Africa and the Financial Crisis

I've been writing a lot about the Financial Crisis and relatively little about African development but I found a great short little paper by Shanta Devarajan, Chief Economist of the Africa Region at the World Bank, about the impact of the crisis on Africa that combines the too. If you're curious about how the crisis has impacted other countries here's a post about it's impact in Eastern Europe and Iceland. It's late and I want to keep this short but here's the core idea followed by the five ways of how the crisis could have an impact, read the paper for more:

It is argued that the transmission mechanisms between the financial systems in Africa and the rest of the world are weak and will minimize the impact on the crisis. African financial institutions are not exposed to risks emanating from complex instruments in international financial markets because most banks in Sub-Saharan Africa rely on deposits to fund their loan portfolios (which they keep on their books to maturity); the interbank market is small; the market for securitized or derivative instruments is either small or nonexistent, and few rely on foreign borrowing to fund their lending operations. Exceptions to this position are then made for countries like Nigeria and South Africa which are seen as having meaningful transmission mechanisms with the larger financial systems in crisis.

This conventional position is now being challenged. As the immediate crisis faced in the last couple of months subsides, and policymakers begin to consider the longer term impact of the crisis in Africa, an emerging view is that the impact on the financial sector in Africa may actually be more significant and longer lasting than first assumed, and the impact on the non-financial sector in Africa will be more notable.

Impacts:

1. Weakened local investor confidence in equities and bonds on African Stock Exchanges
   
2. Return to ultraconservative lending practices 
   
3. Losses arising from central bank reserve management practices 
   
4. Renewed debate on the role of governments in the financial system 
   
5. Weakened balance sheets resulting from a downturn in the real economy
   

Finally, one obvious way the crisis will affect the real economy is through a drop in commodity prices:

Declining demand for commodities will impact African countries significantly. In Zambia for example, the economy is likely to take a hit from a share decline in copper prices (-24%ytd). As the financial crisis surges into all parts of the real economy in developed economies, African countries will experience a substantial decline in exports as the rapid pace of trade expansion in this decade decelerates sharply.

Decentralization And Corruption

Another paper by Ray Fisman, this one together with Roberta Gatti on how government decentralization affects corruption. They use cross country data and find that "fiscal decentralization in government expenditure is strongly and significantly associ-
ated with lower corruption." I'm not going to go into the actual methodology of the paper here - it's definitely an area that needs some further study but I wanted to summarize the different theories as to why decentralization might increase or decrease corruption (from the paper):
Decrease:

• Political competition reduces the ability of bureaucrats to extract rents in exchange for services - The Power to Tax, Brennan and Buchanan (1980)
  
• Competition among localities will more generally discourage governments from establishing interventionist and distortionary policies that might drive away valuable factors of production - Regional Decentralization and Fiscal Incentives, Jin et. al (1999)
  
• Related to last point: Implement corruption free zones to force other localities to improve their own bureaucracies - Special Governance Zone: A Practical Entry-Point for a Winnable Anti-Corruption Program, Shang-Jin Wei (2000)
• Agents in centralized bureaucracy are responsible for many tasks in many jurisdictions, in decentralized bureaucracy they are responsible for a single task. This makes them more directly accountable while in centralized bureaucracy only the aggregate performance is measured - Constitutional determinants of government spending, Persson and Tabellini (2000)

Increase:

• Decentralized regimes are less likely to attract high quality bureaucrats, since the rewards to local politicians will be small relative to bureaucrats at the central level - Fiscal federalism and efficiency, Tanzi (1996).
  
• The post may be more prestigious, visible, and monitored better - Constitutional determinants of government spending, Persson and Tabellini (2000)  
• Lack of coordination among bureaucrats in extracting bribes may lead to ‘excess’ rent extraction, in much the same manner that successive monopolies result in a total price markup above the monopoly level - Corruption, Shleifer and Vishny (1993) - [Great paper, I read this for IPS 207]

Important: Tie local revenue generation to local expenditures, since vertical fiscal transfers may allow local officials to ignore the financial consequences of mismanagement.

