strategy could go one of two ways, the stimulus and its multiplier effect could indeed lead to GDP growth which will increase the incomes of labour leading to increase private spending and in turn, investment, which should decrease the burden of the debt. The alternative is that governments get caught in a even more vicious cycle of increasing debt, and low confidence, indeed this seems to be a case of ‘go big or go home’. Another major criticism I have of this tactic, is that the added fiscal stimulus will lead to more involvement by the government in the economy, which will surely lead to a slower rate of growth in the future. It seems to me then that there's a trade off between getting the economy going again, and having a rate of growth that somewhat resembles pre-crisis levels. Indeed, this was the conclusion that I came to in my RES essay, although a recovery was assured, steady, rapid growth was not.

One idea for fiscal stimulus that I found interesting was the proposal that stimulus didn’t have to be an ‘add-on’ at all, Krugman argued that by simply making up for the austerity measures that local and state governments had to undertake that 3 million jobs could be created, mostly in the education sector. Indeed, this idea could prove to be both a long-term improvement in quality of labour, and short-term improvement of incomes and therefore spending increase. This also circumvents the need for ‘shovel ready’ projects and reduces the risk of the stimulus leading to excessive growth. The role of monetary policy in this situation should also not be disregarded, quantitative easing is already at work with reducing long term rates for government, with the program set to end, the role of interest rates will once again become more important. It would be unwise for central banks around the world to prematurely increase the rates in fear of bubbles forming in financial or asset markets, this will become a delicate issue to come.

One element of the crisis that saw more discussion in this book was the idea of inequality, specifically ‘spending cascades’ where higher spending in high income groups leads to a cascading effect where lower income groups that are in social contact with these high income groups want to spend more. In order to facilitate this spending, debt must be taken on, Krugman cites this as an alternative reason for increased debt. On the topic of debt, it seems to me that there is now greater attention being paid to the debt cycle, is there way to prevent the booms and busts of this cycle? The fluctuations in the cycle seem to be more due to behavioural changes in anything else, with consumers being more willing to take risks and take on debt when incomes are rising, perhaps the cycle could be seen as a representation of the people’s general view of risk. The risks that are taken could lead to reward, or it could lead to busts, it should not be a large problem in our recovery however, as confidence is quite low and therefore willingness to take on debt should be smaller.

The Eurozone situation was particularly interesting to me, as I was not previously aware of the weaknesses of the Euro. With the unified currency, a devaluation of currency not possible, the only recovery option left for some peripheral countries is a long series of austerity. One element of the eurozone situation that surprised me was the ease with which the creditworthiness of one country could be so easily transferred from one country to the next, through the use of a shared currency. Krugman raises an interesting area of economics known as ‘optimal currency areas’, with the following argument being that the eurozone is indeed not ‘optimal’. Issues such as language and cultural barriers, and lack of fiscal support prevented the shared currency from being optimal. This is an area that I will do further reading on, perhaps it warrants a post of its own.

Overall, I find it hard to find issues that I disagree with in this book, being a Keynesian myself. I found Krugman’s analysis of the crisis to be very thorough, and he raises some ideas that I feel are less known such as the ‘spending cascade’. I would recommend this book to anyone that has even a remote interest in the events and causes or the recent crisis. That being said, it’s always good to have an alternative view, and to that end I’m reading Philip Coggan’s ‘Paper Promises’ which has been a completely different experience altogether, look forward to the discussion of that one soon!

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Good News, Bad News, QE

Update: Having just finished reading Philip Coggan's 'Paper Promises' (the discussion of which will be posted soon), there's a new element that I would like to bring to my post on QE. According to Coggan one of the goals of QE is to encourage speculation through lowering yields on bonds, by encourage speculation there is the hope that this would bring higher share, bond and equity prices, all of which would lead to greater confidence from those that own these assets. Of course, the obvious and frankly apt criticism to make of this objective is that there is a fear of bubbles forming. On another level, QE could be seen as another form of the infamous 'Greenspan Put', by encouraging more people to buy shares, bonds and equity, the central bank is in effect providing the financial system with a 'pick me up' which may yet again run the risk of creating moral hazard. On the other hand, this is a more subtle way of bailing the system up when compared with past attempts, which may indeed reduce the risk of such hazard. My opinion of QE is still the same however, that although it may not be universally popular, or indeed, a detriment towards creditors, it remains a successful policy that lessened the impact of this recession.

