The 'Asian Model' Is No Alternative

So says William Easterly:

Suppose we have a group of drivers leave New York at the same time to drive to Washington, and we interview the first 5 drivers who arrive in Washington. We find that they drove Lamborghinis at 150 mph, weaving in and out of traffic down the New Jersey Turnpike and I-95, out-running Highway Patrol cars who tried to stop them. Are they models for success getting from New York to Washington?

No, because since we only studied the “successful” first 5 drivers to arrive, we didn’t know about the vast majority of Lamborghini “failures” – the drivers who got into fatal accidents or were caught by the Highway Patrol and jailed for insanely reckless driving. On average, this approach was a disaster. On average, soccer moms driving mini-vans outperformed the Lamborghini drivers, if we study BOTH successes and failures.

So Asian success either happened in spite of statist industrial policy, not because of it, or industrial policy was an incredibly risky strategy that usually fails but occasionally has big successes, possibly in East Asia.

Either view would help explain why a huge amount of effort spent imitating East Asian success stories has NOT successfully replicated that success anywhere else.

One general problem with social sciences is that the counterfactuals aren't always obvious: everything we study has selection bias, because we can only analyze events that have actually occurred; we look into an alternate universe to see how things would be different if we tweaked this input or that structural alignment. So it's one thing to look at the meteoric economic rise of countries like China in recent decades and conclude that state-run economies present a viable alternative model for market-run economies. But we can't know the counterfactual: China may have grown faster without so much government interference*.

At least that's what Easterly is saying. For another view, Blattman suggests this essay by Dani Rodrik [pdf].

*In any case, one must only look at the economic degradation during Mao's reign to see how much an economy can collapse if a government gets it wrong.

The State of Things

The new TNR econ blog passes along a juicy anecdote:

As another illustration of this, consider an example I got from Orin Kramer, a hedge fund manager and prominent Obama supporter. Kramer has a friend who recently bid on a bundle of home-equity loans the government was auctioning off (presumably after having seized a bank that owned them). The homeowners in this case weren’t subprime deadbeats but people with solid credit histories who were scrupulously making their payments. Still, the friend was the highest bidder at a measly 14 cents on the dollar—and, Kramer says, “I have another friend who claims he overbid.” (The government decided not to sell because it didn't like the price.)

This might sound like a classic "irrational despondence" issue—only 14 cents on the dollar for a bundle of perfectly upstanding loans? But there’s one big problem, as Kramer points out: None of the homes have any equity left in them. Thanks to the cratering housing market, these people's first mortgages exceed the value of their homes, which makes them good candidates to simply stop paying (both the original mortgage and the home equity loan).

The government essentially has three choices: let homeowners default on the loans and enter bankruptcy, destroying their credit and making banks endure the costs of foreclosure in exchange for a devalued house; force the banks to rewrite the terms of the mortgage; or take the risks of mortgage-default away from the banks, write-down the mortgages, and take the financial hit. President Obama's new housing plan tends towards a combination of second and third. But right now the banking industry is in a persistent state of flux. Obama should choose one of the three options, and go for broke with it.

Buddy, 1996-2009

Today we grieve the loss of a good friend.

We miss you.

Ah, it was the Gaussian Copula Function!

Mispriced risk.  The global economic contagion was created by mispricing (read, underestimating) risk.  And apparently this is all a Canadian-educated Chinese mathematician's fault (way to externalize blame!)

So, for me the question is how do governments create policy regimes that encourage proper risk-management?  Obviously, powerful governments have a credible commitment problem since the costs of letting a financial institution dissolve in the face of risk bets gone bad are untenable.  But, as the parable of the Gaussian Copula Function tells us, there is little incentive for financial institutions to moderate or to be cautious.  So, our outcome seems doomed to be Pareto sub-optimal.

Even more concerning is industry and governments proclivity toward over-compensation.  When this financial mess bottoms out and we recommence our dogged climb toward ever-increasing prosperity, there will probably be a heck of a lot of regulation concerning the ways in which CMOs and credit default swaps can be created, rated, bought, and sold.  But, the underlying cause of financial blow up was not crazy mortgage-backed derivatives per se, rather risk mis-management stemmed from a deeply human tendency to discount "outliers" and treat events that occur under a certain threshold of probability as practically impossible.  And, until risk calculations take correlation seriously, financial firms in their legal obligation to produce the greatest returns for shareholders will continue to find ways to delude themselves and their clients into believing that you can make lots of money without taking on any risk.

Obama's Gamble

Tyler Cowen pulls out Occam’s Razor on Obama’s speech to Congress:

When you consider the speech as a whole, Obama is promising the largest attempt and most ambitious at rate of return arbitrage in the history of the human race.

Obama's speech was very effective but it is mostly about borrowing more money. It is odd that in a time when capital markets and attempted arbitrage have so failed us the solution is to resort to...capital markets and attempted arbitrage.