The Value of Connections to Dick Cheney

David Fisman, Ray Fisman, Julia Galef, and Rakesh Khurana have a fascinating (I know I overuse this word but it's really deserved here) working paper that tries to estimate the value to a company of a connection to Vice President Dick Cheney. They look at the market reaction (i.e. stock price) of companies connected to Cheney to Cheney's heart attacks, his selection as Vice President, the likelihood war in Iraq at certain points in time, and the probability of a Bush victory in 2000 to see if these events cause the companies to significantly over- or underperform their respective sectors. They find that the value of such ties is zero.They think that this is to some degree generally applicable to individual politicians in the US:

While prior evidence suggests that business-government relations are an important part of U.S. commerce, our results suggest that these connections are more institutional than personal. That is, there are well-organized institutions (such as political action committees and other lobbying entities) for facilitating these relations that differ from the deeply personalized favor exchange that characterize business-politics relations in so much of the world.

I think that this result needs much further study but the implication that the value to a company of a personal connection to a politician is relatively unimportant compared to more formal and broad lobbying and PACs is going to be hugely important in figuring how to best fight corruption and the influence of special interests.

Update: Here's another similar paper Estimating the Value of Political Connections by Ray Fisman on how news about former Indonesian President Suharto's impacted companies with connections to him. I remember reading this about two years ago but don't remember for which class...

Iceland's Crisis

As most people have heard at this point, Iceland has been one of the hardest hit in the current financial crisis. Björk summarizes the situation best in this very thoughtful article in the London Times:

Gigantic loans, it has been revealed, were taken out abroad by a few individuals and without the full knowledge of the Icelandic people. Now the nation seems to be responsible for having to pay them back.

This weekend I wanted to learn a bit more about what the situation in Iceland is like and found an Icelandic blog Iceland Weather Report linked from A Fistful of Euros that has been giving regular updates on the situation on the ground:

[T]here were massive layoffs here at the end of last month. Most of those were in the construction industry - manual workers, designers, architects … anyone in the business of constructing new buildings. Many were foreign citizens who had been living and working here temporarily in construction. The second-largest hard-hit industry was, obviously, the financial services sector - bank workers being laid off. The third-largest was retail. In addition, many people have been laid off and then re-hired on different terms, which usually has meant that they’ve had to take a pay cut.

Basically, things here have slowed down drastically. Public and private spending has been cut back wherever possible. Pretty much anything that can be postponed, has been postponed. That goes for companies and institutions [public and private], as well as individuals. People aren’t going out to buy new cars or even new clothes these days, nobody is remodelling their house or doing anything of the sort that isn’t absolutely crucial. A state of affairs that I suspect isn’t unique to Iceland - this is what happens across the board in a recession.

What IS unique to Iceland - and very troubling - is the state of our currency.

The New York Times had an article on the impact as well, much of it focusing on the implications of Kronur's rapid fall in value on the economy. The starkness of it all didn't really hit me until I read that a third of Icelanders are considering leaving though:

Her fixed costs are no longer fixed. Five years ago, the company built a new factory, borrowing the 120 million kronur — about $1.5 million — in foreign currencies. But the currency’s fall has increased her debt to 200 million kronur. This summer, her monthly payments were 2.5 million kronur; now they may be double that — the equivalent of $38,500 in Iceland’s debased currency.
“My financial manager is talking to the banks every day, and we don’t know how much we’re supposed to pay,” Ms. Hedinsdottir said.
In a recent survey, one-third of Icelanders said they would consider emigrating. Foreigners are already abandoning Iceland.

So how did this happen? Tom Friedman explains the basics:

The Icelandic banks, while not invested in U.S. subprime mortgages, had gone on their own borrowing and lending binges, wooing savers from across Europe with 5.45 percent interest savings accounts [Note: Interest rates were around 15% because of high inflation].

In a flat world, money can easily seek out the highest returns, and when word got around about Iceland, deposits poured in from Britain — some $1.8 billion. Unfortunately, though, when global credit markets closed up, and the krona fell, “the Icelandic banks were unable to finance their debts, many of which were denominated in foreign currencies.”