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The Great ECB experiment

The European Central Bank (ECB) has recently decided to introduce a negative interest rate effectively charging commercial banks to keep their money with the ECB. The hopes is that this will lead to greater lending by these banks, which should lead to more consumption and investment, while also introducing inflationary pressure. The question is how effective is this?

Objectives

First of all the objectives of this policy should be addressed, consumption and investment are without a doubt integral pieces to the recovery puzzle, however, the amount of consumption and investment that will result from this policies will mainly depend on how commercial banks react to it. The banks could in fact choose to pass on the cost of the negative interest rate onto the consumer, one way of doing so is to charge account holders a maintenance fee or indeed charge negative interest rates themselves. Another option is to not react at all, by increasing the costs of holding accounts, consumers may be choose not to save all together. Some banks may then accept a lower profit in order not to alienate consumers. It is for this reason, that the magnitude of the negative interest rate should be carefully considered, a further decrease in the interest rate may in fact cause consumers to withdraw their money and store it somewhere else.

Why Negative Interest Rates?

Quantitative easing although not without its own problems (I will address my opinions on it in a later blog post), has seemed to serve the USA, and UK well so far, this however is not a viable option for the ECB. The ECB has the unique situation where it is responsible for the economic well being of several countries, making a choice of buying the sovereign debt of a specific country could potentially be seem political favouring, even if it’s in the best interest of the economy. Negative interest rates was then decided on to be another option for the ECB.

Effectiveness

In my opinion the effectiveness of negative interest rates is to be questioned. First of all, I believe there is a fundamental problem with the ECB policy, the fact that the policy will be applied to several different countries means that it lacks the ability to specifically target the individual problems that each country has. Another problem is that the magnitude of the negative interest rate is very low at -0.1%. I doubt this will make too much a change to the lending of banks. Part of the problem is indeed the reluctance of banks to lend, another part of the problem is that business aren’t willing to invest. This ties back to the lack of demand in the economies overall, until that demand is restored, banks may find it hard to lend even if the negative interest rate encouraged it too. Another possibility is that consumers may instead choose to withdraw their own funds if commercial banks were to introduce negative interest rates in turn. This will lead to even less funds in banks to borrow, and also prevents the ECB from imposing a negative interest rate of too high a magnitude.

Overall though I feel what the ECB is trying here will be interesting. I may indeed be proven wrong with the results that come from it, but getting things wrong and learning from it is part of the experience.

[designedeconomics]

A Long Hiatus

Sorry I haven't been making posts lately, I've been very caught up with exams, that being said, there will be new posts shortly, stay tuned.

[designedeconomics]

AS Economics: Is it right for you?

Under the current AS economics specification, students are taught the Keynesian view of the economy. One that preaches aggregate demand as the main reason behind the economic cycle, and that fiscal and monetary policies are our remedies for maladies in this cycle. But, is that right explanation?

Being a student studying AS economics I too was subject to the Keynes treatment, I think you won’t be too surprised when I tell you that I thought that Keynes’ theories was the only explanation for the economic cycle. However, after doing a bit more researching, that is absolutely not the case. Georgism, Austrian Business Cycle Theory, Credit Cycle, Real Business Cycle, the list goes on. I’ll admit that I haven’t exactly understood all these models (one day), but there is one that I want to discuss: Credit Cycle

As the name implies, the credit cycle suggests that the fluctuations in the economic cycle is caused by the expansion and contraction of the amount of credit available in the economy.