This is a gamble for Obama. His plans are ambitious, and perhaps the problems of today call for ambition. But Obama’s plans are contingent on the faith of foreign and domestic lenders in the U.S. government. Right now the government can borrow at very low rates of interest, and so Obama wants to borrow today in the hopes that when the bill comes due the yield on our investments will have made up the deficit. In a sense, Obama is placing an intertemporal carry trade bet with U.S. currency: he’s gambling that the dollars he borrows today will be more valuable than dollars he (or his successors) has to pay back later. It might pay off. It might not.

Or perhaps Obama is setting the government’s discount rate at some very high number. What theory is he operating under? If you view Obama as the head of a very large household, then perhaps he is trying to smooth out our national consumption. In other words, he’s playing a Keynesian game with Friedmanite justifications. Has this ever happened before?

Theoretically, Obama’s gamble doesn’t look much different to me from the Greenspan/Bush gamble following the bursting of the tech bubble. It’s being couched differently, but really he’s playing the same game. Didn't work so well the last time. I guess we'll have to hope for better results this go round.

Monetary Policy as Counter-Insurgency Strategy

Via Blattman, here's the abstract of a new NBER working paper [pdf]:

Between 2004 and 2009, Iraq’s currency experienced a massive real appreciation, driven by both nominal exchange rate appreciation and high inflation. The forces driving this appreciation include the end of economic sanctions, the rally in oil prices, and the influx of US aid. During the same period, a number of insurgent groups confronted the Iraqi government. While once posing a formidable threat to Allied forces, the insurgents now seem to be in a terminal decline.

In this essay, we argue that the real appreciation of Iraq’s currency may have played an important role in weakening the various insurgent movements. Many of these organizations were heavily dependent on foreign funding, and the appreciation eroded the purchasing power of their foreign funds. This may have forced insurgents to turn to forms of domestic financing that are inherently inferior for two reasons. The first is that the collection of local “taxes” by insurgents would reduce their popularity. The second is that local collection of revenue increases the autonomy of local insurgent commanders at the expense of central command authorities.

Correlation doesn't equal causation, of course, but it's certainly an interesting thesis.

Mixed Signals

In times of crisis, we look for reassurance. Roosevelt told us that we have "nothing to fear but fear itself." President Obama is as yet unable to offer the calm reassurance and clear direction markets seek. As one commentator noted, "since the president last went on prime-time television, the stock market has been crumbling. The spread of the worldwide recession is part of that, of course, but the perception that the administration has not worked out what it wants to do to fix the financial crisis — and, like its predecessor, is making it up as it goes along — has played a major role."

Lest you think I am too unkind to our new president, consider these confusing statements from the administration. “The capital needs of major U.S. banking institutions will be evaluated under a more challenging economic environment,” the administration said. “Should that assessment indicate that an additional capital buffer is warranted,” it continued, the banks could be required to give the government a right to acquire common shares, with voting rights...Administration officials said the new statement stopped well short of declaring that regulators were ready to partly or wholly “nationalize” any major banks" (My italics).

If full nationalization is 100 percent government ownership, then isn't the government acquiring a 40% ownership stake with full voting rights "partly nationalizing"? Of course it is, as any sensible person knows. The administration's insistence upon doing x and calling it not x contributes mightily to the perception that the administration is making things up as it goes along.

Why is the administration struggling to develop and articulate clear policy direction? I don't know, but I can suggest three quite different hypotheses.

1. The Median Voter: Administration policy must satisfy the median voter. The median voter did not elect Obama to give more money to big banks. The median voter believes this is something only Republicans do. As the emergent consensus seems to be that nationalization is the necessary next step, the need to appeal to the median voter forces the administration to obfuscate.
   
2. Interest Groups: Administration policy must satisfy the interests of private financial institutions which want government money but not government control. I I think (though don't know for sure) that the donors are as likely to be those who manage and work there rather than those who own the banks. This could create different incentives regarding nationalization. Shareholders care about their equity; managers care about their jobs.
   
3. Intra-administration Politics: having populated his economic team with multiple very large egos, the administration is saddled with conflicting policy ideas and the absence of a clear procedure to decide authoritatively among them.
   

Of course, it might very well be all of the above or something else entirely. Or, it might be the scariest hypothesis of all, that the administration has no idea what they are doing, and are just making things up as they go along.

Deflation Watch

Brad DeLong passes along a troubling picture:



Consumer prices were flat over the past 12 months.

America's Lost Decade

We've already had it:

Over the past ten years, the S&P 500 is down 50% adjusted for inflation (February 17, 1999 to February 17, 2009). By my calculation, the stock market was down roughly 50%, adjusted for inflation, in the worst ten years of the Great Depression (September 1929 to September 1939).

When you add in the fact that real wages were stagnant over the past ten years and debt soared, I think we will look back at the last ten years as a decade of despair.

(ht: Free Exchange)

The Great-ish Depression

Menzie Chinn says things are really bad in the industrial and manufacturing sectors:

To sum up, industrial production is lower than at the corresponding point in any previous post-War recession. For manufacturing output, the same is true back to the 1973 recession (as far back as this series goes). ...

It is interesting to see how fast output has declined in the past six months; industrial production has declined 9.3% (in log terms) since 2008M07, and manufacturing production by 12.3%. The three month rate of decline (annualized, log terms) is 21.7% and 31.7% respectively.