Category Archives: Original Articles

The Cobra Effect

 

I don’t think the British had cobras roaming the street. Wild guess, I know, but it probably explains why they were so surprised to find them in Delhi during the colonial period. One can hardly blame them for wanting to remove them.

So they came up with a simple plan [1]. Have the citizens kill the cobras, show them the skin of the cobras as proof of the kill, and they would be given a payout for their work. It sounds ingenious. You don’t have to hire a lot of people to hunt cobras – imagine how much you’d have to pay them – you’d have more eyes on the problem, and you have the community involved.

Just one problem. The population of cobras went up.

What happened was that a part of Delhi’s population started to farm cobras. As smart as the bounty scheme sounded, Delhi’s population was even smarter. The citizens of Delhi figured out that the cobras had a dollar sign attached to them, so why not make more of them? So, a portion of Delhi’s population started breeding cobras. Of course, the British panicked and ended the bounty scheme. And in response the population released the cobras, because if they no longer have dollar signs attached to them, what use are cobras?

There is an important lesson to be learned from this anecdote: public policy is hard. What the British did not realize is that they weren’t playing a game against the cobras, they were playing against the entire population of Delhi when they initiated this scheme. A game that is much harder to win. This is not an argument against all public policy, but it is important to remember that when you are fighting against the self-interest of many other people, you better be ready for unintended consequences.

Consider the case of the UN trying to mitigate a coolant gas [2]. The structure was – again – simple. Companies could earn one credit if they reduced the amount of carbon burned by one ton. But if they reduced the use of this coolant gas by one ton, the companies would get 11,000 credits. The credits could then be sold for millions of dollars a year. The reason the coolant gas was worth so much more was because it was much worse for the environment. So what do the companies do? They use more of the coolant gas. This way, they could start reducing their use of the coolant in exchange for carbon credits, which turned into money for them. A colossal waste of money for the UN, and the environment suffered, even though the UN was actively trying to do the opposite.

A different version of the unintended consequences problem [3] occurred after the Exxon Valdez oil spill of 1989. In order to prevent such spills from happening, states introduced legislation that placed unlimited liability on such operations. This meant that big companies with the most modern technology no longer performed services there, leaving these tasks to be completed by smaller, less safe operations who would more readily accept that risk.

Of course, we all remember the problems of price control from Economics 101. If a certain good starts becoming very expensive, then the public complains, politicians promise to control the prices, and the supply of that product goes down, since there is no longer any incentive to produce it. The government tries to create a policy to make a good more readily available, but it actually becomes harder to obtain, because fewer people are offering it.

This phenomenon exists in more popular government policies as well. Take social security in the US for example: because everyone is guaranteed a cheque issuing a basic standard of living, people started to save less privately [4]. This means there are less savings available as a whole, which in turn reduces investment, slowing the economy and growth of wages.

Of course, this doesn’t mean that all public policy is a lost cause, or even that we shouldn’t keep these policies, but all of these examples should remind us of one of the fundamental parts of economics: people respond to incentives. It is probably going to be impossible to avoid all of the unintended consequences in a free-market, but when enacting or arguing for certain policies, it is important to remember incentives and it is probably best to keep things simple. Unless you want cobras roaming the street.

 

[1] – http://freakonomics.com/podcast/the-cobra-effect-a-new-freakonomics-radio-podcast/

[2] – http://www.nytimes.com/2012/08/09/world/asia/incentive-to-slow-climate-change-drives-output-of-harmful-gases.html?pagewanted=1&_r=2&hp

[3] – http://www.econlib.org/library/Enc/UnintendedConsequences.html

[4] – https://www.cbo.gov/sites/default/files/105th-congress-1997-1998/reports/ssprisav.pdf

3 Things You Need to Know About the CHOICE Act

While the American public (and the rest of the world) watched James Comey make the highest-viewed testimony in congressional hearing history, the Republican-majority House of Representatives passed the Financial Choice Act, a bill designed to repeal and replace much of the Dodd-Frank Act of 2008.

At first glance, most of the key principles sound pretty great – allegedly supporting equal opportunity, consumer protection, accountability for both the private and public sector, and economic growth.

