Pol•eco•phi

Leveraging Political Science, Economics, and Philosophy to formulate policies to the benefit of the human race.

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Political Dreams, Institutional Nightmares, and Economic Realities. Where is the Euro?

The European Union and later the Union are the products of a political vision that seeks to unite European nations and help them overcome a history of wars. However, in creating the Eurozone, political enthusiasm overshadowed careful economic consideration and planning on the monetary union’s functioning. More specifically, the Eurozone’s economic institutions are wholly inadequate to serve the collective interests of its member states.

By abdicating monetary sovereignty to a European central bank, the GIPSI (Greece Portugal Ireland Spain and Italy) nations’ economies became vulnerable to asset bubbles that could not be prevented (by rising rates). Once these bubbles imploded and demand plummeted, these countries found themselves unable to restore demand through monetary stimulus. The ECB could not help them without violating its mandate of targeting inflation at 2% in the entire Eurozone.

The current situation is a consequence of an inadequate set of institutions to support a monetary Union. There are many institutional mechanisms that are sorely lacking in the Eurozone.

1) The ECB’s sole mandate of inflation targeting prevents it from using monetary policy to support economic growth, even when inflation is below target.

a. This is unlike the Bank of Japan, who actively manages its exchange rate to support the export sector.

b. This is unlike the Federal Reserve, who has a dual mandate of price stability and full employment.

2) The ECB cannot directly purchase its member states’ debts, which restricts those states’ ability to undertake expansionary fiscal policy in case of a recession (like now).

a. This is unlike the Bank of England, who can buy significant amount of debts (“quantitative easing”) to support economic demand and ensure that consumers and investors have access to cheap funds when demand is weak.

3) The ECB is not a lender of last resort. It cannot lend directly to troubled lenders that have no assets to put up for collateral. Therefore, the increasingly strong belief that some member states may leave the union is creating a deposit flight from GIPSI banks, making it a self-fulfilling prophecy. This incapacity to act as a lender of last resort places the burden of supporting failing banks on member states that have a limited capacity to borrow from the markets.

a. The Federal Reserve in contrasts can lend as much is necessary to prevent a banking crisis from aggravating an economic recession.

4) Europe lacks a depositor’s insurance corporation. The lack of a EDIC (European Depositors Insurance Corporation) makes depositors far more likely to run on their banks in cases of financial uncertainty.

5) Europe lacks a federal agency to buy and subsidize mortgages.

a) The lack of an agency to buy and subsidize European mortgages sets up the condition of a credit crisis. Struggling homeowners cannot get temporary reprieves from mortgage payments when they can no longer afford them, which increases foreclosure rates that depreciates property prices. Rapidly falling property prices create a situation whereby a huge proportion of properties are worth less than the mortgages on them. It then becomes rational for homeowners to default on those mortgages, and that weakens bask balance sheets as their shares of non-performing loans increase. Europe needs a Fannie Mae and Freddie Mac.

b) The lack of a publicly-funded and European-wide agency to intervene in the housing market forced the Irish government to buy most of the country’s commercial real estate as Irish people were left owning homes that are worth a fraction of their mortgages. Europe lacks a fiscal union.

6) The lack of a fiscal union, when there is no monetary union is economically dangerous as governments’ need of resources to support unemployed people increase while the economic base from which they can raise resources to meet their transfer payment obligation shrinks. Spain has to find the resources to help the 20% of its unemployed labour force, while the number of taxpayers is shrinking. The lack of a fiscal union implies that states with more resources and more robust economies cannot automatically support those whose economies have slowed down.

The weak institutional framework of European economies compounded countries’ incapacity to restore full employment to their economies through monetary intervention. All of that is bad news for the survival of the Euro as a common currency. In many ways this could have been anticipated because Europe never was an optimal currency area. The effective lack of mobility of factors of production (due to linguistic, legal, and cultural barrier) means that market forces cannot efficiently adjust economic imbalances between various geographic areas of the Eurozone. Italian, Spanish and Greek unemployed workers cannot just pack up and pick up a job in Munich.

