The random economist

Politics in America, Twain, and Confidence Men

noreply@blogger.com (Joe Francois) — Sun, 11 May 2008 11:18:00 +0000

With the presidential election well underway in the United States, I find it amusing to listen to spectating Europeans complain about how complicated the process is. In reality, leadership selection is rather convoluted on both sides of the Atlantic, and I think it fair to also ask your European "man on the street" to explain how the management team of the European Union is selected, the next time he or she comments on the American process. Actually, both the leadership selection mechanisms in the Euroepan Union, and the electoral college in the United States, seem somewhat akin to selection of the Doge in Venice:

"Thirty members of the Great Council, chosen by lot, were reduced by lot to nine; the nine chose forty and the forty were reduced by lot to twelve, who chose twenty-five. The twenty-five were reduced by lot to nine and the nine elected forty-five. Then the forty-five were once more reduced by lot to eleven, and the eleven finally chose the forty-one who actually elected the doge.." (Wikipedia, "Doge of Venice").

There may be wisdom behind such complexities. It shields us from true populism, prevents us from feeling too vested in our leadership, and makes the system harder to game on a consistent basis.

So, if the process of leadership selection in the United States is hard to explain in detail, the spirit is easier to explain. We just need to turn to the pages of Twain. To understand what goes on spiritually in American politics, it helps to first remember that there is an important entertainment element to the whole thing. With this in mind, I recommend reading Adventures of Huckleberry Finn, and in particular the chapters relating to the Duke and King. In Chapter 23, they put on a play. Think of the play as a political administration. What the Duke and King advertise is

"The Royal Nonesuch. 3 Nights only! World-Renowned David Garrick and Edmund Kean! Admission - 50 cents. Ladies and children not admitted."

What they deliver is the King prancing around the stage naked, along with a revelation that the audience has been conned, tricked out of their hard-earned money. Rather than admit they have made a mistake, the audience decides to talk the rest of the town into going to the play the next night.

"Hold on! Just a word, gentlemen." They stopped to listen. "We are sold- mighty badly sold. But we don't want to hear the last of this thing as long as we live. No. What we be the laughing-stock of this whole town, I reckon, and never want, is to go out here quiet, and talk this show up, and sell the rest of the town! Then we'll all be in the same boat. Ain't that sensible?"

Basically, having chosen wrong, they support forcing a second performance on the rest of the town (a second term in office, so to speak), rather than admit to a mistake. Eventually, however, the town does throw the rascals out, in dramatic fashion complete with rotten eggs, cabbages, and dead cats. This is what we are witnessing now. We have had repeated performance of The Royal Nonesuch these last 8 years in Washington. The electoral wheel is turning, and the town mob is gathering their eggs, cabbages, and dead cats and getting ready for political change. This is what is happening, metaphorically speaking, as the elections proceed. Pay no attention to the procedures. Enjoy the theater.

References

(1) Wikipedia, "Doge of Venice."

(2) Mark Twain, Adventures of Huckleberry Finn, Chapter 23.

Scapegoating migrants

noreply@blogger.com (Joe Francois) — Fri, 02 Nov 2007 20:22:00 +0000

The nativist myth: When God created the world, in his wisdom he placed a fixed number of jobs in each country. He also dictated that people within a country should stay only in that country, regardless of famine, drought, war, or love. They should not migrate to other countries, as they would upset the balance and there would be too many people and too few jobs. Therefore it is the job of people in a country to protect the jobs they have, for they will never get more, and the ones they have might be stolen and carried away in a box to another country, along with their cars and other belongings

Assuming that people really believe the story above is the only way I can make sense out of recent anti-migration rhetoric in the US and EU. Indeed the news this week has been surreal. I have been listening to reports and call-in show hosts on BBC stoking the perception that migrants cost money, and encouraging discussion on their contribution to crime. Government officials are also stoking the rhetoric. "Gordon Brown has pledged more jobs for British workers." And when government policy fails (like housing in the UK) it is easy to blame foreigners as they may pay taxes but may not vote. In the Netherlands, there are serious proposals to throw Poles (apparently just Poles for some reason, perhaps because they work too hard) out after six months in Holland-- notwithstanding EU treaties. "Rita Verdonk..said she found the discussion on the integration of Poles unnecessary since Poles should not settle here permanently." Italy is planning to deport EU nationals (i.e. Romanians) for petty crime -- again in violation of EU treaties. ("Italy has begun rounding up thousands of Romanian immigrants for deportation after passing a new "public order and security" law...The move appeared to have the blessing of the European Union. Nello Rossi, the head of Italy's National Magistrates Association, said that "The new law does not appear to conform to our own constitution or to the European law which recognises the right of European citizens to circulate freely and stay within the territory of any member state.") And the Swiss have plans to deport entire families when a child falls short of the law. ("The SVP party has begun a campaign seeking the 100,000 signatures necessary to force a referendum ...(that) calls for the deportation of the entire family if the convicted criminal is a minor... The initiative is reminiscent of the Nazi practice of Sippenhaft, or kin liability.") The rhetoric across Europe is disturbingly racist and tribal. And in the US, the racist anti-migrant rhetoric (immigrant bashing has an anti-Hispanic tone in the US) is steeped in irony. Many (most?) "native" US citizens have Irish or German or Italian ancestors who were refused work because they were Irish or German or Italian. Indeed my own grandmother was an undocumented migrant from Ireland to the US. She was not a criminal. She was simply undocumented.

And then I read stories like this: Towns rethink laws against immigrants, New York Times, 26 September 2007. To quote: "A little more than a year ago, the Township Committee in this faded factory town became the first municipality in New Jersey to enact legislation penalizing anyone who employed or rented to an illegal immigrant.Within months, hundreds, if not thousands, of recent immigrants from Brazil and other Latin American countries had fled. The noise, crowding and traffic that had accompanied their arrival over the past decade abated. The law had worked. Perhaps, some said, too well. With the departure of so many people, the local economy suffered. Hair salons, restaurants and corner shops that catered to the immigrants saw business plummet; several closed. Once-boarded-up storefronts downtown were boarded up again...(the mayor) was voted out of office last Fall."

Yes, when an economy works properly, migrants create work, and pay taxes, and generate demand for goods and services. They can even build housing. When an economy fails to deliver jobs and services, it is not because of migrants. But they are an easy target, and Europe has a long history of stealing the lives and property of easy targets. By promoting deeper integration, the EU was meant to help Europe rise above this dark tendency from its past. Sadly, this week has been a serious step backwards.

Strangely, this week I find myself thinking the EU needs more money to allocate across Europe for its mix of crazy agricultural subsidies, paper-work heavy research subsidy schemes, and infrastructure subsidy schemes. This way, when the Dutch turn to the center for cash, the Poles can remind them of their hospitality as hosts, and the Romanians can similarly remind the Italians. And maybe the EU can serve as a more distant scapegoat, rather than our hard-working mixed-accent neighbors.

Firewalls and Firestorms

noreply@blogger.com (Joe Francois) — Sun, 28 Oct 2007 15:40:00 +0000

This past Summer has seen the sub-prime lending crisis in the United States turn into a global liquidity crisis. Subsequent events illustrate two important things about financial globalziation. First, no financial crisis is really local. The U.S. crisis has sparked a bank run in the UK and has forced the German authorities to use tax payer money to support German banks in crisis. At the same time, because we are able to spread local shocks globally, the markets outside North America are absorbing some of the brunt of the U.S. crisis. In similar fashion, when we next have a crisis somewhere in Asia or Europe, the local impact will be less as global markets are better equipped to handle the shock than are local markets. This logic follows from the simple algebra of portfolio diversification and risk. And yet...

The current crisis also illustrates other, less sanguine, aspects of the emerging global financial architecture. One important aspect of modern banking is the blending of commercial banking services (managing the operating funds and transactions of businesses and households) with investment banking, speculation, and underwriting. For example, Germany's IKB Deutsche Industriebank AG had to receive financial support from the state-owned KfW development bank (along with other banks) because of its exposure to risks linked to the sub-prime crisis in the U.S. Its problems are linked to the bank's investment activities through Rhineland Funding. For those versed in the history of financial crises and regulation, this sounds uncomfortably like problems -- linked to investment activities of banks -- that preceded the crash of 1929. Indeed, in Europe it seems we are always facing banking scandals. It is clearly hard to bring perpetrators to task, and regulation is opaque and politically susceptible. This brings us to another aspect of the European side of the crisis -- an inherent instinct to distrust investors and hide information. Indeed, in a surreal twist on the logic of regulation, senior EU officials are calling for less transparency. To paraphrase Bank of England governor Mervyn King: "the European Market Abuse Directive was partly to blame for the crisis that hit Northern Rock by not allowing the Bank to act covertly." This follows similar statements by the European Commissioner Colin McCreevy (commissioner for the internal market). McCreevy is on record criticizing the UK for applying too much transparency. He said: “Unfortunately, in recent weeks, gold-plated transparency rules stood in the way of the quiet resolution of a problem before it became a crisis: The result was that transparency rules that were intended to underpin investor confidence, when put to the test, actually promoted investor panic." In other words, if we had been able to hide the problem from investors, we could have found a way to keep it quiet until the whole thing blew over. Elsewhere in the press it has been noted that "He said regulators would be wise to learn from the crisis and should adjust rules regarding transparency, saying it was often beneficial for issues affecting the stability of major financial institutions to be carried out behind closed doors." What?! Do recent scandals like Parmalat, Enron, and Bawag mean anything? Might it not be the case that we understood too little about the risks banks had taken on?