Booms:

During a period where there is an expansion of credit, there will be an increase in the amount of leveraged capital, therefore leading to asset prices increasing. The asset price inflation can then become a speculative bubble (we meet again) to develop. Of course this expansion of credit also increases the money supply of the economy, which should naturally lead to more goods and services being consumed, leading to unemployment decreases, and national income growth.

Recessions:

This is also known as debt deflation, a theory developed by Irving Fisher after the Wall Street of 1929, a redeeming theory in my opinion after his infamous statement saying that the stock market had reached a ‘permanently high plateau’. The idea is that when there is a time with high amounts of over-indebtedness in the economy it will tend to liquidation, where firms and people sell assets to cover the debt. Unfortunately these assets are often sold in a hurry (called distress selling), which can lead to the assets being sold for a loss. In turn causing a contraction in deposit currency (basically amount held in banks for check withdrawals/transfers, can be seen as a money substitute), since distress selling can’t cover all debt. The velocity of circulation, which is the rate at which goods/services are being purchased in a certain time, also decreases naturally. As the velocity of circulation decreases, and deposit currency decreases (decreased demand) , there will be a fall in price levels as firms readjust to the market. Provided that reflation doesn’t take place,the net worth of firms effected will decrease, leading to bankruptcies. Profits start decreasing, therefore firms are likely to decrease their labour and trade, leading to a rise in unemployment. Finally confidence overall is impacted, as a result people may start hoarding, leading to a greater decrease in the velocity of circulation. It's just a downward spiral really.

Initially I was quite happy to accept this alternate view on the economic cycle, but then like most things its not without its issues. Although the theory suggests that credit fluctuations correspond with the economic cycle, the economic cycle itself is still based on changes in consumption of goods and services, and to that end, all the credit cycle serves to do is to provide the means for demand to fluctuate. Furthermore, the theory doesn’t seem to allow for fiscal and monetary policy, which definitely has an impact consumption and unemployment, both important contributors to the economic cycle. This leads me to believe that the credit cycle should not be seen as a complete alternative to the Keynesian view, I would advise those that come across it to treat it as another element to the whole story. In fact, I do think it is quite an apt explanation for speculative asset bubbles, and a much better description of how asset prices work when compared to the likes of rational market ideas such as Efficient Market Hypothesis.

All that being said, I still find myself a firm believer of Keynesian theories, the credit cycle only made me realise that the world is rarely as simple as it seems, it’s made me realise that there are other components at work within our economy and it’d be unwise to ignore them. What about AS economics? Really, I don’t have that much of issue with AS economics, the course when taught well, it can really give a student a good basis to springboard off of, and promote a real interest. As for it being rather focused on Keynes? As a widely recognised board, I guess it would be politically wise to teach mainstream economics, and that only. My only wish is that they give some thought to introducing alternate theories into the course, to allow students to make their own minds up. For now, I’m still on Keynes’ side, but who knows maybe these other theories will change my mind.

[designedeconomics]

An article

I recently wrote an article for the school economics magazine so its more of a editorial then an essay, hopefully it'll be published this term. Anyway, I'd just like to share it, please feel free give me any feedback on it.

Can you beat the market?

Well, can you? If I gave you a £1000 to invest with (not going to happen) , could you turn a profit? It seems to me that the common answer is yes, which to a certain extent I agree with, but how large? How much of a profit can be made? Theoretically, billions, but is that skilful investment or is it just pure luck? Most, importantly can you outperform the market?

Let’s start off by playing at little game. I’m going to let you pick an asset to invest in, asset A and asset B (very inventive I know). Asset A’s price has been rising steadily for the past 9 years, with an average growth of 8.6% each year. Asset B’s price has been dropping steadily for the past three months, in fact a 10% price drop. Which one would you pick to invest in? Most people would answer asset A, only logical, right? Well, asset A was property in New York just before the great depression, that year, house prices would drop as much as 30%. As for asset B? Asset B was the stock price for Verizon from July of last year to September, in the next month alone, Verizon’s stock prices rose by 10%. It may appear that I’ve just tricked you, by giving you misleading and limited data, and therefore leading to a ‘wrong’ choice. This is one of the reasons that people consistently fail to chose the right assets to invest in: misinformation, or the incorrect interpretation of data.  Simply put, some people don’t know what to do with the information given to them, and that will in turn lead to random and ‘irrational’ investments of assets.