The current situation is dire and its enormity is somewhat difficult to comprehend, Iceland is a small country and according to Iceland Weather Report the claims that Britan is making on Landsbanki , "are 3-4 times higher than the war compensation claims Germany was made to pay after World War II." Recovering from a shock like this is going to be a difficult, long, and painful process. And yet I want to end this post on a somewhat positive note. While the effects of this crisis are truly terrible and none of what happened can be excused it is also an opportunity to reevaluate and to change direction. Icelanders are a proud, dynamic, and well-educated people and have recovered from worse, or (once more) in the words of Iceland Weather Report:

Cultivating what really matters. A return to basic values. That’s the prevailing emphasis around here these days and yes, it is a Very Good Thing. A few short weeks ago the media was still glorifying our “Tycoons” and doing features on people who decorated their massive concrete homes with cold fixtures and soulless minimalist furniture. What we get now is stories of people sticking together, helping each other [...]

Education authorities are making sure children have a secure place in the preschools even if their parents default on payments. A crisis committee is being set up to help people who have lost their jobs. Mortgages are all being taken over by the state’s Housing Financing Fund and those who can’t make mortgage payments can apply to have them halted for the time being. [..]

We have good, solid resources: fish in the sea, heat in the ground, copious amounts of energy, a beautiful country with myriad opportunities in tourism, and an excellent workforce: a nation of well-educated and hard working people, many of whom are now out of work and who can use their expertise to help rebuild our economy and much of the infrastructure. After all, this is not the worst that we have endured: on two or three occasions in the past the Icelandic nation has been close to being wiped out by calamities much worse than this, such as volcanic eruptions and the bubonic plague.

Factors in the Surge's Success

After my initial (somewhat hastily written) piece on the Surge and the followup I wanted to present some thoughts from someone who was actually on the ground in Iraq before and after the Surge. Lieutenant Colonel Dale Kuehl has a paper in Small Wars Journal that you should read in full but I will present his key points here and then delve into the case of a certain Abu Abed (summary is quoted from the article):

• The factors that led to the drop in violence are extremely complex. It is an oversimplification to say that the surge itself led to the drop in violence. However, on the other hand it is a gross oversimplification that it was a result of paying off Sunni militia.
• The surge in troops was invaluable to help us defeat al-Qaeda and stop the advance of JAM in northwest Baghdad.
• The surge was only as good as the operational design that went along with it. The change in focus from transitioning security to the Iraqi Security Forces to protecting the populace was also a major part of the success last year.
• While units before us were conducting COIN operations we did make fundamental changes in how we conducted COIN based upon the change in operational design. These included changes in tactics at the patrol level, but probably more important a concerted effort at battalion and brigade levels to increase our engagements with the populace and leadership within the communities. Some of these changes we implemented early, some we made as we adapted to the changing situation.

One particularly interesting point is the initial goal of the battalion in training the Iraqi army instead of directly focusing on the security situation:

When we arrived in Iraq in October 2006, the focus of the operational concept was transition to the Iraqi Security Forces. Gen Casey briefed us at the COIN Academy in Taji that we would be transitioning the lead for security in Baghdad to the ISF by summer 2007 while our forces would provide tactical overwatch over these security forces. [...]

We soon shifted our focus from transition to protecting the populace. While I am sure units were doing what they could to protect the populace, the focus upon our arrival was on transition. [...] By [doing this] we made a distinct change in our understanding of the center of gravity of this fight. With this understanding we came to one quick conclusion: we were doing a poor job in protecting the populace. The shift in focus led to a subsequent shift in our tactics, techniques and procedures that placed greater emphasis on getting into the community and engaging the populace to a greater degree at all levels.

Additionally, a big part of the success of the Surge was gaining the support of Sunni groups that had previously been fighting together with al-Qaeda and I think that understanding how exactly this was accomplished is important. Kuehl spends some time discussing this and its implications:

As for why Abu Abed and his men came forward when they did…I don’t know for sure, but do have some thoughts based upon my conversations with him and community leaders. First, these guys did not just spontaneously erupt. I believe there was a group of people who were willing to work with us against al-Qaeda, a minority against the cause of the AQI led insurgency. This minority was getting organized and looking for an opportunity. Among this minority were the imams that Col Gentile introduced me to. Not all were on board at first. I think this group was looking for the right time

A story in the Guardian from last year gives a more in-depth account of Abu Abed in his group, agreeing with their reasons for joining the US efforts but cautioning of the dangers of giving so much power to these warlords that might come back to haunt the US and Iraq military later down the line.