The bad news for Europe is that institutions that can support healthy economic growth cannot be grown overnight. The good news is that the knowledge to create sound institutions exists and can be leveraged to support Europe’s aspirations to peace and prosperity.

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How can institutional reforms maintain the momentum of Chinese growth?

China’s development strategy that relies on export-led growth has allowed it to become one of the fastest growing nations in history, and has helped lift a billion people out of abject poverty. The great recession has showed the vulnerability of Chinese growth to external demand. As demand for Chinese exports from Europe and the US has fallen, so has China’s rate of growth, requiring the communist party to implement fiscal stimulus policies. Exports and Investment play a relatively larger role in China’s growth than government spending, and more importantly consumer spending. The problem with export- led growth is its reliance on foreign macroeconomic conditions, and the problems of investment-led growth are its volatility.

How can China boost domestic consumer demand (an additional engine for growth)? This can be achieved through institutional reform. A key reason why Chinese consumers don’t spend a lot is because they save a lot. They save to ensure their future welfare against unexpected illness, and to ensure that they have a retirement nest eggs. Unlike European nations, China does not have a social safety net. If there was a collective system that guaranteed some form of health care coverage to individuals and ensured a minimum retirement income to people, then the optimal level of savings would fall. If each individual is responsible for his own welfare, that person will tend to “over save” to insure against the risk that she would become sick, or would not afford to retire. Let’s examine how the cost of insuring a risk varies with the pool of insured parties.

If your car insurance only included the members of your neighbourhood, your premiums will be higher than if they included millions of members. Why? Because the probability that a series of independent adverse events (say three car accidents in the same month / 10 times more than normal) could bankrupt your neighbourhood insurance fund is much higher than the probability that ten times the average number of adverse events would happen in a pool with millions of drivers. Since the likelihood of adverse events sufficient to bankrupt the insurance fund falls as the risk is spread over a larger pool of policyholders, it means that individual premiums can fall accordingly. Going back to China, the reduction in the level of savings needed to insure one person against a health risk can go towards consumption. Further, collective insurance schemes can effectively cover an individual’s risk of getting ten cancers in a row, while no individual can save enough to pay the bills for such a highly improbable event.

Secondly, when individuals need to save for their own pension needs, they will be tend to be risk averse and prefer low yielding investment products (like savings account). If individuals have the option to save in a soundly managed fund, that fund can be risk neutral overall by ensuring that it is invested in assets that have the highest risk adjusted returns (through diversification, and risk management). What does that mean? One Yuan invested in a collective pension fund will have more returns than one Yuan saved in an individual savings accounts, therefore less Yuans need to be saved to meet an individual’s retirement needs. Those Yuans that no longer need to be saved for retirement can go towards domestic consumption.

How can the government achieve this transformation?

The Chinese government has benefited from an authoritarian system that allows it to implement sound reforms in a speedy manner because it does not need to entertain much democratic debates and discourses. Therefore, the Chinese Communist Party should create a mandatory health insurance scheme and a mandatory public retirement plan.

Further these plans can be created on a defined contributions basis as opposed to a defined benefit plans. That way, Chinese policymakers can mitigate their solution against the pitfalls of the European welfare systems. The post-World War welfare system is flawed because it creates liabilities that are economically unsustainable and that drag economic growth, through an inefficient allocation of resources via a political system where those that can benefit from the welfare system today can maintain their benefits by adding onto the bill of those that cannot yet vote and will not be able to afford a social safety net.

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On the Illusions of Ideological Wars

The key to harmony in international relations is to free ourselves of the egoistic (or altruistic) desire to free others from the shackles of their beliefs and values that we do not share.