But, I’m not some people, you say. I’ll invest in what everybody else is investing in, with that many people buying it must be profitable...right? This has happened again and again in the past, people buying assets simply because others are buying it, just blindly following in the examples of others. Few stop and think to themselves, wait, is this group right? When a lot of people start buying something, the price of it will rise, greater demand, greater price (economics 101, you’re welcome). Some may see that rising price as a sign of profitability and before you know it, thousands more have invested, and the vicious cycle repeats. The problem is, this irrational demand has skewed the price of the asset away from its intrinsic value, its actual worth. At one point, people stop hopping on the bandwagon, and buying stops, some people realise that prices aren’t going to rise anymore and start selling. The problem is that this selling is rapid, many people don’t end up making a profit, and instead loses money.  If it helps you, think of it as a party, some people start one, word gets out that it might be a good one, people start turning up, and for a while everyone’s happy. Then people stop coming, and soon the ones that are still sober (thinking clearly) realise the party’s pretty lame, and start leaving, people follow suit, and the party’s over. What’ve I’ve just explained is an economic phenomenon known as a bubble, granted, it doesn’t always happen. The basic mechanic behind it is what’s to be noted here: herd behaviour, so many people buy just because others do, not because of careful choices of assets, not smart.

The reasons stated above are rather simple, they’re just really examples of people, bluntly put, being clueless or reckless. There has to be a deeper answer than just ‘people being dumb’. Well, is where it will get a little bit more sophisticated, meet our friend: Efficient Market Hypothesis (EMH) developed by Eugene Fama. The basic principle that it preaches is that the price of any stock always trades at their fair value. How is that even possible? EMH states that stock prices reflect all information available, meaning that the price of a stock should never deviate from its intrinsic value, making it impossible for someone to outperform the market by selling stocks at a price that is higher than what it should be. Things like carefully selecting the right stock to buy and sell doesn’t matter, since you cannot sell it for more than its worth. The only way you can earn more under EMH is by taking higher risk investments, and nobody wants that.

At this point beating the market may seem like quite a grim prospect. From human mistakes to the idea of EMH, the odds seems pretty stacked against you, right? Let's look on the bright side though shall we? Human mistakes can be minimised, through something that you're already doing: learning. One of the main reasons that herd behaviour happens is that people don't really know what's happening to an asset at a given moment. By being educated, especially in economics and business studies, (thank me later economics department) ,you'll be better able to make sense of news and trends in prices. Meaning you'll be less inclined to follow others, and I instead making your own choice. Sure you can still make the right choice, but at least now you're less likely to.

Also, I kind of lied to you about EMH, sorry about that, but you'll forgive me in a bit, I promise. I mean EMH is a hypothesis and not a law for a reason: it's not perfect. Before I explain flaws with it I want to delve a bit deeper into EMH, call this Explaining Economic Theories: Return of the EMH (to be followed by The Revenge of the Return of EMH)

There's three sub sections to EMH: weak, semi-strong, strong (inventive I know, guess it's a trait of economists). All three operate on the theory that asset prices reflect publicly known information. Weak is only when asset prices prices reflect publicly known information,  semi-strong adds the idea that asset prices instantly adjust to new information, and finally strong adds that insider information or hidden information is also reflected on asset prices. There is also one basic assumption that EMH makes: that on the whole investors are 'rational' (I really don't like the use of that word in economics, but that's another matter for another time). What that means here is that on the whole people make the 'right' reaction to a piece of information. This allows people to deviate from the 'right' decision but that the majority don't. In essence it means that investor's choices can be described with a normal distribution curve with respect to the right choice being made.