Finally, while there are many important lessons in the paper I wanted to point out one that everyone can relate to but that is also difficult to write about. As someone unaffected by this violence it is very easy for me to say this but I have incredible respect for those who can do the right thing when faced with this circumstance. Violence breeds violence: when we are attacked by someone it is easy to lash out and blame everyone in their group/country/religion/etc. but in a situation like Iraq a carefully measured and targeted response will not only help to make sure that the right people will be found and brought to justice but also that future killing will be prevented:

During this time we also put in a COP in northwest Ameriyah. While putting in this outpost a deep buried IED exploded killing an entire Bradley crew of six Soldiers and one interpreter. I believe that our response to this catastrophic event was also one of the reasons the Sons of Iraq came forward when they did. One of the imams told me later that the whole neighborhood expected us to tear the place apart after this event. We had been going through a tough month with six other Soldiers killed in the previous two weeks. The restraint and discipline of our Soldiers was noted and cited by the locals themselves as one of the reasons they chose to work with us.

Non-State Actors and the Future of Military Power

I found a very interesting paper on the future of US military (ground) power by Thomas Donnelly in the Small Wars Journal through Tom Barnett's blog. Like all SWJ papers it is relatively short (3-5 pages) and it's well worth reading (one interesting bit: The US Military as a fighting force for use abroad didn't really exist until WW1, before that it was more tasked with protecting people in the frontiers, etc.). What I found particularly interesting though was the following analysis of the role of the military in fighting 'extremism' and/or 'terrorism' (of some forms). The idea that groups like Hezbollah are turning into small "privatized" armies and how to countervail them is very interesting:

Even less persuasive is the idea that, because military power is not the only requirement for success, that we won’t need sufficient military power. Or that, because the enemy won’t mass forces the way the Soviets used to, that there won’t be significant “battles.” We’re not fighting a condition called “extremism,” we’re fighting a series of quite distinct enemies motivated by an extremist ideology and a vicious version of a faith that does not much distinguish between the personal and political, a backwards-looking travesty of Islam that not only elevates God’s law above man’s law but in fact finds the vary notion of man-made law to be illegitimate and blasphemous. Thus, Clausewitz still rules: these wars are politics by other means.

Consider the case of Hezbollah in southern Lebanon (read either the brief section on the 2006 war with Israel in Ground Truth or, for a more thorough and recent analysis, The 2006 Lebanon Campaign and the Future of Warfare by Steve Biddle and Jeffrey Friedman). The organizations are wrongly described as “non-state actors;” they are proto-states, or mini-states, but they are clearly entities that evince state-like behavior. And as they become moreso, their military behavior will become more conventional. We had better start counting and understanding Hezbollah-style “brigades.” The true answer to the irregular-verus-conventional argument is “both.”

Extreme Signs of Global Economic Readjustment

The volatility in Oil, Food, Metal, and Transportation Prices is astounding these days, this paragraph in a Washington Post article really hit that point home:

China has also trimmed the importation of other materials that have fueled its spectacular run of growth. [Charles Bradford, metals analyst at Soleil Securities] noted that ocean freight rates for iron ore from Brazil to China are down to $12 per ton today from about $108 last May.

The Financial Crisis and Human Capital Allocation

Here's an excellent article by Fareed Zakaria on why the financial crisis also presents a huge opportunity to clean up some of the problems of the political, financial, and economic system of the last decade(s) and how the new administration has (available) the brain power to effect this change:

Volcker has also argued that the highly complex financial system was not nearly as stable as people believed and that far-reaching efforts were needed to regulate and stabilize it. Now these issues will get attention at the highest level. The fear on Wall Street is that a Democratic administration would overregulate. But look at who is advising Barack Obama—Buffett, Volcker, former Treasury secretaries Robert Rubin and Larry Summers. It is more likely that what will come from their efforts will be a better-regulated financial system that, while producing less-extravagant profits, will be more stable and secure.