The lures of morally righteous wars and their utopian objectives harm those they were intended to help.  Ideologically motivated wars almost always fail their intended purpose, and they weaken the weakest, those abroad (as collateral victims dealing with humanitarian conditions worse than those created by the ineptitude of former despots), and those at home (whose rung on the social mobility ladder could not be crafted due to insufficient funds). Why do we fall victim over and over again to our willingness to wage ideological wars?

A failure to recognize that treating others’ benign social tumours causes more harm than good.  In so far as others’ practices do not explicitly harm us, the ambition to sculpt the structure of their beliefs according to the mold of our values inflicts on these societies irreparable harm that further limits the spectrum of free and mutually beneficial exchange we can have with them.

In minding our own technological superiority over those we wage wars against, we should guard ourselves from believing that our rationality and the strength of our values will sway people whose beliefs affect most of their sense of well being. Through various channels the rise in education has elevated our consciousness to a level where we can give to Caesar what is owed to Caesar, respect science for what it can demonstrate, and believe in God for matters that are beyond the reach of scientific reasons. Trying the witchcraft of political alchemy on people whose beliefs are the source of all of their consciousness is rightly perceived by them as an assault on their fundamental values and worldview. Hence, we should guard ourselves from transplanting institutions and frames of minds that have yielded fruits in our society to societies that have different belief structures from ours, especially through warfare.

If we cannot win other people’s hearts by charming them with the fruits of our societal achievements, raping them by militarily forcing onto them remedies to conditions that they do not perceive as malign will not do. Humility requires us to shy away from wars of ideology that are inherently sterile and wasteful.

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Is ergodicity at the root of all macroeconomic opinions?

Schools of macroeconomic thought differ widely in their policy preferences to achieve social optima. A broad chiasm exists between Keynesians and neoclassical economists with respect to monetary policy and fiscal policy preferences. While the following description is a summary, it will suffice to illustrate how different views on ergodicity explain the differences in these schools of thoughts.

Keynesians and allies believe that there are economic conjectures whereby monetary intervention can generate real growth (situations where the output gap is significant and inflation is below target for example). Neoclassical economists and their monetary allies believe that the gravity of market forces is so powerful that monetary surprises cannot yield real economic benefits.

On the monetary debate, neoclassical economists & monetarists believe that economies are ergodic as market forces ensure price adjustments that maintain the economy at potential at most times and thus any gains due to a monetary surprise today will be balanced by a price change that will annihilate those nominal gain. Keynesians and allies believe that a short-term gain will forever alter the development path of an economy, hence initial conditions matter. Depending on each perspective the economy either has a long run steady state or a path that can be altered at each short-term junction. While neoclassical economics believes in the ergodicity of economic systems, Keynesians and associates believe in path dependence.

With respect to the fiscal debate, neoclassical economists believe that changes in government expenditures cannot efficiently modulate economic activity and change potential output because agents’ behaviour is altered by the expectations of a balancing fiscal change in the future. Since the government must over time keep a reasonable balance, a tax cut that leads to a deficit heralds higher future taxes and leads agents to save the tax cut (Ricardian equivalence). Keynesians on the other hand feel that short-term stimuli may create a boost in the economy’s growth path whose value exceeds the amount of the stimulus. 

Who should we believe? Both schools of thought have a point. Unlike natural systems ergodicity does not apply always and everywhere with the same power. The challenge of wise economic management lies in the ability to recognize with a certain degree of certainty when a change in expected policy can yield positive results from those instances where a change in policy simply changes the timeframe of economic consequences.

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"It's not true that there's a deposit flight," Really?

Last week, the Spanish deputy Finance Minister Fernando Jiménez, declared that it is not true that there was a deposit flight at Bankia, a troubled Spanish bank. Let’s examine the logic of the statement, any problem that may arise as a result of the statement, and a solution to the problem.

Case 1: Assume that the statement is True

Assume that there is no deposit flight.