The problems, oh the problems. Personally I'm not really a believer of EMH, it's in my opinion one example of how economics has started to stray from reality. For example, one of the proven ways to beat the market: informational time lag (informational asymmetries if you want to get fancy). Some institutions do this, by using supercomputers. They write computer algorithms that check the news constantly, predict how the market will respond and buy and sell accordingly. If semi-strong EMH is true then this shouldn't even be possible! If true, the prices should have instantly adjusted, and no one should be able to take advantage of this time lag.

Yet another example of beating markets (some would say) are hedge funds, many of them make profits that are greater than average market returns. Of course one would argue that hedge funds succeeding are a matter of chance, that of the sea of investors out there they are the ones that got lucky. The counter argument to that counter argument against my counter argument of not being able to beat the market (WE NEED TO GO DEEPER!) is that the fact that so many hedge funds have made a greater than market average profit has to mean something. That this group's success doesn't follow a normal distribution curve. What are you waiting for? Join a hedge fund! If you have millions of pounds just ready to be invested (they're kinda exclusive, like a rich kids' earn more club).

Remember bubbles? Well you can actually use them to earn money. Through a mechanism called short selling, where you basically borrow shares from a lender and bet for the price to drop to make a profit. Think of it like this: I borrow a rock and sell it for £20 (it's one fiiine rock), for some strange reason people lose appreciation for rocks and the price drops to £15. I buy a rock now for £15 and return it to the lender and just like that I've earned £5. Well if you see a bubble starting to burst, you can short the market, sell for a high price, and buy back and return at a much much lower one, profit. Except that you have to get the timing spot on, a little off and you can lose money instead of gain.

To conclude: there is no sure-fire way to beat the market. If there was, we'd all be rich enough to swim in pools of fifties. You can try joining a hedge fund, short selling when a bubble bursts, use supercomputers to take advantage of time lag, or make wise and informed investments, none of them are guarantees. What is guaranteed however is chance, even if you randomly select a stock, there's a chance it'll outperform the market. In fact, according to a study which simulated monkeys throwing darts at a board to chose a random stock. Those monkeys outperformed the market by a margin of 1.7% when compared to the market average. If a monkey can do it, why can't you?

[designedeconomics]

UK property bubble?

What a coincidence that after my post on bubbles for there to be talks of a UK property bubble forming. Some are arguing that it is a more of a regional problem, specifically in London, rather than a nation-wide phenomenon. To be honest, I’m not sure, I’m not certain if there’s even a bubble. It’s hard to be but below is some of my analysis of the situation, take a read and make up your own mind.

Let’s start with the evidence, according to Nationwide data provided by the Guardian, house prices across the nation rose by an average of 8.4% last year. With some cities such as Manchester rising by 21% and certain parts in London rising as much as 25%. Those numbers there are pretty indisputable, it is definitely certain that house prices are rising at a rather alarming rate. Is it a bubble though? There hasn’t be a cause for decreased supply of housing during this time, therefore, it must be increased demand. In fact, according to the Metro, new buyers across the UK rose by 44.5 % over the last year. With demand growing at such a high rate, market supply has also grown to meet this increased demand, over the last year the housing market has experienced a 7.8% growth. What is causing this demand? One part of course is the recent affirmation of the government that the UK is now in recovery, no doubt this increased consumer confidence as well as firms’ confidence. Secondly the government has introduced the ‘Help to buy scheme’ aiding not only first time buyer, but qualified borrowers for houses new and old, with a maximum of up to £600,000 in value of the property. Both these factors have accelerated the pace of housing price rise. The housing market is an illiquid one, meaning that it is harder to find buyers and sellers at a short notice. Therefore it is higher in risk, especially if the quantity of demand and supply is suddenly changed. The worry is that the rapid rise of demand cannot be compensated by a similar growth in supply, and that demand may suddenly change leaving large amounts of spare supply. In conclusion, nation-wide bubble: no. Regionally? Yes, in my opinion.

