AF447 Economics

For Ed everything is always about demographics. For Kevin Drum and others everything is always about energy. Other people have decided that productivity is so high that unemployment is inevitable, or that all consumption is now welfare reducing. Still others that the Chinese are our rightful masters – submit! although poor old Europe runs a trade surplus. And of course these aren’t the only discoveries.

Other people still will tell you that millions of Americans who were gainfully employed up to 2008-2009 are suddenly of literally zero productivity – well, they surely are as long as they’re on the dole, but that’s not what they mean – or just that everyone went mysteriously lazy in a sort of spontaneous mass conversion event. Or that the United States has a serious deficiency of fast trains, which only became apparent all at once in 2008. It has been an era of enormous creativity in the analytical function of economics, which has been more than matched by the united consensus among practitioners in its policy-advising function.

Behold the power of Leszek Kolakowski’s Principle of the Infinite Cornucopia. This holds that there is an infinite cornucopia of arguments in favour of whatever course of action or inaction you happen to have decided on for whatever reason. All these fancy intellectual theories, and none of them consider the possibility that there’s a recession on. If that was accepted, of course, it would suggest that things really are this bad, Alan Greenspan really was this incompetent, maldistribution works like it did in the 20s, this is as bad as it looks, and simply taking your hands off the stick and leaving it to George was relatively the best policy, just because it wasn’t actively harmful.

Actually, the aviation analogy worries me; I keep thinking of the pilots of Air France 447, who flew an entirely airworthy aeroplane from 35,000 feet into the sea in a fully developed stall without seriously trying to recover because (as far as anyone knows) the immediate effects were counterintuitive.

I’m sympathetic to the energy explanation, but I do think the idea that there’s a recession on might still be worth a crack, and we might try pushing down the nose and increasing the air speed.

It’s the geography, stupid

Central and Eastern European economies aren’t doing well. German IFO business confidence tanks, on expectations of poor export orders. These two facts are related.

It’s been said before that the central core of economics failed to predict the great recession (or damn, can’t we call it a depression already? It’s been four years and it’s depressing enough) and that only a few key groups of people noticed anything unusual. Followers of Hyman Minsky and Charles Kindleberger saw the classic pattern of confidence, mania, panic, and crash unfolding. People who understood the economy as a system of accounts saw a number of huge imbalances in the flow of funds. Marxists considered that the source of the imbalances was the super-exploitation of Chinese workers and the maldistribution of the proceeds of growth in the West.

But I’m not sure if economic geography has been given enough credit. One economic geographer who predicted the crisis is of course Paul Krugman. From a geographical perspective, the CEE economies are part of a huge automotive engineering cluster rather like the US rustbelt or the West Midlands in the UK, reaching over from the Cologne area to Slovakia. (Actually, they always have been since the Industrial Revolution – here’s a beautiful 1938 Tatra and a much less beautiful 1914 Skoda 305mm mortar and caterpillar tractor.) From an industrial economics perspective, they are part of the German motor industry’s global supply chain, whether as upstream suppliers of parts and sub-assemblies or as downstream final assembly contractors. You can argue whether geography or functional specialisation determines this, but that’s not really relevant right now.

To put it another way, they aren’t exporters to “the German locomotive” but rather to the German economy’s customers, at one remove. The determining factor of their order books is how well the final products sell, and in the German economy’s historical default state as an industrial exporter, that depends on somebody somewhere buying more German goods than they sell goods to Germany.

A deflationary adjustment of the eurozone trade balances will be deflationary all the way along the supply chains. This is broadly what I was worrying about in May, 2010. The problem is not quite the same as it was for Keynes in the original Economic Consequences, a book which contains a lot of economic geography – back then, if the Germans were ever going to pay off their debts, Keynes pointed out, the rest of Europe had to let them export enough stuff. Now the boot is on the other foot. If the Greeks are ever going to get out of their debt crisis, the Germans have to let them export enough stuff. And if the Czechs and Hungarians and Baltics are not going to slide back into the mud, the Germans have to import enough stuff from them. Nobody imagines that the Greeks will be importing as many BMWs as they used to, so what can the answer be?

Life On PMI Cold Comfort Farm.