Screen Shot 2017-06-09 at 8.56.54 PM

Source: Financial Services Committee

However, reading into just the executive summary (see above) we realize that many of the broad principles are oversimplifications of deregulation initiatives, such as general removals of oversight in risk management within the financial sector. In fact, that’s a pretty good summary of what the Act does: hacking financial regulation by removing powers and funding for many of the regulatory bodies that were formed by the Dodd-Frank Act. I wouldn’t suggest reading the original document of the CHOICE Act, as it looks like this:

Screen Shot 2017-06-14 at 7.42.56 PM.png

Source: Congress.gov

In other words, the Republicans took the Dodd-Frank Act (Titles II in their – wait for it – Subtitle II) and removed much of the responsibility enforced upon corporations simply by striking out mentions of ‘corporations’ in the Act.

So, here are three things you need to know about the CHOICE Act.

1. Repeals Dodd-Frank Titles II and VIII

Dodd-Frank Title II gave the Federal Deposit Insurance Corporation the right to find ways to liquidate large corporations close to failing, which enforces shareholders and creditors to assume all losses. [1] Dodd-Frank Title VIII allowed the Financial Stability Oversight Council to designate FMUs (financial market utilities), systems that provide infrastructure for financial transactions, with additional rights in oversight. [2] Its replacement, the Bankruptcy Code, is the Dodd-Frank Title II, with the phrase “and corporations” taken out of the majority of the clauses, and the ability for corporations to transfer estates to “bridge companies,” the corporate version of a loan shark company.

2. “Exempt[s] banking organizations that have made a qualifying capital election from any. . . federal law, rule, or regulation that. . . provide limitations on mergers, consolidations, or acquisitions of assets or control . . . [that] relate to capital or liquidity standards or concentrations of deposits or assets.”

What this effectively means is that after a bank has a certain amount of money ($50,000,000,000), [3] they are exempt from federal limitations that relate to capital or liquidity standards – so larger banks that are usually kept away from each other to maintain a more competitive market will be free to merge and acquire one another and other, smaller, competing banks. In the long run, this could mean that we could see an effective Franken-Bank monopoly of sorts. (If you think you’re being robbed by your bank now, wait till it has no competitors…)

3. “Exempt[s] banking organizations that have made a qualifying capital election from any federal law, rule, or regulation that permits a banking agency to consider risk “to the stability of the United States banking or financial system”

Systemic risk was probably the cornerstone topic of the 2008 financial crisis – at that point, the government realized that banking had become more than a private, for-profit industry, but rather, an integral public good that served as the financial infrastructure of the modern-day economy that sought to manage and re-delegate uncertainty of risk. While I’d argue that a regulation that permits a banking agency to consider risk “to the stability of the United States banking or financial system” (as corporations are bound by law to otherwise solely serve the interests of the shareholder to maximize profits) is largely a symbolic gesture because it doesn’t really enforce the consideration, it does close potential legal precedent for decision-making executives to consider policies that, while not maximizing profits, would be beneficial in managing systemic risk.

But the key thing that I have noticed as I wander through this labyrinth of an Act is that it grossly deregulates the financial markets to even pre-Obama era standards. Where banks can find loopholes to bypass M&A regulations; where financial regulatory bodies that have been around for around 80 years find sources of revenue (such as fines) redirected to serve the Treasury’s deficit; where, while the punishments for financial crimes have increased in severity, the bodies that enforce the laws are abolished or replaced by opaque extensions of the executive branch; and where, in a rather strange political contradiction, the Speaker of the House is given a “pocket veto” on executive orders regarding new financial regulations. Based on historical events following the continual deregulation era within the financial industry in the Nixon and Clinton eras, there is clear precedent to understand that, as it stands, financial deregulation, especially in the way it has been done in this bill, is the American highway to the next economic meltdown. I mean, there is a reason why this bill was picked to be voted on during the Comey hearing.

Continue reading…

Anti-Intellectualism: The Demerit Subsidized Good?

Recently, President Donald Trump announced the intent of the United States to withdraw from the Paris Accord. For some, this was a shock as there was an overwhelming consensus that climate change was, for one, real, and two, that there were time constraints in ensuring our survival as a species. However, what seems to be the small majority of people, those greedy or playing politics, is really part of a greater movement of what can broadly be classified as ‘anti-intellectualism’. Yet, this trend is hardly new, especially in the field of economics. So the question then becomes: how did we get here?