What I personally find really interesting is his succinct summary of something I have heard over and over in the last few weeks - How the inflated financial industry caused a misallocation of talent into the financial sector:

The financial industry itself is likely to shrink, and that's not a bad thing, either. It has ballooned dramatically in size. Curry points out that "30 percent of S&P 500 profits last year were earned by financial firms, and U.S. consumers were spending $800 billion more than they earned every year. As a result, most of our top math Ph.D.s were being pulled into nonproductive financial engineering instead of biotech research and fuel technology. Capital expenditures went into retail construction instead of critical infrastructure." The crisis will stop the misallocation of human and financial resources and redirect them in more-productive ways. If some of the smart people now on Wall Street end up building better models of energy usage and efficiency, that would be a net gain for the economy.

Esther Duflo recently wrote about this for VoxEU and two years ago I read an excellent paper on the incentives for productive and unproductive economic behavior by William Baumol that I cannot recommend strongly enough:

[The] allocation between productive activities such as innovation and largely unproductive activities such as rent seeking and organized crime. This allocation is heavily influenced by the relative payoffs society offers to such activities. This implies that policy can influence the allocation of entrepreneurship more effectively than it can influence its supply.

More on the Rising Dollar

I recently posted on how increasingly broad deposit insurance might be one reason for the rising dollar and wanted to post some more on this after seeing the following referenced by Tom Barnett from an Economist article I read a while ago (Btw, the Barnett article is really interesting if you're following the whole 'Post American Century' debate):

[Kristin Forbes] found that a lack of financial development at home makes foreigners keener to invest in America. What attracts them is the size, liquidity, efficiency and transparency of its financial markets compared with what is on offer in their domestic markets. This finding adds weight to theories which explain global imbalances as a consequence of slow financial progress. In this view, poor countries save hard and buy foreign securities because of a dearth of good options at home.

Capital Controls?

Capital Controls (i.e. government regulation on financial flows in and out of the country) are a complex topic that I've been meaning to learn more about for a while (and will suspend judgment on for now). I haven't had the chance to do that yet (and probably won't for a while) but I did see the following in Paul Krugman's column on Malaysia's response to the Asian financial crisis:

The scope of global "contagion"--the rapid spread of the crisis to countries with no real economic links to the original victim--convinced me that IMF critics such as Jeffrey Sachs were right in insisting that this was less a matter of economic fundamentals than it was a case of self-fulfilling prophecy, of market panic that, by causing a collapse of the real economy, ends up validating itself. But I also concluded that the threat of further capital flight would prevent Asian economies from simply reflating, that is, increasing public spending and cutting interest rates to get their economies growing again. And so I found myself advocating temporary restrictions on the ability of investors to pull money out of crisis economies--a curfew, if you like, on capital flight--as part of a recovery strategy.

Krugman (in 1999 at least) seems like a cautious supporter of Capital Controls:

Until the Malaysian experiment, the prevailing view among pundits was that even if financial crises were driven by self-justifying panic, there was nothing governments could do to curb that panic except to reschedule bank debts--part, but only part, of the pool of potential flight capital--and otherwise try to restore confidence by making a conspicuous display of virtue. Austerity and reform were the watchwords. The alternative--preventing capital flight directly, and thereby gaining a breathing space--was supposed to be completely impossible, with any attempt a sure recipe for disaster. Now we know better. Capital controls are not necessarily the answer for every country that experiences a financial crisis; sometimes confidence can be restored without the need for coercive measures, and even when calming words fail, "burden sharing" by banks and other lenders will often be enough. But it would now be foolish to rule out controls as a measure of last resort.

Dani Rodrik seems to be a more vocal supporter, as witnessed by this piece in the FT and his post on Nonsensical Arguments Against Capital Controls. Finally, for those who want to learn more is an empirical study on the Malaysian situation by Rodrik and Kaplan showing that Capital Controls were indeed effective there.

The Impossible Trinity

While reading O Canada, an article by Paul Krugman on Robert Mundell's Nobel Prize I saw the following bit of brilliance:

Later Mundell would broaden this initial insight by proposing the concept of the "impossible trinity"; free capital movement, a fixed exchange rate, and an effective monetary policy. The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).