Even if it is true, a prudent investor will deduce that there’s no smoke where there is no fire. Perhaps there is no deposit flight at Bankia, but if it is in the news, and a deputy minister needs to reassure the public, then something is not right. A prudent risk averse move will be to withdraw one’s savings from Bankia (ideally ahead of other prudent investors). If a few people are withdrawing their savings as a result of that statement then there will be a deposit flight at Bankia. Hence, the statement that there is no deposit flight at Bankia will trigger a deposit flight at Bankia and have the opposite of the hoped for result.

Case 2: Assume that the statement is False

If the statement is false, then there is a deposit flight at Bankia. In which case, all investors would be wise to withdraw their savings from Bankia and hence accelerate the deposit flight from Bankia. In that case, Bankia will declare bankruptcy sooner rather than later and the government may need to support it.

In either case, the dominant strategy is to withdraw one’s savings from Bankia. If we take into account that the government has an incentive to lie about a deposit flight at an institution it might have to support otherwise, then case 2 seems more likely. In fact, by commenting on the deposit situation of a troubled lender, the government, as an interested party only makes the situation worst.

How to Stem a Deposit Flight? A Creative Solution to Bank Runs

Denying or confirming a deposit flight does not help address the issue. Denying a deposit flight is not credible but only reinforces a deposit flight, while confirming one accelerates it. Further, a statement from the government is not credible because the government has money to loose in the event of a deposit flight. Instead, the European Central Bank should take an equity stake in Bankia. As the lender of last resort, it clearly has the capacity to pay depositors. Secondly, if Bankia had central bank support then depositors should feel safer having their deposits at Bankia (because they cannot go wrong) relative to other banks whose financial situation is unknown (we don’t know that they are not in trouble). Further, if Bankia’s shares stabilize, the European Central Bank could mop up the modest amount of liquidity it injected to stem a potentially chaotic and contagious bank run while making a profit for its balance sheet.

Exceptional times call for exceptional measures: the European Central Bank should consider buying equity stakes in troubled lenders to reassure depositors and prevent bank runs. A bank run could be devastating because once confidence in the financial system unravels; the ECB can no longer stabilize the system. In a credit crisis where financial participants stop lending to each other out of fear, they hoard liquidity to protect their own balance sheets, hence making monetary stimulus inefficient.

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Can Mario Draghi save the Titanic Euro?

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Can Super Mario Save the Euro?

Greece’s hung election raises the spectre of a Hellenic exit from the euro monetary area. To contain the crisis, the European Central Bank under the leadership of Mario Draghi has used creative policies to prevent a sudden escalation of the credit crisis in the periphery of the Eurozone, notably in Spain and Italy.

Two questions come to mind: How have ECB interventions helped contain an escalation of the Euro crisis?

Can the ECB’s interventions maintain the cohesion of the Eurozone in the next few years?

Super Mario in action:

By providing liquidity to European banks, the ECB is slowing down the consequences of the Euro credit crisis. Firstly, subsidized loans at 0.5% interest rate allow European banks to lock in a guaranteed profit and to stay afloat. An Italian Bank can borrow at 0.5% and invest in European sovereigns at 5+%, which allows these banks to secure a profit. Secondly, ECB liquidity allows under-capitalized European banks to meet depositors demand for their money. A typical Spanish bank would be under capitalized, because its assets in the form of worthless mortgages have depreciated significantly (due to the implosion of the Iberian housing bubble), while its liabilities in the form of demand deposits remain intact. In such an environment, the slightest run on banks or financial shock could spell the doom of many of these institutions. Liquidity from the ECB allows those banks to continue to function, and prevents a run on banks which would have chaotic consequences.

Secondly, to secure a return on cheap ECB loans, European banks invest their cheap cash in European sovereign bonds, which provide them with a higher yield. While this may sound surprising, European sovereign debt is a better investment than consumer debt (as unemployment remains stubbornly high, and personal budgets are overstretched in countries where solidarity maintains social cohesion where austere states can’t afford to spend), or corporate debt as companies have no room to expand in an environment where taxes are increasing and consumers have nothing to spend.