As the heat wave which has been hanging over Southern Europe for the last couple of weeks steadily eases off there is little sign that any of the warm air which is disippating is reaching the chilled motors of the European and Chinese economies. The results of this months flash PMI readings are at best more of the same, and at worst show continuing deterioration. While current conditions stabilised in some areas, new orders, and especially new export orders often hit new post-recovery lows. There is every likelihood that the final August global readings will be much more of the same. Continue reading

The country of humor is … Germany!

As an economics blogger, I am not an expert on international humor, but today’s sad news got me thinking. Germans insist – mostly unsuccessfully – that “German humor” is not the least bit oxymoronic, the rest of the world just doesn’t seem to understand it. Which is why the prejudice will probably live on.

One of the most German of all humorists, Vicco von Bülow (”Loriot”), passed away on Monday at the age of 87. Explaining what Loriot meant to German humor and culture is difficult (see above). He was probably to German humor what Monty Python was to the British. His sometimes absurd drawings and stories of twisted everyday situations were a provocation at first, but have strongly influenced the way Germans have continued to develop their humor – in comedies, but also in literature and film. “This is just like in Loriot” is almost a standard expression in German, describing an everyday situation that turns to become so absurd that it is just hilarious.

An example from Loriot’s work: a couple on a romantic date. He, slightly older and played by Loriot himself, starts a short, somewhat serious but also romantic monologue. The only problem: he has a small piece of a noodle from the last dish stuck on his face. The woman cannot concentrate on anything but the noodle on his face. He, somewhat annoyed by her distraction, tries to remove the noodle but then sticks it to some other part of his face. The noodle therefore travels around his face while he tries to get into a serious relationship talk with a completely distracted girlfriend.

Another example is the almost wordless clip “The picture is crooked”, where an older gentleman (again: Loriot himself) waiting in a hotel room for a business meeting, in his attempt to correct a slightly crooked picture on the wall, destroys the whole hotel room.

The most absurd, yet very German, example is probably “Gentlemen in the bath tub“. Two men meet for the first time in one man’s bath tub, and discuss various aspects of taking a bath, when to let in water, at what temperature, when to put a small duck into the bath tub etc. It is mostly a struggle for authority where both keep a formal distance (“Herr Dr. Klöbner!”) while sitting naked in a mostly empty bath tub.

There are a few ingredients to German humor of the Loriot type: you need an audience that knows and has witnessed too many times before how people take themselves and their procedures and rules a little too seriously. In other words, they need to be German. What is more, you need a twisted everyday situation that turns absurd in a very subtle manner and in a way that does not offend your audience. And you need to put in hard work. Loriot did not consider himself particularly funny (although he was the most modest person I have ever seen). For him, humor was simply hard work: carefully observing German everyday life, constructing these situations in a small play, working out the details with the actors (for instance with the brilliant Evelyn Hamann), and thereby making it absurd in the Loriot type of way.

To be sure, not all Germans like Loriot. But his work is a perfect example of two aspects of German humor: it exists, and it is very hard to export (something that Tyler Cowen pointed out a while ago). Therefore, being German is perfect if you are a humorous person: On the one hand, you (more or less) understand and appreciate US, British and also other European humor to some extent. On the other hand, and mainly thanks to Loriot, you have access to a very special source of German absurdity humor. When it comes to humor, Germany might actually be the best-supplied country in the world.

Eastern European Growth – Coming Rapidly Off The Boil?

The latest round of EU GDP data, brought to light a reality which many who have been closely following the economies of Eastern Europe already suspected: that the heavily export dependent economies in the region would almost inevitably be dragged down by the rapid slowdown in Europe’s principal economic motor, the German economy (see this post for background). Continue reading

This economic government is neither economic nor government

I don’t know why the FT Brussels blog thinks it’s surprising that the Portuguese economy is showing signs of life, or at least non-catastrophe, while the “German growth engine” is slowing down. This shouldn’t be complicated – a current account surplus increases GDP, a deficit reduces it, and globally, current accounts must sum to zero. If the Portuguese – or southern Europe in general – reduce their trade deficit, as the large majority of their trade is within the Eurozone, Germany has to reduce its surplus or else redirect it to extra-European trade. Because the EU is the wealthiest trading bloc on earth, such redirection implies that Euro-exporters need to cut prices. Whether they lose some aggregate demand by cutting volume or by cutting prices is a secondary question.