It may be time to revisit the logic and working of the old U.S. system that was underpinned by the Glass-Steagall Act. Following the Great Crash that opened the show for the Great Depression, the U.S. Congress introduced a system of financial firewalls. Some were geographic, with a deliberate segmentation of regional financial markets. Others related to areas of operation. Basic commercial banking had to be kept separate from investment banking. This was accompanied by Federal guarantees of commercial bank deposits. The cost of this guarantee was regulation. With financial innovation, and the ability of investment firms to offer bank-like services (like money market accounts), this system was eventually dismantled, ending with repeal of Glass-Steagall in 1999. This was accompanied by a wave of financial mergers in the U.S. that, many believe, did promote greater efficiency in the financial services sector. The geographic fragmentation of U.S. banks did lead to small and capital-weak institutions unable to weather the liquidity crisis set off in 1929. And there are benefits to bigger banks. Yet, in light of present events one might wonder about the merits of segmentation of commercial and investment services... We again find ourselves in a world where banks are blending investment and basic banking activities. The result is that institutions that are important to the working of the basic monetary system underpinning the economy are threatened by financial cross-obligations in their investment arms. At the same time, it is not clear that incentives and rules are structured properly for full transparency about risks undertaken.

There are arguments for letting banks collapse in the current crisis, to send the "right signal" to the market that management (and investors) are responsible for their decisions. In the absence of explicit government guarantees, it is the role of investors, management, and rating agencies to sort out risk and communicate information. However, it is clear that we live under a second-best set of political constraints. It is not possible to let major banks go under, along with corporate and private savings. Instead there will be bailouts. Witness Northern Rock , IKB Deutsche Industriebank AG, and BAWAG. Whether is is explicit (like the deposit insurance scheme in the US) or implicit (like repeated bailouts in the EU), we live in a world where political constraints mean risk-taking behavior by bank management is underwritten by the public purse. We may wish it was otherwise. We may be able to argue that theoretically the world would be better if this were not so. However, the reality of populist politics in the industrial world means it is not possible let such institutions fail. If we admit that a mix of implicit and explicit guarantees is unavoidable, then we need to rethink regulation. This includes capital requirements under Basel II, but it also means more. We need to revisit the concept of firewalls between the basic liquidity services of financial institutions, and their more adventurous investment activities. It is encouraging that the chairman of the Basel Committee on Banking Supervision Nout Wellink is skeptical of US bank plans to fix the current problem with conduits (junk bonds?) with an "uber-conduit" or superconduit. Wellink's comments are diplomatic. Comments on the blogosphere are less diplomatic. (For example "I'll be the first to admit I'm not a financial expert. But engaging in even more of the same behavior? Sounds like trying to solve a gambling problem by gambling your way out.") Also, notwithstanding the opinions of Messrs. McCreevy and King, we need more transparency, not less. We also need to at least consider modern versions of the 20th Century's financial firewalls. We can then let the investment industry be as innovative as it likes (within the law) while maintaining a more stable though admittedly less exciting sub-sector for basic transaction services.

Further reading:

[1] "Understanding How Glass-Steagall Act Impacts Investment Banking and the Role of Commercial Banks," Brain Bank.

[2] "Suspend Rock shares – it’s a false market," The Sunday Times online, October 28, 2007.

[3] "Credit Crisis Spreading New Jitters in Europe," The New York Times online, October 26, 2007.

[4] "European Commissioner McCreevy blames UK gold-plating for Northern Rock debacle," MoneyMarketing, Paul Mcmillan - 26-Oct-2007.

[5] "Boom and Bust in Early America," in Money, Greed, and Risk: Why Financial Crises and Crashes Happen By CHARLES R. MORRIS, Times Business online (Chapter 1). This provides a good read on earlier times. The present crisis is nothing new. To quote: "The secret of successful banking, reported a New York practitioner of the banker's dark arts in 1836, was to issue notes with 'a real furioso plate, one that will take with all creation—flaming with cupids, locomotives, rural scenery, and Hercules kicking the world over.'"

[6] "Super Conduit to the rescue!" Salon.com letters to the editor, 16 October 2007.

Ich bin übersiedelt.

noreply@blogger.com (Joe Francois) — Sun, 28 Oct 2007 15:36:00 +0000

I have not been writing here lately, as I have been focused on the minor issue of moving this Summer from Holland to Austria. The experience has brought many things to mind -- migration and integration rules in Europe, market failure in the home construction and renovation market, the long way Europe has to go before its service markets are really integrated, variations in education policy across the EU, and such. When I moved to Holland ten years ago a local banking scandal (the South Holland banking scandal) was wrapping up, and as I moved to Austria a comparable banking scandal is unfolding in the local press. (The BAWAG scandal -- and efforts to apprehend the parties involved --makes interesting reading.) And then there is the very real (yet seemingly surreal) question, should we hedge our children's college funds better against currency risk? And most important, what do you do when DHL loses your professional library in shipment? (They did eventually find it, but the experience makes one think.) The dust has not settled, but the teaching term has begun and we are covering the global macroeconomy. The topics we cover in class are being mirrored in the financial markets, so there is much to talk about in class.

It is time to declare victory and go home

noreply@blogger.com (Joe Francois) — Sun, 01 Jul 2007 23:18:00 +0000

We have been here before

We are still negotiating the Uruguay Round. This may come as a surprise to casual observers and negotiators alike. After all, documents were signed in Marrakech in 1994 concluding the Round.

As the Uruguay Round drew to a close, US and EU negotiators were unable to make substantive progress on agriculture, middle-income countries were demanding credit for unilateral liberalisation undertaken outside the GATT, and LDCs were demanding one-sided concession from the OECD. The unelected leaders of the nascent anti-globalisation movement, flush from their first kill with the death of the Multilateral Agreement on Investment, demanded that the representatives of elected governments either give them some control over the process (a “seat at the table”) or end the process entirely. Lester Thurow declared the GATT dead, and....

You can read the rest of this posting on VoxEU.

How Big is China?

noreply@blogger.com (Joe Francois) — Tue, 19 Jun 2007 19:49:00 +0000

China-bashing is back in fashion in Washington and Brussels. The U.S. Congress is demanding that China re-value its currency to correct what is perceived as a trade imbalance. The financial press has called this, delightfully, a product of “The collective brain deficit trust, otherwise known as the US Congress.” Europe is also growing increasingly impatient with the Chinese propensity to undervalue its currency – and more broadly with the Asian tendency to do the same. With massive imbalances in the English-speaking world, and Asian currencies effectively pegged, the euro has been left to pick up the slack. Logically, this leaves exporters in Europe unhappy. The U.S. current account problem is not, of course, China’s fault. The Bush Administration, aided and abetted by local governments and private households, has been fiscally profligate. Combined with dismally low savings rates, this means the U.S. ran a current account deficit of 6.5 percent of national income, according to the IMF, in 2005 and 2006. Thankfully, this is projected to fall to “only” a deficit of only 6.1 percent in 2007.

China’s exchange rate policy mirrors, in some ways, the growth path followed by German from 1947 through 1970. Germany built its economic miracle on a strong export industry supported by an undervalued D-mark and by the recycling of its surplus through foreign investment and aid. (See Hetzel for more on this.)

So… if China is following a path marked by Germany, what exactly is the problem? To put it bluntly, the problem is the dragon in the middle of the room. China’s economy has grown, to be hyperbolic, to epic proportions. Before I discuss numbers, I should briefly review the concept of purchasing power parity and the Balassa-Samuelson effect. Because wages are low, service prices tend to be low in developing countries. This translates into a general low price for non-traded goods, so that official exchange rates understate the actual value (and hence size) of the domestic side of developing economies. Various efforts are made to adjust for this (i.e. to make values reflect relative prices) when we compare per-capita incomes. This means that the size of China’s economy is underestimated when we use world prices. This is even before we add the issue of an undervalued exchange rate. This point is illustrated in the figure below.

In the figure, the left-hand axis plots China’s GDP, while the right-hand axis plots China’s current account surplus as a percent of GDP. The first set of numbers is at nominal prices, and the second reflects adjustment of China’s GDP to reflect differences in prices and purchasing power (known as a PPP adjustment). What emerges is that while China’s trade surplus, as a share of GDP, is huge at official exchange rates, it is actually quite reasonable given the actual size of the Chinese economy. Indeed, if we valued the basket of China’s domestic (i.e. non-traded) goods and services at U.S. prices, the Chinese economy is roughly 81% the size of the U.S. economy, while the trade surplus is only 2.7 percent, rather than the 10.0 percent estimated by the IMF at official exchange rates. A consequence of China’s current exchange rate policy is to overstates its trade surplus, and understate the size of the underlying domestic economy. Indeed across Asia we tend to understate the size of the regional economies and overstate trade relative to domestic activity for the same reason. You can make these, and similar calculations, yourself with data from the IMF's World Economic Outlook.