Mario Draghi’s move to provide liquidity to banks that then turned around to buy their nations’ debt is a masterful move. It allows the ECB to put a cap on sovereign interest rates without violating its charter, which forbids it to finance sovereign borrowing. By indirectly capping the level of interest rates on EU sovereign debt, the bank is in effect preventing these rates from reaching the threshold at which rising debt service burdens increase the probability of default, which further constrains credit and drives rates higher, until the increasing risk of default causes defaults in a self fulfilling prophecy dynamic.

This intervention came at a cost however. Portfolio management theory demonstrates the benefits of diversification. As such, European Banks have an incentive to invest in sovereign debts of countries to which they have relatively less exposure. Italian Banks will therefore buy other EU country debt; in effect, providing European banks with cheap liquidity, and thus allowing them to invest further in each other socializes the cost of a default by any euro member. In exchange for more time, politicians are assured that their countries will pick up a greater share of the tab, should they not find a satisfactory solution.

Can the ECB save the Titanic Euro?

Given its current constraint of inflation targeting as its sole objective, the ECB cannot save the Euro. As previously covered in this blog, the austerity measures are counterproductive because they reduce the economic base from which the resources necessary to pay the debt must be extracted. Further, given that European banks are undercapitalized, ECB liquidity does not allow them to help economic expansion because they hoard cash to buttress their balance sheet rather than lend to citizen who are losing their jobs or to companies that have no room to grow.

In such an environment, ECB monetary actions are inefficient. Since the ECB cannot invest in government bonds, it cannot allow governments that can no longer borrow at affordable rates to support their economies through fiscal expansion. Further, ECB liquidity for European banks do not help restore consumer confidence, as the latter are faced with uncertain job prospects, rising taxes, and must support unemployed relatives. Furthermore, ECB monetary interventions do not help European companies who do not have customers to sell to, and whose competitiveness is not helped by a stubbornly high Euro.

In light of these facts, it is reasonable to infer that the ECB’s monetary interventions can buy time for efforts to preserve the Euro block, but are insufficient to resolve the Euro crisis. I maintain my assessment that the Eurozone will break up in parts by 2013.

Mario Draghi like Mr. Thomas Andrews knows that the Titanic Euro will sink, it is only a matter of time, the goal now is to help the maximum number of people stay afloat.

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The Dual Face of Racism: The Duality of Racism

The Duality of Racism:

Having negative feelings and attitudes towards people based on their race is unambiguously considered racist. In most social milieus declaring that “I hate [ any group of human being]” is considered wrong, and will draw social disapprobation. However, declaring sympathy to a group of people based on positive characteristics is considered acceptable. It is ok to believe that people of Chinese ancestry are good at math, or people of African descent have super normal abilities in artistic expression and athletic performance. We may describe this as positive racism. The problem with “positive racism” is that it is noxious nonetheless. The acceptance of positive prejudices reflects the duality of racist feelings.

Positive racists act on their feelings in ways that are detrimental to the victims of racism and society. As such, a talented Japanese Jazz musician may not get a fair hearing to demonstrate his talent. Should he get his groove across to a talent scout, a musical impresario may deem him unmarketable because people cannot associate a Japanese saxophonist to Jazz. Likewise, a motivated African American student with a solid aptitude for Mathematics may never receive the positive reinforcement she needs from her teachers, to embark on a career in engineering. Make your own examples.

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May the 7th 1954: The Siege of Dien Bien Phu ends

On the 7th of May 1954, the siege of Dien Bien Phu ends. It is a tremendous victory for the  vietnamese forces over the french colonial army. This victory ends French colonial rule of Vietnam, and, regrettably, paves the way for American involvement in Vietnam.  Arguably, Vietnam's distance from France, a long war with the pre-eminent western super power, and its location in a region vibrant with various successful political models of governance (Japan, China, Korea, Thailand, Malaysia), shielded it from French political interference and French institutional modes of governance.