When looking at the Wikipedia article for said 'Impossible Trinity' I found it to reference exactly that quote from this same article. Well, it really is an excellent summary of a very interesting idea.

Why the Dollar will remain the World's Reserve Currency

After my recent post on the (questionable) value of a countries' currency being a reserve currency, I wanted to follow up with an excerpt from a brilliant article by Bill Emmott, former Editor of The Economist. The article itself is about the issues facing the US and the rest of world in the years ahead, both politically and economically. It really is a great article and worth reading, but what I wanted to point out here is a very good argument for why it is unlikely that the Dollar will cease to be Reserve Currency of choice any time soon:

The first point to be made is that the dollar's role in global foreign-exchange reserves was much smaller in 1990 (50 percent of global reserves) than it is today (about 63 percent), so even a fresh decline in its use would not be path-breaking. The second is to ask what the alternative is: the euro, the currency of a region that has gone into recession more quickly than the United States, and whose banks are just as troubled? And not, certainly, China's yuan, unless that country's leaders are poised to surprise us all by making it convertible and reducing controls on capital flows, both of which are necessary before a currency can take on reserve status. By default, the dollar is likely to keep its leading role. Whether the United States will again be a beacon of economic policy and performance depends on how bad its recession proves to be and on how well it adjusts to a new period of higher household savings and lower consumption and debt.

Strategic Petroleum Reserve

Sophia was just reading an article about the Strategic Petroleum Reserve of the United States (and a proposal to double it) and while I knew how much oil was being stored I had no idea about how it was stored, very very cool (from Wikipedia):

The Strategic Petroleum Reserve (SPR) is an emergency fuel store of oil maintained by the United States Department of Energy.
The US SPR is the largest emergency supply in the world with the current capacity to hold up to 727 million barrels (1.156E+8 m3). The second largest emergency supply of oil is Japan's with a 2003 reported capacity of 579 million barrels (9.21E+7 m3).

The reserve is stored at four sites on the Gulf of Mexico, each located near a major center of petrochemical refining and processing. Each site contains a number of artificial caverns created in salt domes below the surface.
Individual caverns within a site can be up to 1000 m below the surface, average dimensions are 60 m wide and 600 m deep, and capacity ranges from 6 to 37 million barrels (1 to 4.3 million m³). Almost $4 billion was spent on the facilities. The decision to store in caverns was taken to reduce costs; the Dept. of Energy claims it is roughly 10 times cheaper to store oil below surface with the added advantages of no leaks and a constant natural churn of the oil due to a temperature gradient in the caverns. The caverns were created by drilling down and then dissolving the salt with water.

Unlimited Deposit Insurance: One Reason the Dollar is Rising?

Here's a great article on the problems with unlimited deposit insurance from Alan Blinder and Glenn Hubbard (via Greg Mankiw's 'More Commentary on the Financial Mess'). One of the interesting parts was about increasingly broad deposit insurance might be one of the reasons that the dollar is rising as savers in other countries with less favorable schemes move their money to the US to keep it secure. This would normally be expected anyway as spooked investors move their money to the more stable US but in this case financial insecurity is spreading from the US to the rest of the world but legislation like this might be one of the factors that money is still pouring into the US:

Third, an unlimited deposit guarantee in the U.S. would pull funds out of other countries, just as Ireland's guarantee led to an inflow of money into Irish bank offices in the United Kingdom. The Irish-British deposit flow happened on a small scale; but the U.S. is the 800-pound gorilla of the world market. Even amidst all this chaos, money has been flocking to our shores.

Thus we might wind up worsening an odd sort of beggar-thy-neighbor game, causing a "giant sucking sound" as deposits fled other countries for the sanctuary of the U.S. and its FDIC. The implications for our international friends could be enormous. In a misguided attempt to create financial security at home, we might inadvertently make the world a significantly more dangerous place to live.