In the interest of overkill and overstatement, the second figure compares Germany, China, and the U.S. in 1980 and 2007. Again, we are looking at GDP and the current account surplus, adjusted for PPP. What this shows is that, valued at OECD prices, China’s economy has surged past Germany, and is now over 4 times as big as Germany’s. This contrasts sharply with unadjusted data. At official exchange rates and without adjusting for China’s price levels, the two economies are roughly the same size. Also striking is the size of the relative trade surpluses. The IMF projects that Germany will have a current account surplus of 5.3 percent (at official exchange rates), which is equal to 6.1 percent of PPP-adjusted GDP. China’s trade surplus, on the same basis, is 2.1 percent of PPP-adjusted GDP. In terms of the share of goods and services produced and priced on the same basis, Germany’s current account surplus is 3 times larger than China’s on a share basis. Yet Congress is not bashing the euro zone. Congressional moves attacking currency manipulators (i.e. Baucus-Grassley-Schumer-Graham) target Asia, not Europe.

Given the relative under- and over-valuation of Asian and European currencies, and the relative size of current accounts relative to actual GDP, one is left a bit bemused. China is following a macroeconomic growth path marked out by Germany, and for this it is being condemned. At the same time, U.S. imbalances are being pegged on everybody but the U.S. itself. And no one is talking about the real reason why China’s surpluses have such a big impact on the world economy. Quite simply – China has grown huge, and this is masked by current exchange rate policy, combined with a healthy does of Balassa-Samuelson effects. For a long time, as the world’s biggest kid on the block, U.S. imbalances have had a major impact on global capital markets, sometimes sucking capital in from smaller countries and regions. China (abetted by Japan) appears to be softening this effect somewhat. Do we really want this to end abruptly? Be careful what you wish for, as you may actually get it.

Further reading

[1] Be careful what you wish for,” John Mauldin, FXstreet.com, 16 June 2007.

[2] German Monetary History in the Second Half of the Twentieth Century: From the Deutsche Mark to the Euro,” R.L. Hetzel, Federal Reserve Bank of Richmond Economic Quarterly Volume 88/2 Spring 2002: 29-64.

[3] Baucus-Grassley-Schumer-Graham,” International Political Economy Zone: Tales of Power, Money, and Occasional Violence, Wednesday June 13 2007.

[4] Balassa-Samuelson Effect," Wikipedia.

[5] The IMF's World Economic Outlook database.

[6] The International Comparison Program.

[7] " France Raises Prospect of New Bra Wars," The Scotsman, 19 Jun 2007.

We must all hang together, or most assuredly we shall all hang separately

noreply@blogger.com (Joe Francois) — Fri, 18 May 2007 17:30:00 +0000

Europe and Russia are in a codependent relationship. West European powers in Brussels are playing the role of a codependent spouse, denying injuries to the children and believing that somehow they can manipulate things toward a positive outcome while ignoring outright attacks on Members of the EU family. Russia plays the role of the abusive partner in this very real drama.

Imagine if Russian interests (whether government or mafia based) shut down the computer systems of the UK or U.S. government, and all the banks and financial firms in London or New York, cutting them off from the financial world. Imagine further that the cyber attacks were extended to the emergency services, aiming to cripple the police and ambulance services. At the same time, imagine that Russia blockaded a major pipeline supplying oil to Germany, and imposed a boycott on agricultural exports from France. And imagine if the car of a Swedish Ambassador was attacked by supporters of President Putin. Indeed, all this is happening to EU and NATO Members at the moment. Only the names have been changed. Except the Swedish ambassador. That really did happen. The other victims are new Members of the European Union. They are Poles, Estonians, and Lithuanians. The EU is being tested on the foreign policy front. It is being tested and it is failing miserably. This proves the case for a stronger European executive (president, foreign minister, etc) for, to quote Benjamin Franklin “We must all hang together, or most assuredly we shall all hang separately.” Maybe the Eurocrats in Brussels also need a refresher in history. Quite simply, Russia wants to neuter the East Europeans again. Germany has -- one hopes unwittingly -- again been a party to this process, with its complicity in Russia’s effort to isolate them politically and economically. Witness evolving German energy policy in the region. As West Europeans seem to have a short historical memory, I will provide a quick historical recap here.

To understand Russia’s diplomatic trouble with Central and Eastern Europe, one has to look at it through the lens of history -- the history of Russia's past imperial adventures in the Baltics. The closest parallel I can think of is Japan’s continued problems with China, Taiwan, Korea, and much of Southeast Asia. Japan was a brutal imperial power, slaughtering hundreds of thousand of civilians as it aimed to subjugate populations and build an East Asian empire. Yet it still has not faced up to its role as an aggressor. It teaches in schools that it was a victim in World War II, it still denies well-documented war crimes, and suffers from repeated gaffes by political leaders with a penchant to cause riots in Seoul and Beijing. Similarly, Russia’s view of its own 20th Century history is at odds with the memories of many countries that Russia stepped on during the 20th Century as it chased imperial ambitions. Russia was both victim and aggressor in World War II. Yet it only remembers half of this experience. Judging by Japan’s experience, Russia’s problems with the European Union may run for decades unless its view of its own history is revised. Russia is acting like post-Imperial Japan, quick to remember its role as victim but with no sense of guilt about its own aggression.

The European preliminaries that led to World War II included the Soviet Russian absorption of the Baltic States, with the complicity of Nazi Germany. Indeed Nazi Germany and Soviet Russia started as allies. On the basis of a non-aggression pact (the Molotov-Ribbentrop Pact), they divided up Central and Eastern Europe into spheres of influence, and the East Europeans emerged from the hellish consequences of this German-Russian gamesmanship only in the 1990s. This mirrored an earlier absorption of Poland by the Austro-Hungarian, German, and Russian Empires in the 18th Century. In the 20th Century repeat of this carving up of Central Europe, both Germany and Russia were brutal imperial masters. After the war, Germany took responsibility for its actions, and has served admirably at the center of the European Experiment (the EC/EU) since. Russia, on the other hand, still resents losing territory it had seized when it worked in concert with Nazi Germany to divide Europe. After the war Soviet Russia was allowed to keep the parts of Poland it occupied in 1939, annexing them to the Soviet Union. (They are now part of Ukraine, Belarus, and Lithuania). Indeed Stalin moved all borders West at the end of the war. This historical episode colors the conflicting views on current Russian claims that they should be viewed as liberators by Estonia. The Estonians (and the Baltics in general) remember that independence was first lost when the Soviet Russians made a deal with the Nazis and then invaded. Similarly, Poland remembers that it was the Russians who massacred tens of thousands of Poles in the Katyn forest. (Gorbachev finally admitted to the massacre only in 1989.) The Russian Army also halted its advance on Warsaw to allow the Wehrmacht time to finish killing off the Polish Home Army (55,000 Polish defenders died during the delay) so that they could install a Communist government – waiting 66 days for before they moved back into Warsaw – an occupation that really only ended in the 1990s. The Poles also remember that they were left behind the Iron Curtain when the war ended.

So what should Europe do? In theory, the EU represents a deliberate, collective break from a past colored by centuries of European civil war. To be an effective brake on repeated history, it needs to stand together to fight collective tendencies to repeat history. This means the EU15 (and Germany in particular) need to overcome their collective penchant to engage in appeasement, selling out Central and Eastern Europeans to outside bullies. The cyber attack is state sanctioned (if not sponsored) terrorism. If these were UK banks that were being targeted, or French or German trade sanctions, Brussels would be up in arms. If all EU citizens have equal rights, a higher profile protection of its Eastern Members is called for. Russia needs help fighting its own historical deamons. The EU is acting as an enabler. Turning off electronic bank transfers across the Russian border might catch Russia’s attention. Withdrawing all European Union ambassadors, collectively, for consultation, also seems appropriate. Holding joint summits seems inappropriate to me. It is like giving your abusive spouse more money for his next round of binge drinking. If this continues, eventually it will be German and British Banks, Austrian and Italian energy, and demands of a more military and territorial nature.

Further reading
(1) NATO experts investigate 'well-organised' cyber attacks on Estonia.
(2) the Molotov-Ribbentrop Pact
(3) Tough love vs. Enabling of an Abusive Family Member
(4) Moscow had a hand in Estonia riots, cyber-attacks: experts
(5) Druzhba: The not-so-friendly Russian oil pipeline
(6) Estonia calls for EU help on Russia embassy siege
(7) EU protests over Russian attacks on ambassadors
(8) ‘E-stonia’ Accuses Russia of Computer Attacks
(9) Russian response in meat row "insufficient", EU says.
(10)Enabling and Codependency.

As long as we are talking about corruption...

noreply@blogger.com (Joe Francois) — Tue, 15 May 2007 22:06:00 +0000

The European sharks smell blood and are circling. Paul Wolfowitz, President of the World Bank, as of this writing has just received further backing from the Bush Administration. This is possibly a signal that they want him to stand tall as they push him out of the administration's sinking lifeboat. The problem, technically, is the cloud of corruption surrounding the President of the World Bank. This is somewhat problematic, as the World Bank is the OECD's anti-corruption missionary.

