Saturday, January 31, 2009

Moral hazard for dummies

The collapse of Lehman is universally recognized as the start of the total meltdown of the financial system last autumn. The Bush administration decided to let Lehman fail, at least in part because of the 'moral hazard' implicit in saving banks from the consequences of their recklessness.

The moral hazard idea is quite simple - if you guarantee to someone that you will help them out if they get into a mess, they have less incentive not to get into a mess. So, if I buy my daughter another ice cream after she has carelessly dropped the first one, more ice creams may hit the deck in the future (yes, I have and they did).

Since banks getting into a mess is bad news for all of us, moral hazard in the financial system is particularly important. If they think we'll bail them out whatever they do, then they will do, ehm, whatever. Well, whatever will make them a pile of money until their luck runs out.

So there was a rationale for the Lehman decision. But, guess what. Now, moral hazard is far more severe than before, because of the demonstration effect of the Lehman collapse. The authorities' bluff has been called: they let Lehman slide, and in the chaos that followed, bailed everyone else out (in the case of AIG, about a week later). $700 billion, no questions asked.

This is much worse than if Lehman had been bailed out in the first place. The government attempted to show the banks that they can fail, and was so scared at the consequences that it immediately dropped the whole moral hazard agenda. A bit like my daughter kicking up such a fuss when I refuse to buy another ice cream that I end up buying here another one anyway, along with a couple of Disney DVDs and a new doll.

Who is going to believe, after all that trauma, that a big financial institution in trouble will ever again be allowed to fail? Unless regulators act very smartly, moral hazard will be an even greater problem in the future than it was in the disastrous decade just passed.

Friday, January 30, 2009

Gordon Brown's debt...

A Conservative party poster doing the rounds shows a newborn baby under the slogan 'Dad's nose, Mum's eyes, Gordon Brown's debt'

The implication is that typically, a Labour government's reckless spending has bankrupted the country, and our children will be paying for Brown's profligacy for years. As George Osborne says, 'in the end all Labour governments run out of money'.

There is an important nuance to be made here. The government, in fact, was perfectly solvent until the banking crisis took hold. Public debt in Britain was 42% of GDP in 1997, when Brown took over the Treasury, and is now around 48% of GDP (about 2/3 of the ratio for France and Germany, less than half Italy and Belgium, and about a quarter of Japan). So far, so not-particularly-damning.

But there is more. Without the rescue package for the banks, the ratio would be much lower - about 41%.

So, actually, Brown's stewardship of the government finances has been pretty conservative (small 'c'). Where the Tories could have a case, of course, is that Labour did nothing to arrest the spectacular growth of private sector debt, related in particular to the ridiculous housing boom Brown happily presided over. But that has nothing much to do with the government's fiscal position.

The Labour government - like all the others - missed the enormous bubble being generated by global finance, and - unlike many others - allowed British households to take on excessive debt. But to claim the government itself is heavily indebted is simply wrong.

So maybe the slogan should be 'Dad's nose, Mum's eyes, Mum and Dad's debt'. After all, aren't the Conservatives the party of individual responsibility?

Tuesday, January 20, 2009

Are we going bust?

Well, apparently so, since the government has decided to use more public money to bail out our hopeless banks.

Peter Oborn in the Daily Mail trumpets that

We’re a nation on the brink of going bankrupt

The reason?

'thanks to Alistair Darling's insane generosity last October...It is no longer difficult to imagine the national debt doubling or even trebling if this banking crisis persists for much longer. If that happened, the economy would collapse, Britain would go bankrupt and the receivers would be brought to bear.'

What does that mean exactly? Who are the receivers?

Well, it turns out the receivers are ... us. Or rather, those of us who are net savers over those who are net debtors. So in other words, I owe the money to my Dad, I think.
In fact, national debts exist precisely for the purpose of resolving crises - ours ballooned during the Second World War, but was quickly reduced to more normal levels in the postwar years. At the moment UK national debt is a little over 40% of GDP, although in practice rather more given the liabilities taken on from the banking crisis.
In other words, the UK is in a similar position of a person earning £100,000 a year with a £40,000 mortgage. Not so worrying after all, perhaps?