I could probably rant on and on about the historical context of the shift backwards from Keynesian to Neoclassical thought, given I am a  New Keynesian (I have such ousted potential biases), but that’s not what actually bothers me about the field of economics today. The answer to the aforementioned question really comes from a more economic question: who has a demand for economics as a study? In today’s economy, two main types of employers exist. The first one: the government. As it has for nearly over a century, the government has employed economists not only in the macroeconomic department, to make decisions on the interest rate and such, but also as advisors to policy makers to better understand the effects of various policies concerning price controls, regulations, and other proposals they may have for an agenda in parliament or for their respective platforms. More recently, however, economists have also been increasingly employed in the private industry to better understand markets and economic trends in order to improve profitability.

Very often, these economists are handpicked by political actors as policy advisors, subsidized independent government advisors and academics. Hence, it is no surprise that they act, more often than not, in their own self-interest, and that we find ourselves listening to elected and appointed officials cite fairly illegitimate “economists”. This is probably why the American government still has found ways to convince a large portion of the general public that privatized healthcare has benefited the “common American”, despite the fact that, according to PBS, the average American household spends $10,350 as of 2015, spending the most among developed nations and yet has some of the worst health care coverage and quality [1].

These legitimized, though illegitimate, economists are not necessarily the ones that have the best ideas, theories or research, but rather the ones that are willing to vouch for ideas that serve specific private interests – ones that, more often than not, benefit specific interest groups (i.e. large, wealthy corporations) or, as we have seen through Brexit and the American election, ideas that political actors find relevant to flashy campaigns. (Though that is not to say there are no legitimate economists who have reasonable theories supported by reasonable data.) These economists’ ideas, sometimes shrouded in things like “secret data” or other violations of basic scientific principles, which some economists, like John Cochrane from the Stanford Hoover Institute [2], have decried, are being subsidized. This is at the opportunity cost of ideas that, while may not find themselves to be part of the campaign or corporate interest, may be in the best interest of the public. Unfortunately, these are effectively delegitimized.

The (alternative) fact in the matter is that economics is not a science whereby its academics have leeway to make much error- real policy is constructed from their data, which affect large populations of people in often life-changing ways. Good economics, based on transparent information, processed in transparent manners, with papers open to discussion and further investigation – is a merit good.

“The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”

– John Maynard Keynes

 

Citations

[1] http://dpeaflcio.org/programs-publications/issue-fact-sheets/the-u-s-health-care-system-an-international-perspective/

[2] http://johnhcochrane.blogspot.ca/2015/12/secret-data.html

The Trump Effect: Will Trump cause the next Global Financial Crisis?

 

Throughout his campaign and first 100 days as President, many of Trump’s proposals have been indisputably controversial. From the 11% decline of the Mexican Peso immediately following the election to the 25% increase in U.S. construction materials, it may seem clear that Trump’s presidency has resulted in increased volatility in the global financial markets. This is surprisingly not the case, as Trump’s administration has resulted in the most stable equity markets since President Kennedy (1961-63) [1]. However, the fundamentally radical nature of Trump’s platform raises speculation as to how the markets have maintained this stability. His most recent point of contention results from his intended $3.6 trillion cut in government spending over the next decade in the following departments [2]:

Radical claims such as this, alongside the general consensus of underperformance in his first 100 days [3] have led to recent discussions involving impeachment. Political uncertainties like this typically result in slower market growth and increased investment in Treasury Bonds or in commodities such as gold. Despite this uncertainty, the S&P 500, DJAI, and the NASDAQ have all shown significant growth since the November election, as shown in the graphics below. The growth achieved across each major equity market index suggests investors have confidence in the Trump administration’s economy.

S&P 500Dow Jones

NASDAQ

The performance of U.S. financial markets alongside the 3.97% [4] growth in GDP is reassuring for most investors. However, the bond market may tell a different story. 10-year Treasury yields have remained consistently low, with a decline of 3.1% over the last 6 months. The yield curve is a common indicator used for predicting recessions in the U.S., and should therefore be evaluated alongside the apparent growth of the U.S.’s capital markets. In simple terms, the slope of the yield curve is defined as the difference between a short and long-term rate of U.S. Treasury issues [5]. Generally, increasing short-term rates indicate that the economy is slowing down. Eventually, if these short-term rates rise high enough, the yield curve may invert and lead the economy into a recession. To strengthen the validity of this indicator, it is important to highlight that an inversion of at least 100 basis points or more has predicted 6 out of the last 7 recessions [6]. By viewing the graph below, it may become clear that a major inversion is currently underway in the U.S. Treasury Bill market.