Someone has to carry the anti-corruption flag, as neither the Europeans, nor the Americans, are up to it. Indeed, as long as we are discussing corruption, it seems to me we should bring up some European cases to balance the scales. For example, can someone explain to me why German Chancellor Gerhardt Schroeder is not in prison? At the end of his term as Chancellor, he negotiated a gas pipline deal with the Russians that, in essence, turned over a bit more of Europe's collective energy security to Russia. He made security concessions to the Russians while representing his country at the negotiating table. According to the International Energy Agency, "the Northern Pipeline will make Germany even more dependent on Russia in terms of gas supplies." Schroeder's government even gave a €1billion guarantee to Gazprom. As a reward, when he retired he switched sides at the table, assuming chairmanship of Nord Stream. This looks to me like conflict of interest. It certainly seems as bad as many things the Bush Administration has done -- like Cheney's handling of the U.S. energy industry's interests. Then again Cheney is not in jail either. However, I am not convinced the Bush Administration deliberately sold U.S. security for profit. Rather it was collateral damage. In Schroeder's case, he quite simply sold German (and European) energy security interests to the Russians, and retired into a high-salaried job working for the other side. In a country obsessed with investigating corporate corruption, I am baffled as to how this one has stayed out of the courts. If the Germans won't do it, maybe the Poles could put him in jail. Yes, a German sold Polish security to the Russians (again...)

Another, more current question, relates to British bribery. Britain belongs to the OECD, and has signed onto the OECD Anti-Bribery Convention. In December, the Serious Fraud Office in Britain closed an inquiry into rather obvious allegations that BAE had paid substantial bribes linked to sales in Saudi Arabia. The Blair government pressed for closure of the investigation (something that surely involved Blair himself) because the investigation "risked jeopardizing relations with the Saudis." In other words, notwithstanding treaty obligations against corruption, when it comes to British defense exports to the Middle East, corruption is ok. This is not over. Since Swiss bank accounts were used to pay the bribes, the Swiss are investigating. The U.S. Congress is also investigating, and may use the issue to block further BAE expansion into the U.S. defense market. In addition, while the Saudi arms deal, known as al-Yamamah and worth an estimated £40 billion, stretched over many years, there are new allegations involving BAE and Saab (yes, even the squeaky clean the Swedes are now caught up in corruption scandals) sales of Griepen fighters. In this case prosecutors from Austria, Britain, the Czech Republic, Sweden and Switzerland are all working on the investigation. So here is a case where a British company, BAE, is having problems with its moral image (if not its behavior -- a decision for the courts). And in this case the British Prime Minister has apparently intervened to extricate the company from a corruption investigation. It has not helped national security, as the company will be punished in OECD markets for its behavior in the Middle East.

And while we are at it, in addition to Swedes (Saab), the British Prime Minister, and the former German Chancellor, we can add the former Presidents Chirac of France and Berlusconi of Italy, who both avoided criminal prosecution for corruption by virture of the office they held.

This whole epidose is steeped in irony. In retrospect it is clearly ironic that the Republicans, under the Clinton Administration, felt free to go after President Clinton for what was clearly personal behavior problems. This was somehow reprehensible. Under such a standard, it is ironic that the Bush Whitehouse characterizes the apparent rule-breaking of Wolfowitz as somehow ok. If you remember the spectacle of an impeachment surrounding a sexual peccadillo, it is hard to know how to take it when Press Secretary Tony Snow says Wolfowitz "made mistakes," but shouldn't be fired. It is also hard to know how to take it when the European pot calls the American kettle black. Lewis Carrol would approve.

Further reading

1. The OECD Anti-Bribery Convention
2.Swiss confirm BAE inquiry
3.Schroeder's Gazprom pipeline job provokes storm
4.Schroeder Govt Guaranteed Credit for Russia’s Gazprom, Report Confirmed
5. International Energy Agency Speaks Out Against Russia’s Baltic Gas Pipeline
6. Chirac after the presidency
7. Italian PM's fraud trial resumes
8. Today's Idiom = "The Pot Calling The Kettle Black"
9.Through the Looking Glass
10.Wolfowitz barricades self in World Bank office.
11. The Daily Show spin on the Wolfowitz scandal

Endnotes:

1/ "What sort of things do you remember best!" Alice ventured to ask.

"Oh, things that happened the week after next," the Queen replied in a careless tone. "For instance, now," she went on, sticking a large piece of plaster on her finger as she spoke, "there's the King's messenger. He's in prison now, being punished: and the trial doesn't even begin till next Wednesday: and of course the crime comes last of all."

Lewis Carroll, Through the Looking Glass: Chapter 5 "Wood and Water", M. F. Mansfield & A. Wessels: New York 1899 .

Sometimes appearances are everything

noreply@blogger.com (Joe Francois) — Mon, 16 Apr 2007 16:34:00 +0000

The headlines following the G-7 and World Bank-IMF meetings this last week were not all about global imbalances, the changing role of the World Bank in poverty reduction, growing unease about globalization, or calls for reform of the IMF. No, they have also been focused on the relationship of the president of the World Bank to a former Bank employee, and the manner in which he has handled the appearance of conflict of interest in managing the departure of this romantic interest when he took over at the Bank. Who needs substance, when you can have scandal?

If you work for the U.S. government as a civil servant, you need to follow a certain set of rules guiding ethical behavior. If you look closely at those rules, you will find that they do not really proscribe behavior that is unethical. Rather the rules proscribe the appearance of such behavior. I was, at one time, baffled by those rules. They are made by a Congress who generally and explicitly exempt themselves from those same ethics rules (so that they can and do continue to run ethically amok, individually and collectively.) Yet the rules do serve a purpose. For the electorate to have faith in the workings of the government, they must believe it is ethical and fair. An ethical and fair regime populated by career employees that appear corrupt will be crippled in its operations. You can vote out unethical congressman and parliamentarians. A functioning civil service shows much more inertia in terms of (potential and actual) employee turnover. For this reason, it is a necessary though not efficient condition that civil servants appear to be free of corruption, regardless of the tabloid-based entertainment provided by politicians. Indeed, if a politician wants to go after the civil service, he will attack its reputation in this regard individually or collectively (witness Reagan's attack on the U.S. civil service in the 1980s, and the Valerie Plame affair more recently).

In a similar vein, international civil servants must also appear operationally honest. This is especially true for the man/woman tasked with running the World Bank. The Bank, among other tasks, has appointed itself a promoter of good governance. It cannot do this, and has no credibility if it tries, under present circumstances. If there is the appearance of corruption around its top employee -- aka Bank President Paul Wolfowitz -- then that employee must go. If he is going to stay, it simply has to be the case that doubts about his ethical character can be fully removed. If they cannot, then regardless of the actual ethical qualities of the situation, he must go.

Now maybe the Bush administration is playing a deep game, and their strategy is to attack the World Bank from within by piling it from the top down with corrupt leadership. I do not believe they are capable of actually managing such a game (though if they were they would try). But regardless of whether the present situation is deliberate or accidental, it must end.

Simplicity -- a screed in two paragraphs

noreply@blogger.com (Joe Francois) — Wed, 11 Apr 2007 19:43:00 +0000

I have been reading a recent short book by Timothy Gowers, on mathematics and models and such (Mathematics: a very short introduction). In it he makes a point I agree with: "When devising a model, one tries to ignore as much as possible about the phenomenon under consideration, abstracting from it only those features that are essential to understanding it..." This is from a mathematician effectively explaining that there is a special art in good science, since theoretical models are by definition simplifications and abstractions. I made a similar point in a 1997 book, when discussing partial equilibrium models: "By definition partial equilibrium models do not take into account many of the factors emphasized in general equilibrium trade theory. While this is the root of the practical limitations of applied partial equilibrium modeling, it is also the source of its basic advantage... It may be difficult to justify... more complex and less transparent models, when they may yield only margin extensions of the basic insights drawn from simpler approaches." The critical thing is that good models (theoreical or empirical) offer useful simplifications. Musicians (Charles Mingus: "Making the simple complicated is commonplace; making the complicated simple, awesomely simple, that's creativity." ) and super-mega-geniuses (Albert Einstein: "Everything should be made as simple as possible, but not simpler.") would agree. But apparently not all members of the tribe of trade theorists. Some would, though. Some of my favorite theory papers are by Krugman. His papers can display a brilliant ability to boil down potentially complex and difficult issues to sharp, clear expositional models. His 1980 AER paper on gains from trade, in a world with identical two countries with identical tastes, endowments, and technologies and only one sector, for example, is brilliant. So is his explanation of linkages between productivity growth and the process of job creation and construction, using the example of hot dogs and buns. (from an editorial in Slate). Yes you can make the model in his AER paper more complicated, and subsequent literature has. But the basic point is best seen in a simple structure.

So what do you say when referees, and journal editors who should know better, send you letters and reports that basically say "the point you make is clear, and a relevant one, and the model is simple and clear. However, the referees feel you should use a more complicated model...because it will make the theory more interesting"? What? Interesting as in more complicated, harder to follow, with a more circuitous mathematical path to the same basic results? This is definitely where we step out of the realm of math and science, and into the realm of fashion trends and complexity for the sake of complexity. Complexity with the purpose of making what we are doing look too hard and complicated for others to grasp. In terms of models, minimalism (where possible) should be the rule. If it is not necessary, don't build it in. And if your model is too complicated to explain anything with, well... I told you so. Enough said.

Time for crazy ideas -- part 2 (spaghetti or spiderwebs?)

noreply@blogger.com (Joe Francois) — Tue, 10 Apr 2007 07:23:00 +0000

In a previous post, I suggested that we give up on agriculture in order to complete the Doha Round. I want to focus here on the bread-and-butter business of the World Trade Organization -- prospects for negotiations to reduce merchandise tariffs. For the impatient, the punch line is a call for either zero manufacturing tariffs by the OECD on an MFN basis, or else an OECD-based plurilateral agreement in the WTO for zero tariffs in manufactured goods. For the more patient, read on.