What is true, however, is that if the trade-deficit states in the Eurozone try to solve their problems by reducing their current accounts, their living standards will fall and so will the trade-surplus states’ GDP. This appears to be precisely what is happening.

So what about that “economic government”, eh? Even the title doesn’t fill me with confidence. It amounts to a cliché of European politics, an old tune favoured by the French foreign ministry (because it rivals the Bretton Woods institutions) and the EU Commission’s ECFIN and internal market directorates (because it offers them more power). This is, at least, the first time I’ve seen any detail about what it is and what it’s meant to do. And all it seems to have to offer is yet more deflation.

Let’s go through this one. The original Stability Pact demanded restrictions on government budgets. The Eurozone states did try hard to implement this and therefore got less of the late 90s boom than other countries did. In the early 2000s recession, France and Germany ran substantial budget deficits and eventually breached the pact. Some other countries, like Ireland, were enjoying a massive property boom and ran budget surpluses. The IMF, ECB, DG ECFIN, etc, couldn’t have been happier.

So, how’s that working out for you? It’s almost as if those eurosclerotic ol’ social democratic finance ministers from the early Bush age had had a point all along!

And the answer is apparently another Stability Pact, just bigger, badder, and more, with balanced budget clauses and a ban on wage settlements being indexed to inflation. To put it another way, you personally are being asked to trust the ECB to put you out of work if prices look like going up. That’s the only way to deal with inflation!

Things the economic government does not cover include – anything about intra-eurozone trade, anything about macro-prudential bank regulation, anything about unemployment, anything about growth. You might think these are some pretty big issues. But the Merkel-Sarkozy paper doesn’t even mention any of the problems that actually happened. There was a massive housing bubble (nothing) fuelled by spectacularly dodgy banking (nothing) recycling a massive trade surplus (nothing) that led to a huge recession (nothing).

Finally, it’s not actually true that southern Europeans don’t work as hard as Germans. Greeks actually put in more hours. It seems fair to say that the differences are not due to Germany’s vast resource wealth. If it’s not land or labour, it must be either capital – the Germans have more and better tools to work with – or entrepreneurship – German companies are better organised. (Look, this isn’t a controversial statement, is it?) It’s rare that you have to bring your own computer, tractor, machine-tool, or whatever to work. It’s rarer that anyone asks you how you think your workplace should be organised.

But for some reason, the only answer anyone is prepared to offer to the failure of half Europe’s management class is that everyone else should take a pay cut.

On the value of “basic science” in economics and other disciplines

A few months ago, Larry Summers was reported to have made some comments regarding rules of thumb he used to distinguish between useful and not-so-useful economic papers when he was working in government:

He had a fairly clear categorisation for which ones were likely to be useful: read virtually all the ones that used the words leverage, liquidity, and deflation, he said, and virtually none that used the words optimising, choice-theoretic or neoclassical (presumably in the titles or abstracts).

However, while this sounds kind of harsh, he made sure to temper his criticism by saying that some seemingly useless things of apparently limited applicability might turn out to be useful in years to come (microfoundations for macroeconomics, perhaps?).

This last caveat is one I’ve frequently encountered in two contexts: From people who want to defend basic (natural) science, and from people who want to defend some discipline in economics that is just plain wacky. The argument is the same: It might turn out to be useful in the future.

Though true in the strict sense (I can’t rule out possible value coming from this research), the argument is frequently a “cheat”: I suspect that the person supporting basic science (or abstract economic theorizing) believes that this is nice and valuable intrinsically no matter what the usefulness of the results may turn out to be. But since this is a tough pitch to sell to the general public (especially for the economist), they try to say that “well, this could actually turn out to be valued highly by you even if you don’t care about the intrinsic value.” And yes, there are clear cases of (truly) useful things that came out of (seemingly) pointless and abstract theorizing. Here’s an example from the US Department of Energy:

The discovery that all matter comes in discrete bundles was at the core of forefront research on quantum mechanics in the 1920s. This knowledge did not originally appear to have much connection to the way things were built or used in daily life. In time, however, the understanding of quantum mechanics allowed us to build devices such as the transistor and the laser. Our present-day electronic world, with computers, communications networks, medical technology, and space-age materials would be utterly impossible without the quantum revolution in the understanding of matter that occurred seven decades ago. But the payoff took time, and no one envisioned the enormous economic and social outcome at the time of the original research.