Environmentalists Get Their Story Right

I've been writing a lot about the financial crisis because its a current issue and it's really exposing some of the underwork of the world financial system but with everyone talking about that and the upcoming US election there is less focus on long term issues. One of these is global warming/environmental destruction, and I just read a BBC article about the newly released Living Planet Report by the WWF (which uses Apture on its site) and about how they are comparing it to the current financial crisis by calling it an ecological credit crunch:

The Living Planet Report is the work of WWF, the Zoological Society of London and the Global Footprint Network.
It says that more than three quarters of the world's population lives in countries where consumption levels are outstripping environmental renewal. This makes them "ecological debtors", meaning that they are drawing - and often overdrawing - on the agricultural land, forests, seas and resources of other countries to sustain them.

He said the more than $2 trillion (£1.2 trillion) lost on stocks and shares was dwarfed by the up to $4.5 trillion worth of resources destroyed forever each year. The report's Living Planet Index, which is an attempt to measure the health of worldwide biodiversity, showed an average decline of about 30% from 1970 to 2005 in 3,309 populations of 1,235 species.

Really great and timely marketing. And also an important thing to keep in mind and to put things into perspective.

Krugman on Stockmarket Bubbles

Paul Krugman makes a great argument that the Fed shouldn't worry too much about stockmarket bubbles because their bursting doesn't cause the same excessive supply as bubbles in the real economy.

The thing to understand is that a stock market boom is not like a boom in physical investment--say, a boom in condominium construction. That kind of boom depresses future spending because it leaves behind a landscape littered with unsellable condos. But that isn't quite what happens when stocks surge: When the market value of Croesus.com doubles, that doesn't mean there will be an overhang of vacant dotcoms weighing down rental rates two years from now. It's paper gains today, paper losses tomorrow; who cares?

One thing that might potentially be an issue is indirect effects of stock markets on other parts of the economy but that's for future investigation. One other bit about the article that I found particularly interesting (and amusing) was the following mention of the dangers of excessive indebtedness:

Ah, they say, but what about debt? Shouldn't Greenspan act to counter the defaults that could accompany a market crash? If consumers go deeply into debt to buy stock or to buy consumer goods because their market gains make them feel rich, this could depress spending later on. But really bad debt overhangs come when businesses (especially real estate developers) overborrow, which is not, as far as I can tell, a big problem in America right now.

Incredible as this sounds now, it wasn't actually a lack of foresight because the article was written in early 1999 when levels of indebtedness had not yet reached the highs they did over the last 5 years.

Krugman on the Value of Reserve Currencies

A very short and interesting article by Paul Krugman on why having your currency be a Reserve Currency might not be too big of a deal:

What about our ability to borrow in dollars, to sell dollar- denominated bonds to foreigners? Hey, other countries do that too. But our debts are in our own currency! So? We still pay interest on them. True, we could inflate away our foreign debt. But we won't--and if investors thought we would, they would demand higher interest rates.

P.s. If you feel like you've been seeing a lot about Paul Krugman recently you are absolutely right: I like to learn by reading a lot by the same person at a time so I'm slowly making my way through his writings and academic work. The key thing is to know when you start seeing diminishing returns and read other things and to make sure to pick smart people.

Economic Modeling

When I first started learning about Development Economics (in Public Policy 184, Poverty and Policies in Developing Economies, which I actually eventually dropped in favor of other things) I was struck by a lecture on the Harrod-Domar model because it was very obvious to me that the model was completely insufficient and overly simplistic. I had already read The Elusive Quest for Growth by William Easterly who basically made fun of people for ever believing this model could accurately describe anything (Easterly sums it up as "GDP growth will be proportional to the share of investment spending in GDP."). 

After class I decided to ask the Professor about what the benefit of studying a model like this was since there were clearly hundreds of other factors which played a role. She explained that while this was absolutely true, it was important to try to strip away as many factors as possible and build something that one can easily reason about and see if it still makes useful predictions because it can help one get a better understanding of what is actually going on.

One should be careful to realize that there may be lots of other processes at work but that trying to understand all processes at once was not going to lead to any useful analysis. While the Harrod-Domar model is in fact far too simplistic - it's assumption of constant returns to capital make lots of sense in the short term when there is high unemployment but makes little sense once there is a balance between labor and capital - it did lead to a better understanding of some of the processes at work.