In the run-up to the NAFTA in the 1980s, the word on the street was that multilateralism was in trouble. More bluntly, the catchphrase was "GATT is dead." Unable to win sufficient points with the EC on agriculture, and the developing world on services, the U.S. focused instead on a bilateral strategy. An important added ingredient in the policy mix was the belief that a major Asian trading partner (Japan) was unfair and kept its currency low to promote exports. So the U.S. turned to its neighbors -- Canada and Mexico. Intellectually, we had Jagdish Bhagwati condemning NAFTA and Paul Krugman selling the idea of strategic trade policy. In fact, this does not sound so different from the present day. Yes, the EC was smaller than the EU. And yes the U.S. Congress is railing against China instead of Japan. Yet multilateral trade negotiations in Geneva are again stuck, and impatient negotiators are working on relatively easy bilateral agreements to take their minds off the impasse in Geneva. The U.S. has signed a deal with Korea, while the EU is busy negotiating with Korea as well. Asian parties are also talking (again) of regional solutions --though so far this has been dominated by bilateral agreements. The web of bilateral and regional agreements grows increasingly complex.

There are important differences between the previous dance of regional agreements on the grave of multilateralism, and the current one. The spider's web of regional agreements now in place has done serious damage to the basic non-discrimination principle of the trading system. (This is commonly referred to as a spaghetti bowl rather than a web, usually as in "Prof. Jagdish Bhagwati has called this the Spagheti bowl..." Sorry, but I do not think a bowl of pasta sounds sufficiently sinister. So, since this is my space, I will use the spiderweb metaphor...) When the GATT was set up, a founding principle was the idea that small countries should be treated as equal to big ones, so that there would be no side deals that might lead to a repeat of colonial trading empires or to unbalanced (and unfair) negotiations between unequal partners. Any pretension that this is still the case is gone. The EU now actively uses preferential trading arrangements (can we call this a neo-colonial trading system yet?) to push its agenda in developing Africa, while the U.S. now routinely incorporates trade deals in its geopolitical maneuvers. In this way the US tries to tie Jordan and Egypt and Central America with commercial bindings. With the exception of a few of these agreements, none, individually, really matter much for the U.S. and EU. Trade agreements with Botswana and Jordan and Costa Rica and Israel are not going give a big boost to the economies of Europe and North America. Rather, the logic is geopolitical. In the Cold War era, the OECD Members all saw a global trading system as an important strategic asset in keeping the west united against the communist threat. Clearly, this no longer holds. The result is the use of free trade agreements to cement bilateral political deals. This has led, predictably, to FTA burnout. The U.S. Congress is tired of the recent string of regional trade agreements. They cost political capital to support, and the economic benefits are not all that big. Similarly, while the European Commission pushes ahead with regional agreements, the European electorate also appears to suffer from globalization burnout. And we clearly do not have a Bill Clinton to drive the GATT/WTO negotiating round home this time around.

In a sense, the irony of trade as a geopolitical tool in the Cold War was that trade was removed in an important way from the political arena. I do not mean that it was not a political issue. Rather, the push for a broad multilateral system coincided with post-World War II efforts to dismantle bilateral trading systems that were an offspring of old colonial empires. It also meant that the U.S. perceived its foreign policy interest to include promoting liberal trade regimes. So trade was less bilateral (and so less a tool of bilateral and partisan dealings.) The non-discrimination clause of the GATT was important here. It helped to prevent a slide back into the economic underpinnings of centuries of trade-based military conflict involving European commercial empires. (Just think of the Dutch and British wars in the Indies, the Opium War, the British and French Wars, everyone looting the Spanish empire, Japan and its East Asian Co-prosperity Sphere vs the West, England in the Indian subcontinent, &tc &tc). Given the apparent long-run historical implications of bilateralism, we should be worried by its vigorous revival.

The Doha Round is supposed to promote the interests of developing countries. Negotiators have tried to follow past GATT negotiating rounds, with the adoption of a tariff cutting formula. Yet, it is proving almost impossible to fit a formula to the varied tariffs of developed and developing countries. In addition, our spider's web of regional agreements (ok, you can call it a spaghetti bowl) has created conflicting incentives for developing countries. This system helps some countries by discriminating against others. In many cases it helps the poor by hurting the not-quite-as-poor. It also confuses matters with complex requirements for rules of origin. These are necessary because, given an FTA, there is otherwise a risk of transshipment. There is evidence that rules of origin prevent takeup up notional trade preferences, or at least impose costs that eat significantly into their benefits.

There may be a simpler way to move forward, without the need to balance formula coefficients across North and South. It is time for the high-income countries to simply declare zero tariffs for all manufactured goods. In one step, this would present a maximum concession to developing countries, eliminate entirely the need for rules of origin, and greatly simplify the administrative costs of doing trade. It would also undo recent damage linked to FTAs, preferential North-South deals, and the return of bilateralism. Most multinational firms in the OECD (computer manufacturers, motor vehicle manufacturers, &tc) would embrace such a simplifiction of the rules they face. Indeed this is exactly what happened with the Information Technology Agreement. It started with 29 members, and now has 70, covering 97% of trade in information technololgy products. A similar approach could be followed collectively across the OECD either simply as binding commitments, or perhaps as a plurilateral agreement. (A plurilateral agreement would be one that applied to all signatories.) The advantage of a plurilateral is that simple conditions could be set for developing countries (such as flat tariffs in a band of 8 to 10 percent, for example, with a schedule for reduction) to immediately sign on, and to realize benefits today from a concrete commitment to rationalize their own policies tomorrow. It would also take the wind out of the sails of conspiracy theorists that argue that poor countries are poor because of OECD protection. (As an aside, most import protection against developing countries is imposed by other developing countries.) Such an approach could set in motion a tremendous, relatively automatic rationalization of trade rules. Unlike bilateral agreements with small countries and city-states, such an agreement would be worth spending political capital in Washington or Brussels to promote.

But what about all the fans of FTAs? How would they feel about such a WTO-based approach. In a sense, this is one logical path mapped out by the intra-OECD FTAs that now include, in various combinations, the U.S., Canada, Mexico, Korea, Australia, and New Zealand. Indeed, one could pitch this when necessary as a super-FTA, with pre-defined membership criteria. They could have their FTAs and the WTO too.

Further reading:

"Comments in the Financial Times on the U.S.-Korea FTA.," M. Wolf, J. Bhagwati, F. Bergsten, A. Sapir, D. Vines, and more leading characters in this drama. There is even a bit of he-said she-said between Bhagwati and Bergsten. This is good stuff!

"America's Bilateral Battle Against Free Trade," J. Bhagwati on the real risks posed by the emphasis on regionalism instead of multilateralism, Financial Times, April 2007.

"Who's Afraid of an All-Out Trade War? We'll Do Okay if Push Comes to 'Shove Off'," P. Krugman on the joys of trade wars circa 1990 (or as Peter Sellers would say, "how I learned to love trade wars...")

"The Regionalism Debate: An Overview," A. Panagariya, published in World Economy, June 1999, 477-511.

"Liberalizing Trade in the Developing Countries," A. Panagariya, takes apart the neo-protectionist arguments in the antiglobalization/NGO school of thought, published in Foreign Policy, September/October 2005.

"Preference Erosion and Multilateral Trade Liberalization," J. Francois, B. Hoekman and M. Manchin, final version published in The World Bank Economic Review 2006 20(2):197-216. Takes a critical look at how much scope there really is for preference erosion, and quantifies rules of origin costs in the context of EU preference schemes.

"Clothes Without an Emperor: Analysis of the Preferential Tariffs in ASEAN," M. Manchin and A. Pelkmans, 2007. Offers evidence that Asian tariff preferences have largely been a farce, eroded almost completely by rules or origin and related compliance costs.

The Trade Deficit and the Politics of Misdirection

noreply@blogger.com (Joe Francois) — Tue, 27 Feb 2007 00:05:00 +0000

The political class in Washington is becoming increasingly agitated about the U.S. trade deficit... again. The reaction is to blame Europe, Japan, and China. We have House of Representatives Speaker Nancy Pelosi and her team saying, "We ask you again to join us and develop a meaningful action plan that addresses the burgeoning deficit" in a letter to President Bush. We have blogs trolling through past episodes of U.S. deficit panic. We have been here before. Well, maybe not here, but in a frighteningly parallel universe version of here, with ballooning trade deficits, large budget deficits, and general panic in Washington. Yet past episodes usually involved a high dollar making imports cheaper and exports uncompetitive. Real U.S. exports are actually up 25 percent since 2001. As a percent of GDP, they are also up from 10.2 percent to 11.1 percent of GDP since 2001. In contrast, when the trade deficit surged between 1991 and 1994, the dollar was up 22 percent. At the moment it is down by a comparable amount between 2001 and 2006. While things are similar, superficially, to recent past deficit scares, they are also different in important ways.