Solutions As I wrote in my first post, in my opinion one way that the growth of bubbles could be slowed is to raise interest rates, by doing so people would be discouraged from taking out loans. Therefore less people are likely to purchase the asset, in this case properties, less slow in demand rise should reflect in the slowing of price rise as well. In this current situation however, raising the interest rate could prove detrimental to the rest of the economy. First of all it goes back on the promise of Mark Carney’s forward guidance, which promised a maintained interest rate of 0.5% provided unemployment does not drop below 7%. Some may argue that we might as well do it since unemployment is at 7.1%, and is currently dropping. However, doing so would also reduce the likelihood of private investment, which in my opinion is very important during this time of UK recovery. It would also help to curb the rate of unemployment decrease by raising productivity. Not to increase productive capacity, which would also aid future fiscal expansionary policies. (crowding out effect, will be explained in later post, don’t want this post to get too crowded) (no pun intended, OK, maybe a little :P)

Another way of slowing this bubble growth is to reduce the credit supply. I’m not the only one that has this idea, the governments’ Help to Buy scheme has become a prime target. The Bank of England has called for a reduction in the max loan value of the scheme from £600,000 to £350,000 - £400,000. However, how effective would this loan value drop in reducing the purchase of property? What about in places of high property price rise? Well according to the BBC, 80% of the loans taken out under the Help to Buy scheme are outside London and the Southwest. Suggesting that it doesn’t play a large part in the inflation of prices in those regions. Secondly, the avg. value of loans taken out under the scheme is£150,000, suggesting it is mainly targeted by low income buyers. So bubble inflator? Not so much.

You’ll notice that I’ve basically raised ‘solutions’ and promptly shot them down. I think that there doesn’t need to be any ‘solutions’ to this bubble, overall it contributes more positively than negatively. I am an advocate of precautionary measures however, a 0.25% interest rate raise, in my opinion, would suffice.

[designedeconomics]

Bubbles for the Economically Uninitiated

Hello readers, this will be my first post here on designed economics, with this blog I hope to share ideas that I’ve come across in economics, as well as discussing current affairs. That’s enough for introductions, below is my explanation of a rather interesting economic phenomenon: the bubble.

Bubbles may sound like relatively light hearted and joyous affair. Unfortunately the reality is anything but. To understand bubbles, it would be extremely helpful to first of all understand what herd behaviour is.

Herd Behaviour and its Role in creating Bubbles

This is when people in a group can act together, even though there is no direct plan to. Why? One reason is the ‘following’ of a leader. Often one will follow the example of someone more successful, if that successful person where to for example purchase shares of a certain kind, the ‘follower’ might be inclined to do the same. After all, how can the successful person be wrong?

Now expand that thought, that is one ‘follower’, not doubt there are others that follow the same person, and some of these ‘original followers’ may in turn gain ‘followers’ themselves, this effect magnifies and I’m sure you can see the large scale this can lead to (called a network effect). Furthermore, it becomes even easier to join into this large crowd once it’s formed, the rational thought that comes to mind would be ‘How could such a large group be wrong?’ It is here that lies one of the very fundamental problems of herd behaviour, the behaviour of this large group is often not reflective of the collective intelligence of the group. Since many are following, they are basing their decisions on the decisions of others, instead of assessing the situation by themselves and coming to their own conclusion. Effectively this means that only a small proportion of the group has a clear idea of what is going on, with the rest depending on those with the knowledge to make the right decision, not very smart at all.

Another reason that herd behaviour occurs is rather easy to explain, that is social conformity. Humans in nature are very social creatures, we want to belong in a group, and rarely do we want to be the odd one out. This may lead people into adopting or engaging in activities that they themselves do not want or are reluctant to. This can then, logically lead to herd behaviour, since many don’t want to be left out, so they’ll join the group.