While reading a piece by Paul Krugman on High Development Theory (more on that in a future post) I was struck by this following explanation of how useful simple models can be:

Dave Fultz was a meteorological theorist at the University of Chicago, who asked the following question: what factors are essential to generating the complexity of actual weather? Is it a process that depends on the full complexity of the world -- the interaction of ocean currents and the atmosphere, the locations of mountain ranges, the alternation of the seasons, and so on -- or does the basic pattern of weather, for all its complexity, have simple roots?

He was able to show the essential simplicity of the weather's causes with a "model" that consisted of a dish-pan filled with water, placed on a slowly rotating turntable, with an electric heating element bent around the outside of the pan. Aluminum flakes were suspended in the water, so that a camera perched overhead and rotating with the pan could take pictures of the pattern of flow.

The setup was designed to reproduce two features of the global weather pattern: the temperature differential between the poles and the equator, and the Coriolis force that results from the Earth's spin. Everything else -- all the rich detail of the actual planet -- was suppressed. And yet the dish-pan exhibited an unmistakable resemblance to actual weather patterns: a steady flow near the rim evidently corresponding to the trade winds, constantly shifting eddies reminiscent of temperate-zone storm systems, even a rapidly moving ribbon of water that looked like the recently discovered jet stream.

What did one learn from the dish-pan? It was not telling an entirely true story: the Earth is not flat, air is not water, the real world has oceans and mountain ranges and for that matter two hemispheres. The unrealism of Fultz's model world was dictated by what he was able to or could be bothered to build -- in effect, by the limitations of his modeling technique. Nonetheless, the model did convey a powerful insight into why the weather system behaves the way it does.

Much has been said of late about how Krugman specializes in building highly stylized and extremely simple (and initially much criticized) models that turn out to capture everything that is necessary to prove his point:

You make a set of clearly untrue simplifications to get the system down to something you can handle; those simplifications are dictated partly by guesses about what is important, partly by the modeling techniques available. And the end result, if the model is a good one, is an improved insight into why the vastly more complex real system behaves the way it does.

In many of my later Economics classes I found that most Professors just taught the models without explaining their inherent limitations and it made everything feel fake - instead of using the models to elucidate the underlying processes they were using smoke and mirrors to make simplistic points. Lectures became intricate exercises in trying to figure out where the models broke down and started diverging from reality when the lecture itself never mentioned the fact - a useful exercise for the conscious student but very dangerous for everyone else. In conclusion, models are extremely useful in studying economic proccesses (and many other things) as long as one is aware of the limitations, or in Krugman's words:

The problem is that there is no alternative to models. We all think in simplified models, all the time. The sophisticated thing to do is not to pretend to stop, but to be self-conscious -- to be aware that your models are maps rather than reality.

The Financial Crisis Abroad

When not writing about Sarah Palin or the Presidential Election, most American news sources are focusing on the Financial Crisis the world is going through right now. Most of my readings on the topic have come from Greg Mankiw's blog via his excellent 'Commentary on the Financial Mess' posts which link to recent articles by important Economists from all over the web and has provided an incredibly rich collection of opinions and theories on what is going on in the economy.

Unfortunately, while some of these do touch upon the situation in other countries, most of them are very US centric. The Economist does a very good job of covering the situation in other countries, this week it had an interesting briefing on how the global financial crisis is impacting Eastern Europe. But the Economist has only so much space to devote to the issue each week and I have found that most of my information actually comes from the excellent Europe focused A Fistful of Euros blog. They seem to be having some issues with broken links right now (especially in their archive) but if you want detailed information about the impact of the crisis on Europe this is an excellent source. Many of their recent blog posts have been extremely detailed and informative so head over there and check it out. Here are their articles on Hungary, Kazakhstan, Spain, and the Baltic States

Simone White - The Beep Beep Song

These days I spend most of my time listening to The Economist Audio Edition or Podcasts and don't have nearly enough time to listen to music (though I still make it to concerts - I saw Stereolab at the Fillmore yesterday). Furthermore, this blog is largely focused around academic subjects, but music is still a big part of my life and as such I wanted to post the video for incredible an incredible song by Simone White here:

I heard about it through a very clever and beautiful commercial for the relatively new Audi R8 supercar (which I first saw last summer in Monterey and have seen all over the place since then). Enjoy.