The situation is at once deceptively simple, and yet quite complex. From national income identities, a growing deficit "squeezes" GDP. Throw in some mindless accounting, and you can argue that it costs jobs. Throw in a video camera as well, and some air time on CNN, and you have the Lou Dobbs show. (No I am not going to link to mind candy. Google it yourself). Yet things are not so simple. The U.S. has an unsustainably low national savings rate. The IMF projects that the U.S. may borrow 7 percent of GDP in 2007. In part, (and technically by definition) this is what drives the growth of the trade deficit. Congress should be asking itself if, as policy, the U.S. should feel comfortable borrowing 7 percent of GDP, given that it will need to borrow even more (publicly or privately) to fund surging retirement and health care benefits in the immediate future.

It is also informative to work the numbers a bit, and deconstruct the surging deficit. An obvious candidate is inflation. If we look at the deficit in constant dollars (you can download these from BEA in 2000 dollars), the trade deficit since the Bush White House took over in 2001 has grown by one-third. Another 10 percent of the nominal growth is due to a general increase in U.S. prices. So roughly one-quarter of the growth is simply inflation. Another force driving the nominal deficit growth is linked to the drop in the dollar. On a trade-weighted basis, the Federal Reserve's nominal broad dollar index has fallen by about 14 percent since 2001. This is despite the broad Asian peg to the U.S. dollar. Against the euro, the dollar has lost more than 35 percent. On this basis, in foreign currency terms, another third of the surge in the deficit is clearly linked to exchange rate changes. The same imports cost more. The ironic thing here is that the move in the dollar -- down -- should be helping the trade deficit, all other things being equal. However (and this is the proof that we have not really been here before despite the déjà vu) the currency is being driven this time by the same forces driving the trade deficit itself. The U.S. wants to borrow increasingly more money. There apparently is not sufficient growth in the supply of credit from our collective foreign bankers. So.... mathematically something has to budge. Since the U.S. borrowing spree has refused to budge, the solution in the market has been to drive down the dollar, so that the same foreign currency-denominated credit goes farther in dollar terms. You can borrow more dollars when they are worth less. The remaining growth in the deficit, about one-third of the total nominal growth, can be linked to rising oil prices and growing U.S. demand for foreign credit.

So, in a roundabout way, I agree with the Democratic leadership of the U.S. Congress. Something needs to be done. That something includes a more economically literate discussion of the issues. The American public does not need populist economic rhetoric. The growth in the deficit is large, but not as large as advertised in the current round of speeches, and not for the reasons cited. In real terms, most of the growth has been driven by the surge in U.S. collective borrowing, combined with high oil prices. Any real policy debate should therefore start with U.S. borrowing (federal, state and local, and private) and the reasons for rising oil import bills. Beating up on China, the EU, and Japan is a sideshow at best -- populist rhetoric. The Euro has appreciated by roughly 50 percent against the dollar (the flip side of the dollar falling by 35%) since 2001. What are they supposed to do exactly? The Asian peg is a problem, but the U.S. needs to be very careful how it unwraps that particularly complex web of excess global liquidity (from Japan's implicit support of the massive Yen carry trade) and U.S. need for more and more buyers in domestic bond markets. Discussion on budget (not trade) deficits and energy policy would be a constructive response to the deficit. Beating up on trading partners is not.

We know the weather reports are wrong

noreply@blogger.com (Joe Francois) — Fri, 26 Jan 2007 23:22:00 +0000

We have an innate desire to know what will happen. It can manifest itself in the form of very practical questions related to technology and applications of physics and biology, like "if I sharpen this stick, and throw it at one of those mammoths, can I feed my family with it?" Questions can be strategic in nature, like "if I invade Persia with my legions, will I win?" Big questions at the moment include "if we continue to pour carbon into the atmosphere at current rates, are we doomed?" and "if we increase our commitment of troops in Iraq, will we be reelected?" The path to answers has ranged from the scientific method to scapulimancy, computer simulation of prototype machinery, eminent study group reports, the I Ching, consultation of sacred texts or oracles, business forecasts, and climate change models. At one level, all of these represent a genuine effort, given beliefs and available technology, to discern the future. Depending on your cultural predispositions, some of these methods are preferred to others. For those that belong to the tribe of Aristotle and Bacon, the drive to understand has led us to a combination of formulating theories about cause and effect, and confronting them with experiment and mathematics.

In an uncertain world, what is the role of scenario or policy studies? I include here macroeconomic forecasts, as well as climate change models and the recent hybrid of the two -- studies of the economic consequences of climate change.

An important example now in play at the monent is the Stern Report. The report offers us a synthesis and interpretation of available climate and economic simulation modeling. There has been heated discussion in editorials and blogs (see the RealClimate blog) about the quality of these estimates. If the report is correct, then inaction in the face of rising levels of global warming and greenhouse gasses implies very high opportunity costs relative to the alternative path of corrective behavior. If it is wrong, corrective action can be a costly mistake.

What is the function of an inherently political report on economic and climate forecasts? For that matter, what is the function of the broader family of forecast and simulation-based policy studies? At one level, they are certainly meant to quantify the issues at hand. Viewed in this way, it really is important that the numbers be right. If we are going to make decisions, we want accurate forecasts. This seems to be the spirit behind much of the critical economic discussion (dissection?) of the Stern Report. Did we get interest rates (i.e. the discount rate for future costs and benefits) correct? (Jane Galt offers a good discussion of the discount rate issue). Are underlying assumptions about the trajectory of technical change correct? (See "Running the rule over Stern's numbers," BBC). Is opportunity cost calculated correctly?

This discussion and criticism is important, especially if the purpose of the forecasting study really is to accurately forecast. Indeed, from this starting point, the criticism of the Stern Report has been quite harsh. Richard Tol, from Carnegie Mellon University, is quoted by BBC4 saying "There is a whole range of very basic economics mistakes that somebody who claims to be a Professor of Economics simply should not make...Stern consistently picks the most pessimistic for every choice that one can make. He overestimates through cherry-picking, he double counts particularly the risks and he underestimates what development and adaptation will do to impacts." These criticims are from people who believe climate change is happening, and that something needs to be done. At one level, the criticims are valid. However, I think many of the critics have missed the point of the study. The purpose the study is not really to get an accurate prediction of exact economic costs 30 years from now. Rather, the purpose of the report is to serve as a focal point for discussion, and to provide a broad sense of alternative directions and magnitudes. It is a policy study, and hence by definition is something of a straw man. The discussion it fosters will most certainly discard many of the premises of the study, and will move in directions not covered in the original forecasts and estimates. This is ok. The role of policy studies (even when the economics are sloppy) is to serve as starting points for discussion by creating a structured, rational inventory of our uncertainties. The Stern Report creates a space for constructive argument. Arguably, reports by oracles and high priests have served a similar purpose in the past. In this sense, they are all important and useful, even if wrong.

To illustrate the point, I am going to quote Kenneth Arrow out of context. In a very personal, worldview discussion of uncertainty and the hopelessness of accurately modeling what will happen in the real world of markets, Arrow offers the following anecdote from World War II:

''Some of my colleagues had the responsibility of preparing long-range weather forecasts, i.e., for the following month. The statisticians among us subjected these forecasts to verificiation and found they differed in no way from chance. The forecasters themselves were convinced and requested that the forecasts be discontinued. The reply read approximately like this: ' The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.' '' ^[*]

Arrow's point is that, at one level, the weather reports really were useless because they were wrong. Yet he then goes on to say that "Accuracy of prediction is a desirable aim, but it is not the only aim of economic theory. As in meteorology, understanding is possible, desirable, and useful even when predictability is very limited." Like CGE studies of trade policy, finance ministry and Congressional Budget Office budget forecasts, and military plans, we know the precise estimates in the Stern Report will prove wrong. This does not preclude their usefulness for policy debate.

We stress accuracy and statistical robustness when we teach econometrics and modeling. We also get bogged down in debate on the merits of observation vs. simulation. Maybe, in paying attention to the accuracy of the art, we sometimes lose sight of its purpose. Accuracy is not the only important function of forecasting and numerical modeling. It may also be to create space for constructive argument. We need policy studies for planning purposes.

Further reading:

1. The Stern Report.
2. The BBC4 report, "Running the rule over Stern's numbers".
3. "BBC Finds Stern Report Wanting", (The Volokh Conspiracy)
4. Robert Mendelsohn's "A Critique of the Stern Report"
5. The RealClimate blog.
6. Jane Galt's discussion on the discount rate issue.

^[*] K. Arrow (1992), "I Know a Hawk From a Handsaw," in M. Szenberg, editor, Emminent Economists: Their Life Philosophies, Cambridge University Press.

ECON 101 -- Opportunity Costs (a transatlantic tale of guns and butter)

noreply@blogger.com (Joe Francois) — Fri, 19 Jan 2007 18:10:00 +0000

In introductory economics classes, one of the first basic concepts we cover is opportunity cost. Wikipedia defines opportunity cost as "the cost of something in terms of an opportunity forgone (and the benefits that could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i.e. the second best alternative." This definition is ok as far as it goes. The challenge in the classroom is to find examples that students can easily grasp. In older U.S. textbooks, the long shadow of the Vietnam War meant that the example was typically guns and butter. Another classic student examples is "pizza and beer." To update these examples, I offer here both a European and U.S. spin on the concept, based on things the typical undergraduate has probably heard about through the European and North American news services. My modest hope is that, with examples like this, students might better understand the opportunity costs of public policy and expenditures.