Vietnam's ability to model its development economic models best suited to its historical and political context allowed it to prosper beyond most other former French colonies that are still mired in poverty and underdevelopment.

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The Dual Face of Racism: Who is Racist?

Who is racist?

A minority of people would self-identify as racist. A silent majority use race as a heuristic that leads to racist behaviour. A general perception that say green people are 10% more likely to engage in racist behaviour, leads us to be prejudiced against a majority of green people. In our mental risk assessment, our instinct is to distrust all green people. Implicit association tests are widely used to establish racial (and other) prejudice(s). Subjects are given a positive and negative anchor, and are tasked to assigning statements to their anchors. By analyzing the length of their responses and comparing these to a pre-test survey of their beliefs, researchers can infer prejudice. Essentially people take longer to respond to cognitively dissonant questions. For example, prejudiced people will take more time to assign the phrase “Green people are like any other persons” to the Positive (or True) category, than the phrase “Purple people are like any other persons” if they harbour racist feelings against green people. You can test it on Harvard’s Implicit Association Website [5]. The results of tests that aim to measure prejudice demonstrate that most people are prejudiced.

[5] Implicit association Tests. See https://implicit.harvard.edu/implicit/demo/selectatest.html

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The Dual Face of Racism: Why is Racism Morally Reprehensible?

Why is racism morally reprehensible?

In short, judging individuals based on characteristics that are beyond their control is unjust. None of us would agree to arbitrary judgement based on characteristics of our person that are beyond our control, if we were seated behind a veil of ignorance (See John Rawls) [4]. From a social perspective, choosing individuals based on race instead of aptitude constrains the production possibility of beneficial and desirable goods that result from social interdependence.

[4] Justice as Fairness # John Rawls

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On The Dual Faces of Racism: What is Racism?

On The Dual Faces of Racism: What is Racism?

Racism is the belief that individuals possess abilities, handicaps, or special characteristics that are linked to their race. Racism sentiments are noxious to a well functioning society because people relate to others based on their racist sentiments. Racist people may deny economic, social, or political opportunities to others based on their race and not their character or aptitude.

For example, countless studies have shown that minorities are discriminated against in the labour market based on their race and not their qualifications. [1] This article is a good example of wage gaps by ethnic origin (as a proxy for race), in the labour markets of France, Germany, and England.

Beyond Economic discrimination, social discrimination is also pervasive. People from other races, are considered less desirable partners. An interesting data crunch from Ok Cupid demonstrates how race affects dating markets. In a world without racial discrimination then race should be irrelevant in the dating market, just like our astrological signs are. At its worse, social discrimination takes violent forms. Most western democracies have experienced violent racial riots in response to emblematic incidents of racial hatred perpetrated by a representative of the government. Of note, the 2005 “civil unrest” in France, the race riots in LA in 1992, the race riots in Brixton UK in 1981, amongst others.

Social discrimination inevitably leads to political discrimination. President Barack Obama’s historic victory is particularly exceptional, as he had to overcome voters concerns about his opponents’ politically motivated charges that America was not prepared to vote for a man of African ancestry. [3]

[1]  http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0297.2009.02338.x/pdf

[2] http://blog.okcupid.com/index.php/your-race-affects-whether-people-write-you-back/

[3] http://thecaucus.blogs.nytimes.com/2008/04/22/bill-clinton-irritated-by-race-card-questions/

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The one and Only Mini Cooper

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Me at the British National Gallery

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1st Stop in London, 51 Brondesbury Park Road

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Farewell Toronto, Hello London

After a break from my blog, I am resuming my blog entries. I have left Toronto and relocated to London for personal and professional reasons. Stay tuned for new blog entries.

Going forward, I will continue to write on the same themes but I am thinking of writing more consecutive entries on the same subject and aim to make them shorter. Zacharie