However, it seems wrong (especially of an economist) to just transfer this argument from basic science (whether mathematics or theoretical physics or whatever) to economics. The reason is simple: Take two types of research. One (“applied research”?) is practical and will with high probability lead to valuable insights (in  terms of practical usefulness, economic value, material benefits to humanity or whatever). The other one (“basic research”?) is highly abstract and divorced from empirical applications and will with high probability fail to lead to such valuable insights. However, with both of them there is uncertainty, and we can imagine some probability distribution over “insight-value” that these could generate. It seems to me that unless we have reason to believe that the tail of the “basic science” distribution is fatter – i.e., unless the probability of making truly mind-blowing important progress  is higher for basic than for applied science – then we should always go for the applied in so far as the pragmatic value of the insights is what we want. The expected value would be higher, and the probability of an insight of any given value would be higher with the applied research. In other words, we need a “fat-tail” argument – an argument that the distributions will differ for observations lying far away from the mean. Since discussing differences in the tails of various distributions in another context was part of what made Summers resign as President of Harvard, this is a point I think he would get easily.

My point is just that I can see the possibility of this fat-tail argument in terms of certain types of basic science, but that does not mean it is present in economics. In physics there could be some argument such as “the higher the granularity and precision with which we can understand and manipulate the world around us, the more opportunities are open to us for manipulating it to our benefit,” and this can be supported by examples from experience. In mathematics there could be an argument that “the more analytical tools for a broader array of problems, the more mathematics will be able to power up other disciplines and improve their reach and value”. However, I am at a loss to see what more sophisticated representative agent-modelling in DSGE models or rational addiction models will give us. To me, such work seems more like Tolkienesque fantasy about alternate worlds. And if such fantasy about alternate probably-not-even-conceivably-realistic worlds can be useful – then the question is: Which ones are most likely to be useful, and how do we tell? Why representative agents deciding with optimal control theory? Why the (apparent) bias towards non-regulation and free markets?

Also – if such modeling divorced from evidence “could potentially” turn out to be useful – surely it could also “potentially” turn out to be harmful? For instance, if it misled (at times influential) economists into thinking that the world is simpler than it is and that it is imperative that we implement policies derived from such rational choice fan-fiction. An anecdote that may provide a possible example: Brooksley Born apparently, according to some, pushed hard for the regulation of a booming, wild-west-frontier derivatives market. In this she was stopped by President Clinton’s Working Group on Financial Markets. Alan Greenspan claimed that regulation could lead to financial turmoil, and at one point the very same Larry Summers we started with called her and said that

“You’re going to cause the worst financial crisis since the end of World War II.”… [Summers then said he had] 13 bankers in his office who informed him of this.

The Policymaker’s Fear Of The Italian Penalty Shot

“While the impact of service-sector liberalization and privatizations may be positive on medium-term growth, the budget cuts are likely to have quite negative effects on the short-term GDP dynamic. We expect Italian GDP growth to slow to close to zero in 2012 and 2013.” Giada Giani, Citigroup

According to one anonymous German official speaking off the record to reporters from Der Spiegel, “a country like Italy can’t be saved”. We will have to trust that he was referring to the country’s size when he made the statement, and not its existential core. If he was, he may well be right, at least under the Euro Area’s current institutional arrangements. Let’s take a quick look at why. Continue reading

Going Dutch – One Possible Solution To the Euro Debt Crisis?

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing — after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago — ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it. Continue reading

Is The Risk Accompanying Estonia’s Eurozone Membership Really So Low?

“But the go-ahead Estonians are already scenting the next challenge. Should the single currency crumble, they are determined to be on the inside track for any new German-centred “super-euro”. Goodbye “eastern Europe”; welcome to the “new north”.”
Edward Lucas, writing in The Economist

Estonia’s economy put in another sterling performance in the second quarter of this year, even if the expansion rate fell back to quarterly 1.8%, down from 2.4% in Q1, and 2.5% in the last quarter of 2010. Well, you didn’t expect the economy to keep growing at such strong rates for ever, did you? Evidently not. The interannual rate peaked at 8.5% in the first quarter, and dropped back slightly during the last three months to 8.4%, still this is no mean pace.

Continue reading