A U.S. example -- The Iraq War

The New York Times and International Herald Tribune recently published estimates that place the cost to the U.S. of the War in Iraq at approximately $1.2 trillion dollars. This offers, of course, a classic chance to ask "what if..." along the lines of the old Vietnam War era examples. I have done some price checking on a list of items -- NASA's manned Mars proposal, the price of Hummers, and the total value of income by U.S. State. Based on these, we can scale the $1.2 trillion spent as follows:

We could fund the proposed NASA manned and unmanned Mars program ($120 billion), and have enough money left over for 9 International Space Stations (with full funding of operating costs -- $120 billion each).

We could permanently colonize the moon ($50 billion) and Mars ($1 trillion.).

We could buy 44 million brand new H3 hummers. This is enough for 7 out of every 10 married couples in the United States. It is also enough for every adult in California, New York, and Texas.

We could buy everything, goods and services (i.e. state GSP), produced by the U.S. plains states (Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota, South Dakota) and the New England states (Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont) for an entire year -- and throw it away.

We could by all the U.S. manufacturing output in all 50 states (cars, trucks, laptops, jetskis, microwave ovens, 747s, again based on state GSP) manufactured in the United States for an entire year -- and throw it away.

A European example -- The Common Agricultural Policy:

A more peaceful example of costs involves the EU's Common Agricultural Policy (the CAP). The European Commission spends roughly $65 billion (€50 billion) a year on subsidies to farmers. This has, naturally, been a highly controversial subject in European politics. Over a ten year horizon, the annual costs work out to only $650 billion. This is only half the projected cost of the Iraq War. Working within this budget, Europe could have done the following instead:

Colonize the moon ($50 billion) and split the cost with the U.S. to colonize Mars ($500 billion for half).

Buy the entire output of Denmark, Ireland, and Finland for one year (goods and services).

Buy all the outstanding shares in IBM ($120 billion), Boeing ($70 billion), Daimler-Chrylser ($63 billion), and General Electric ($392 billion), based on market valuation on 19 January 2007 (according to Forbes).

Increase gross domestic expenditure on R&D by 25% a year. This assumes EU27 GDP is $13.4 trillion, the CAP costs $65 billion a year. It also uses the official Eurostat estimate that total R&D spending in Europe is 1.84% of EU27 GDP.

Public policy involves tradeoffs, and this implies that to do some things, we use resources that might have been used to do something else. This holds as much for governments and countries (and humanity) as it does for individuals and households. This is an important lesson to keep in mind.

Deficits redux

noreply@blogger.com (Joe Francois) — Thu, 18 Jan 2007 21:13:00 +0000

A short follow-up on my earlier posting,Deficits and ... more deficits. The "reserved central bankers" in the U.S. are now using words like "frightening" and "crisis." What they said this week:

We now have Janet Yellen, the San Franciso Fed President, on the record saying the long-term budget picture ''frightens me... We'll be looking at budget deficits that will make us wish for the level that we have now...''

Federal Reserve Chairman Ben S. Bernanke said the U.S. government may face a ''fiscal crisis'' in the coming decades.

from Reuter's,''Federal Reserve Chairman Ben Bernanke on Thursday told U.S. lawmakers that a review of U.S. tax code would be a good idea. 'I think the conventional wisdom among economists is that tax cuts don't necessarily pay for themselves,' Bernanke told the Senate Budget Committee."

On top of this, it seems that U.S. investors may be catching on, and shifting their portfolios abroad. ''U.S. investors send their cash packing.''

Time for crazy ideas: part 1

noreply@blogger.com (Joe Francois) — Mon, 15 Jan 2007 14:16:00 +0000

Albert Einstein defined insanity as "doing the same thing over and over again and expecting different results." One gets the feeling, looking at the progress of multilateral trade negotiations in Geneva, that we are borderline crazy. There are two issues where this seems to be the case -- repeated negotiations circling around the same intractable issues. One set of intractrables involves the importance of agriculture to the overall success of the negotiations, and the other is the role of OECD tariff reductions in determining likely benefits to developing countries from the current set of negotiations at the World Trade Organization (WTO). In both areas, we keep repeating ourselves and expecting a different outcome. Maybe it is time for a change, or at least time to step back from these issues. I will focus on agriculture here, and on OECD tariff concessions in a later posting.

Agriculture has been a thorn in the side of the modern trading system since its inception. Following pressure from the United States in the 1950s, agriculture was largely cut out of the system of rules and disciplines defined by the predecessor to the WTO -- the GATT (General Agreement on Tariffs and Trade). Indeed, until the creation of the WTO at the conclusion of the Uruguay Round of trade negotiations, agriculture remained outside the system. Ironically, it was the EU that exploited these exclusions most, and the U.S. that later regretted their introduction. This exclusion was largely an intra-OECD issue, with high profile disputes between the U.S. and Europe ranging from broiler chickens in the 1960s to soybeans in the 1970s and 1980s. The developing countries did not participate actively in the GATT, and so until the Uruguay Round, launched in the 1980s, this remained largely a source of intra-OECD conflict.

The effort to bring agriculture into the GATT/WTO system almost caused the collapse of the Uruguay Round, as the French threatened to bring the whole temple down around them if the European system of agricultural protection and subsidies (the Common Agricultural Policy or CAP) was compromised by the negotiations. The solution, in the end, involved lying and obfuscation. Commitments were made that were not really commitments, and liberalization was implemented that was not really liberalization. Everyone declared victory and went home. The basic process involved converting non-tariff barriers (licenses, quotas, inspection delays, import bans...) into tariffs that were supposed to reflect the then current level of protection. In reality, in politically sensitive areas the rates set were far above the rates needed, and the process became known as "dirty tariffication." (A good place to start reading on dirty tariffication is here: "WTO: Uruguay Round Agreement on Agriculture".) Indeed, there were worries that the "liberalization" undertaken as part of the Uruguay Round Agreement on Agriculture (known in the land of trade-related acronyms as the URAA) would lead to less trade.

At the time, estimates of the benefits of the Uruguay Round were dominated by agricultural liberalization. I was at the GATT at the time, and agriculture was indeed a large part of our initial assessment of the projected benefits of a successful conclusion to the global trade round. In the end though, as we learned more and more about actual commitments in agriculture (agriculture negotiations had been somewhat secretive even with respect to the rest of the GATT negotiating bodies at the time), our estimates linked to agriculture were dramatically reduced and eventually dropped from the calculus, and in the end trade ministries were reduced to statements like: "we have set the groundwork for future liberalization in agriculture."

In the end, the Uruguay Round did have important implications for agricultural liberalization and developing countries. However, the mechanism was not what was anticipated. In recent years, the new dispute settlement body (the DSB) (the legal underpinnings of the WTO) has led to successful cases against the U.S. and EU (led by Brazil) on cotton and sugar. At the same time, under different dispute mechanisms in the WTO, developing Latin American countries recently won a high-profile case against the EU on bananas. The most difficult issues are being handled through the legal machinery in Geneva, and developing countries are even winning. As it turned out, none of this really hinged on the agriculture negotiations themselves. (A good place to read up on the state of play at the WTO in Geneva on development issues is the Bridges Weekly Digest.)

So where are we now? Not surprisingly, we are now, again, at an impasse. If one looks ahead though, it is not clear to me that we should be stuck here, or that this is even the right road to be on anyway. Maybe it is time to change tack completely. (Warning: for those vested in the last several years of policy negotiations and the supporting policy research industry, the next line may be disturbing.) Maybe we should ignore agriculture for now, drop it as a negotiating issue, and move on to other things in a more streamlined Doha Round. How can I say this? I offer three reasons.

The first reason relates to medium-term policy sustainability in the OECD. The current set of agricultural policies in the U.S. and EU is not sustainable. In the case of the EU, the combination of (i) aging populations and (ii) an Eastern Enlargement that has taken in poor, agricultural economies means that the CAP as we know it is doomed. The European Commission knows this, and EU Members have already launched on a policy reform process that recognizes that future agricultural policy will have to be very different (and much cheaper) if it is to survive the budget constraints brought on by aging populations, and the demands for structural funds from new members. The EU has made a commitment to reform (necessary regardless of how events unfold in Geneva), and we can expect the process to continue. So, why not just wait? We can probably get the same results we would from active negotiation. In the case of the U.S., the budget hole is now so deep, and the looming costs for Medicaid and Medicare with retiring baby boomers is so large, that large farm outlays are likely to be a victim of the storm of budget rationalization that will arrive with the next White House team. So again, why not just wait? We will get rationalization anyway, regardless of whether or not we push this through Geneva.

The second reason also relates to medium-term changes, only in the middle-income and rapidly developing low-income countries. India and China (aka 2.2 BILLION consumers) represent economies growing at 8% to 10% per year. At these rates, changes in consumer demand for foodstuffs will move rapidly toward more expensive (and more grain and soybean intensive) meats and processed food products. This will put rising pressure on food prices. Recent baseline projections from the OECD and FAO build in assumptions about ongoing technical change sufficient to neutralize these demand-side pressures on agricultural prices. Reading between the lines, these technical changes are needed to avoid projections of substantial food price increases. Technical change notwithstanding, it is hard to believe that prices will not rise. Rising prices will make it easier for the U.S. and EU to back off of price and income support programs for farmers, and indeed will change the South-South policy calculus as a wedge is driven between food importers and food exporters.