Well, it's true the bank losses could end up being significantly higher than a year's worth of UK output - even several multiples of it - but as long as British savers are still prepared to take on UK government debt (and with sterling weak, they have few options), the government can keep servicing it. And given the state of the private banking sector, government debt is a relatively attractive prospect for British savers, as the reduction of interest rates on National Savings suggests. It's certainly a better bet than RBS shares. And as the GDP growth returns after the recession, the debt/GDP ratio should be reduced, provided governments run more or less balanced budgets (eventually).

So, Peter Oborn, the UK is probably not going bust. But its banks are, and the government has no option but to bail them out in one way or another. Or, preferably, take them over completely, as our own Willem Buiter argues in his brilliant but terrifying Maverecon blog.

Sunday, January 11, 2009

A free lunch for heirs

One easily anticipated, but generally unforeseen consequence of the popping of the housing bubble is that inheritance tax thresholds are now starting to look absurdly generous.

Last autumn Gordon Brown allowed himself to be bullied into increasing an already generous tax-free allowance of £312,000 (only 6% of estates liable) to £350,000 by 2010. Much of the argument for this was based on the 'unfairness' of taxing ordinary people who had had the bad luck of inheriting homes worth hundreds of thousands of pounds after a decade of inflation (already a shaky case - why shouldn't beneficiaries of an unearned windfall be taxed?).

Now, of course, house prices are collapsing and even fewer estates will fall into the net. £350,000 is just short of the average London house price in 2007, but this has seen a decline of nearly 20% over 2008, and more declines are predicted. The average UK price was £210,000 the same year, now closer to £165,000.

Of course, falling out of a tax band because an asset loses value is not a win-win situation, but to the extent that housing inheritances are reinvested in the housing market, those who inherit stand to gain because the asset's value in this market is retained, but it becomes tax-free. Given that hardly anyone had to pay the tax even before this give-away, and the ease with which it is legally evaded, the bottom 95-6% of the population end up giving the top 4-5% a housing 'tax credit' worth maybe a couple of billion pounds per year.

Wasn't new Labour about governing in the interests of 'the many, not the few'?

Friday, January 9, 2009

My economic forecast for 2009...

... is as good as good as anybody else's.

An interesting exercise in these depressing times is to read yesterday's newspapers. Although a few people warned a while ago that we were looking at a financial bubble which would drag us into recession or worse (Robert Shiller, Paul Krugman, Dean Baker, Larry Elliot, Nouriel Roubini) most of the experts and policymakers didn't see it coming.

This is hardly surprising, since actually nearly all analysis of the real economy in real-time is hopelessly approximative.
Here is a random article I found on google whilst looking for something else:

Slump in sterling pounds economy

Sterlings' steady slide is exacting an increasingly painful toll on the UK's ailing economy.

Stirling Currency
Stale sterling: The pound's weakness is making it more costly to import foreign goods

The tumbling value of the pound helped push up the cost of imported products in June at the fastest rate since the 1970s, official figures showed.

This added to inflationary pressures while eroding the spending power of Britain's embattled consumers and squeezing corporate profit margins. And an official report is tipped to show the Consumer Prices Index breached the 4% barrier in July, preventing the Bank of England from helping the economy by cutting interest rates.

The pound yesterday tumbled to its lowest level since late 2006 against the dollar, falling below $1.91. Sterling is trading at 78p against the euro, near the record lows it hit earlier this month.

This currency weakness - driven by fears Britain is heading into recession - is making it more costly to import foreign goods and adding to inflationary forces. That will worry the Bank of England, given cheap import costs have been an important factor supporting the economy for more than ten years.

Between 1995 and the end of 2006 the cost of imported products, excluding oil, tumbled 15%. Trade figures showed the cost of imported goods rose a record 15.6% in June, with the price of food gaining 26%. Even excluding oil, import prices rose by 8.9% in June, the most since 1993, the Office for National Statistics said.