Okay, that’s all fair and well, but I CAME HERE FOR BUBBLES WHERE ARE THEY?! Or what are they even, I’m confused. Well, I’m sorry for causing this confusion may allow me to clear that up, right about now. Bubbles are simply the manifestation of herd behaviour in relation to economics. What do I mean?

 Let’s apply herd behaviour to the stock market for example. In our example a group of famous investment professionals invest a large sum into a certain stock. Many soon follow, thinking that it’s a good idea, and so more and more of that stock is bought, naturally the price of the stock starts to rise rapidly, this is a bubble. However, the magnitude of price change also depends on the amount of credit available. Usually, bubbles only inflate when there is a large amount of credit available.

Interestingly, the price rise also has the effect of affirming the notions of followers, the price of the stock they purchased is rising, that can only mean the stock is valuable right? And thus they are now even more certain of their decision. Now certain people are smart, and seeing this sell their stocks for a profit at this point, however these people are a minority and don’t make a large impact on the overall price of the stocks. At this point, eager to get into the ‘trend’, people are still buying in. At one point, money will run out, naturally the stock’s price will stop rising. Thinking that this is the peak of the bubble, people start selling. If everybody follows suit, the bubble pops, prices plummet. Some get lucky and sell before prices hit rock bottom, the rest are now left with a stock that is worth much less then when they bought it. Those that borrowed money have now lost money, and do not have a way to repay their debts.

Why?

That was the first question that came into my mind when I came across bubbles. Why does nobody see this coming? Why does it keep on happening again and again? From the housing bubble that partially caused the great depression to the dotcom bust of the 2000s. History indeed seems to repeat itself.

Well, why doesn’t anybody see a bubble? Let me answer this question by posing another one: How do we know when something is overvalued? That is the fundamental problem with bubbles: the overvaluation of an asset, thinking something is worth more than it is, and investing in it. Indeed there is no definitive answer to this question, value is itself a subjective measure, therefore an objective answer is hard to offer. That being said there are indeed objective measures of value, one is to compare the earnings of an asset to the safest investment there is. This may be in the form of a government bond, for example if the earnings of a bond was 2%, and the earnings of an asset was 1%, then it is overvalued. Since you could invest in a safer asset AND earn more, it’s just not logical.  Another way of measuring value is to look at a stock’s price to earnings ratio (PE ratio). This is calculated by dividing the price of a share by the earnings per share, usually for the past year. This PE ratio is then compared to the market average, if it is lower, than it is considered undervalued, and vice versa. A problem with PE ratio is that expectations also plays a part in the price of shares. For example if a company has warned that earnings might be lower than previously expected, it may not be necessarily be reflected in a lowering P/E ratio until earnings are released. In the end, no way is perfect, and determining the value of a stock is up the judgement of the individual, be it a good one or a bad one.

As to why bubbles keep on appearing again and again, it is more of a psychological cause, as is discussed in A Short History of Financial Euphoria by John Kenneth Galbraith. We as humans are rather unlikely to put blame on the whole of a group, the whole of the ‘herd’. Usually blame is pinned onto the few ‘leaders’ instead of the whole group, when the harsh reality is that everyone had a part to play in the bubble and subsequent burst. Moreover, when someone warns of the possibility of a bubble it is often met with hostility, since so many are invested into this trend, the accusers become ‘non-believers’ and ‘outsiders’. Therefore it is extremely hard to change or alter the momentum of a bubble once it starts going, and it is rather easy to start following a new trend.

Solutions?

In my opinion, bubbles will always happen. There’s no stopping it, it WILL happen. What is possible though, is to stem their growth. One way of doing so is education and making financial information more transparent. By doing so, more people will be able to make informed and more appropriate judgements on the intrinsic value of assets, instead of aimlessly following in the example of others, this would no doubt reduce the velocity with which herding behaviour happens. Another possible idea is to limit the amount of credit available in the economy, this could indeed help to slow the growth of bubbles.

That concludes my first post here on designed economics I would appreciate any feedback and would be happy to discuss ideas that you may have.