The third reason involves the toxic soup of oil -- economics, politics, terrorism, and security. A surprise victim of events has been agricultural commodity prices. For reasons that will not go away, the U.S. and EU are both pushing their respective biofuel industries. (The EU just announced a target to replace 10% of vehicle fossil fuel use with biofuels.) This follows Brazil, which has been relying for years on its sugar industry for the same reason. The result has been a surge in prices. In mid-December, the European food industry press was noting that prices had reached highs not seen for ten years. ("Cereal Prices at Highest Levels for a Decade") . The President of Mexico is now making promises to keep tortilla prices low, after price hikes for corn driven by U.S. biofuel demands. And in scenario analysis, the International Food Policy Institute (IFPRI) has projected that an “aggressive biofuel growth scenario shows dramatic increases in world prices for feedstock crops." In addition, "the strong price increases for root crops like cassava in the first aggressive scenario suggest that without the necessary productivity improvements, aggressive growth in biofuels could have adverse effects on well-being in regions like Sub-Saharan Africa, where a large proportion of cassava consumption is for food..." ("Bioenergy and Agriculture: Promises and Challenges"). If global security trends continue, and if the U.S. and EU are on a permanent bent to achieve energy security through renewable energy, then the rules of the game have been rewritten substantially. The poor should probably start worrying about rising food prices, rather than demanding them.

On net, it looks to me like agricultural prices will be rising anyway, and U.S. and EU agricultural support programs will be contracting anyway, whether or not we make a big push on these issues is Geneva. The real problem areas for the poorest producers (sugar, bananas, cotton) are being managed through the international court system. As for the rest, we are doing the same thing, and getting the same results. Maybe it is time to try something else.

When is a constitution actually a phonebook?

noreply@blogger.com (Joe Francois) — Sat, 30 Dec 2006 14:20:00 +0000

The rotating 6-month EU presidency will be going to Germany with the start of the New Year. One of the stated goals of the German government (and specifically the German Chancellor Angela Merkel) is to revive the European Union constitution. This follows a contentious and failed effort to get European voters to approve the constitution two years ago. The draft text aims to consolidate and streamline the operations of governing a club of 27 sovereign states. Germany wants to save as much of the original text as possibly. Yet this same text failed when both Dutch and French voters rejected the treaty in May and June 2005. If anything, the mood of skepticism among Europeans has deepened since then. Something has to be done, but a re-run of 2004-5 is not a good idea.

To appreciate the importance of the issues at stake, it helps to look at history. The entire European Project grew out of the violence of European history, especially the first half of the 20th Century. That period saw the current stable of EU Members deeply enmeshed, yet again, in what amounted to a protracted European civil war. This was not the first century of Europe-wide war, of course, but it was the first to truly harness the wonders of modern industrial technology as part of the game. In living memory, entire European cities were firebombed and turned to rubble, whole European ethnic groups were forced into slave labor or death camps built on Henry Ford's assembly line innovations, European colonial empires were completely squandered, and European civilian populations were deliberately targeted by all sides. Europe's scientific infrastructure was all but destroyed, with a generation of Continental intellectuals (and entrepeneurs) either voluntarily fleeing to America or forced to serve behind the Iron Curtain. (All of these practices, realized with more primitive technologies, have of course been part of European warfare throughout its history. Instead of fascism vs. communism vs. socialism vs. republicanism, in earlier centuries much of this instead involved battle between competing Christian fundamentalist camps.) The modest goal of the European Community (now the EU) has been to finally stop this destructive competition between and within nation states by deepening political and economic ties across the continent. Current political debate is over the inanities of EU economic policies, and the labor market impact of enlargement. But this is really a sideshow. One could argue that such debates are actually an intended outcome of the European Project. It is far better that German, French, British, and Polish politicians and pundits argue vociferously, violently even, over the central bank, agricultural policy, and migration while squandering billions of euros on farm subsidies and regional support payments, than it is having them rattling sabers and squandering billions on tanks and warships instead. Indeed, for this reason, it really is important that Europe does sort out its voting rules, streamline its decision making process, and give its citizens a sense of ownership in the Project.

If the European Project is so important, why is it so unpopular? To start, one should lay the proposed EU constitution next to the U.S. Constitution with its Amendments. The U.S. Constitution, in modern typeset, is about 20 (double-spaced, big print) pages long, with another 15 pages of Amendments. The proposed EU constitution is 485 (single spaced, small print) pages long. In other words, it is the size of the phonebook for a typical mid-sized city (and over 25 times longer then the U.S. counterpart). You can read through the U.S. Constitution with your morning coffee and croissant, and have an intelligent conversation about it afterwards. You cannot do this with the EU constitution. The U.S. Constitution is shorter because it focuses, primarily, on how government will be structured, and on how member states can amend that structure in the future within the framework of the Constitution itself. The structures of government are considered sufficient to then establish law within the framework it defines. In contrast, the EU constitution is full of charters, protocols, exemptions, and existing elements of EU law. It is so long it requires a table of contents. An EU constitution that simply spelled out the rules for finance and decision making, with an article that "all existing elements of EU law as defined by its Members under treaty are subsumed into the body of this constitution unless modified here or by the governing structures defined herein" and a defined procedure for amendments could also have been about 20 pages long. Daily papers could have then run versions as a Sunday supplement, and Europeans could have read it over breakfast and carried on an intelligent conversation about it afterwards. In such a fantasy world, they probably would have even voted for it. If you were to give Americans their actual Constitution, combined with the volumes of (often crazy and special-interest driven) text that make up the body of U.S. Federal law, and asked them to vote for it as a single document, they would have rejected it as well. If the goal is to give European citizens a choice in defining their basic framework for collective self-government, then the task is to define a compact document that defines how rules are made, and not what all the rules actually are or might be.

More striking to me than the relative complexity of the documents (and the relative number of forests that must be felled to print each of them) is the text of the preambles. To appreciate the marketing challenge faced by the European constitution, simply compare the preambles. The U.S. Constitution starts out

"We the People of the United States..."

The proposed EU constitution starts out

"His Majesty The King Of The Belgians, The President Of The Czech Republic, Her Majesty The Queen Of Denmark, The President Of The Federal Republic Of Germany, The President Of The Republic Of Estonia, The President Of The Hellenic Republic, His Majesty The King Of Spain, The President Of The French Republic, The President Of Ireland, The President Of The Italian Republic, The President Of The Republic Of Cyprus, The President Of The Republic Of Latvia, The President Of The Republic Of Lithuania, His Royal Highness The Grand Duke Of Luxembourg, The President Of The Republic Of Hungary, The President Of Malta, Her Majesty The Queen Of The Netherlands, The Federal President Of The Republic Of Austria, The President Of The Republic Of Poland, The President Of The Portuguese Republic, The President Of The Republic Of Slovenia, The President Of The Slovak Republic, The President Of The Republic Of Finland, The Government Of The Kingdom Of Sweden, Her Majesty The Queen Of The United Kingdom Of Great Britain And Northern Ireland..."

These opening lines say an awful lot. In modern terms, the European document has a packaging problem. In the first case, the constitution is presented to us an expression of self-government by the citizens involved. In the other, the constitution is presented as a document of compromise among the monarchs and presidents involved, imposed from above by central authority. No wonder Europeans feel detached from the European Project. Europeans are not told that they have in effect built the draft constitution. They are told that monarchs and presidents did. The goals in the (rather long) preamble may be noble, but they are presented as the goals of the rulers, not the ruled. The tone of the proposed constitution preserves a distance to be kept between Europeans and Brussels. One almost gets the feeling average citizens cannot be trusted to organize themselves and make collective decisions themselves. They must instead go through layers of the Member States' power structures to reach Brussels.

At this point, most card carrying anti-American European readers will be fuming. The situations are different, they will say. A solution grown from European ideas is needed, they will say. The American constitutional experience is irrelevant, they will say. This is a shame. Ironically, the U.S. constitutional experiment has, in many ways, simply been an earlier run of the current European conundrum. An expanding set (initially of 13 sovereign member states) struggled to define common commercial and foreign policy under a set of rules (the Articles of Confederation) that worked even worse than the current governmental structure of the European Union. Its replacement, the current Constitution, is clearly a document born out of the ideas of Europe's Age of Enlightenment. It embodies an interpretation of Montesquieu's writings on the separation of powers (a concept that itself goes back to Aristotle), while also reflecting the writings of Harrington, Locke, and others from this era. It even draws on the experience of the pre-imperial Roman Republic (and Polybius' spin on mixed government). While the U.S. constitution pioneered the definition of a modern federal system of government, a number of EU Member States and associates (Germany, Austria, Belgium, Switzerland) have followed suit. In defining its Enlightenment-based constitutional system, the U.S. has struggled through its own Civil War, its own efforts to establish a central bank and common currency, the problem of balancing large and small state interests in the legislature (the Connecticut compromise), and subsidiarity (aka state's rights as embodied in the 10th Amendment).

Europe needs to sort out its management structure, and needs to give its citizens a sense of collective ownership. The European Project is important. Constitutions around the globe have been inspired by European thought. It would pay for Europeans to draw on their own intellectual history -- and its application around the globe -- in defining an elegant, streamlined (and more tree-friendly) solution that its citizens can read, understand and debate, and ultimately adopt as their own. A phone book is not the solution.

© JFF & Intereconomics, LLC 2006