Economist Peter Dixon of Commerzbank said: 'The fact that the pound is falling is not doing us any favours - it is a problem that could well make inflation significantly worse.'

This was published in the Daily Mail last August. Now, oil is cheap, the pound is worth about 20% less, inflation fears have been replaced by deflation fears. And Commerzbank, which paid Peter Dixon for his economic analysis, has just been bailed out by the German government.

And that was just five months ago, when the current crisis was already well on the way! Looks like the press, as well as the economics profession, needs to take a long hard look in the mirror.

Wednesday, January 7, 2009

New paper! In Search of the Elusive Equality/Efficiency Trade-Off

Yes, I've written a paper. To call it new is a bit cheeky, since I first presented this work at the 2004 APSA conference (people have started and finished PhDs in the meantime). The paper is co-authored with Mark Blyth, the man who taught me, amongst other things, that The Matrix is political science.
Anyway, here's an abbreviated intro, and if you fancy reading the rest a link is provided. Comments very welcome, of course (especially critical ones).

Policymakers, political pundits, and even political economists, are much enamored by the notion of ‘trade-offs.’ That is, while we may seek more of good ‘X’ to satisfy our desires, doing so necessarily implies a diminution in our consumption (or production) of good ‘Y’. For example, one of the most famous trade-offs of the post war era was the Philips curve, which purported to show an inverse relationship between the rate of change in money wages and prices (more prosaically, unemployment versus inflation) (Philips 1958). Lower unemployment necessarily implied a trade-off in terms of higher prices. It should give us pause then that as soon as the Philips curve was declared an immutable fact of life, the curve, and the trade-off it implied, collapsed (Friedman 1975/1991).

The validity of theorized trade-offs may matter less than the conviction with which such beliefs are held by policy makers. Once such ideas become the ‘conventional judgment’ regarding economic affairs, to use Keynes’ term, they tend to become self-reinforcing. In this regard, one particular trade-off seems particularly hard to shake-off. A little over thirty years ago, Arthur Okun’s well known book Equality and Efficiency: The Big Tradeoff argued that “efficiency is bought at the cost of inequalities in income and wealth.” (Okun 1975: 51). In Okun’s view, societies simply had to choose between an efficient economy and an egalitarian society. If equality undermines incentives or if pro-equality policies distort market allocation, economic performance can only be improved at the expense of a less equitable distribution of income. This dilemma has informed much of the debate around the relative economic performances of the United States and other Anglo countries on the one hand, and continental Western Europe on the other.

However, the equality/efficiency trade-off is far from universally accepted. The unpalatable implications of Okun’s argument have encouraged politicians and scholars to find ways around the stark choice between Anglo-Saxon inequality and the economic underperformance of the largest continental European economies. In this paper we provide further evidence to challenge the existence of a trade-off between economic performance and social justice.

Our paper addresses the problem from an unexplored angle, by examining the ways in which the institutions of welfare capitalism regulate markets. Liberalization – the freeing of markets from the burden of heavy market distorting regulation and legalistic restrictions – has been an influential policy prescription for enhancing economic efficiency and growth. The theory underpinning this prescription is that ‘free’ markets are more efficient than more ‘regulated’ markets, provided that functional legal and property rights arrangements are in place; in the absence of distortions caused by government interventions, the free operation of the price mechanism will allocate resources efficiently.

This article uses data from a variety of sources to assess how this ‘institutional’ dimension of efficiency relates to levels of inequality in Western European countries. Although it is well documented that high spending welfare states in Western Europe tend to have low levels of inequality and poverty, we find that the same high spending and egalitarian welfare states also tend to have efficiently regulated markets. In contrast, less regulatory efficiency is generally associated with higher levels of inequality. This analysis therefore provides novel support for the view that there is no simple trade-off between efficiency and equality, by showing that efficient market regulation can be - and usually is - combined with egalitarian policies and institutions, and that inefficiencies tend to have inegalitarian effects.