The graphic above features a comparison between short and long-term U.S. Treasury Bills, where green demonstrates the rates of 3-month T-Bills and blue demonstrates the rates of 10-year T-Bills. It is clear that there has been a significant increase of short-term T-Bill rates, from 0.5% to nearly 1.0% since March. On the other hand, the 10-year T-Bill rates have seen a sharp decline from 2.7% to 2.25% during this time. These shifts have immediately followed Trump’s proposed budget cuts made on March 16th. Referring back to the yield curve, the trend of this inversion of short and long-term rates may be a clear sign that the U.S. economy is heading towards a recession.

What does this mean for the global financial markets? The stability of these markets will be dependent on the decisions that President Trump makes over the next few months. Although globalization has facilitated economic development, it has also resulted in increased interdependencies between the global financial markets. The implications of this became clear in the 2008 financial crisis, when countries such as Iceland reported bankruptcy as a result of the U.S. subprime mortgage crisis. If the U.S. is to suffer a financial crisis, the entire global financial system will suffer. Despite the fact that the U.S. has maintained stable GDP growth rates and bullish trends in their market indices, it will be important to proceed with caution when evaluating the strength of the U.S. economy and the global markets as a whole.

 

[1] http://www.cnbc.com/2017/04/28/trump-has-presided-over-the-calmest-first-100-days-since-kennedy.html

[2] http://www.cbc.ca/news/world/trump-budget-breakdown-1.4027472

[3] http://www.newyorker.com/magazine/2017/05/01/a-hundred-days-of-trump

[4] http://www.multpl.com/us-gdp-growth-rate/table/by-year

[5] http://www.investopedia.com/terms/y/yieldcurve.asp

[6] https://www.fdic.gov/bank/analytical/fyi/2006/022206fyi.html

After Brexit, Who’s Next?

After the surprising result of Brexit, there are more and more doubts about the feasibility and efficiency of Eurozone system. Brexit uncovered major concerns, such as the European single market’s lagging global trading competitiveness, immigration issues, risks on unitary regulations and laws. This event triggered the alarm for Eurozone countries to reconsider whether it is beneficial to stay in Eurozone.

Let’s take a close look at the actual economic changes to those Eurozone countries to judge which countries are better off within the Eurozone, and which are worse off. We build an Economic Scorecard Model (final data as below) based on 20 years of data from 1997 to 2016. The seven economic indicators used are real GDP, unemployment rate, inflation rate, government debt, industrial production, retail sales index, and trade balance. Based on the characteristics of each economic indicator, we have analyzed each variable from absolute and relative levels.

Ireland is the best-performing country in Eurozone with an overall score of 69.51. Ireland aces real GDP and unemployment rate metrics and ranks second for industrial production. Belgium, Malta, Germany, and Finland rank from second to fifth place with scores of 62.59, 57.32, 55.79, and 55.6. Looking at the bottom of the rank. Slovakia, Cyprus, Greece, and Portugal have overall scores below 40. Unsurprisingly, Greece only has an overall score of 32.04 with worst performances in real GDP and industrial production metrics. The Economist would agree with our model when they state, “As it turned out, the super-responsible ECB spent the 2000s making a monetary policy that fit the laggardly German economy, and which was actually too loose for Greece’s economic situation” [1]. Portugal has an extremely low score of 19.57with zeros and single-digit scores for five factors out of seven.

Now, on to the more dominant countries. Germany, as the largest manufacturing and exporting country in Europe, has the highest world rank at 4th place with a score of 55.79. Eurozone brings plenty of benefits to Germany, and as Fortune would put it, “Germany’s gains in competitiveness were immediately translated to gains in trade, since the freedom of goods, services, persons and capital allowed German products to circulate freely and quickly throughout the European Union” [2].  The Euro helps Germany offset the effect of booming export on currency appreciation. Their ability to keep good prices competitive relative to other European markets gives them huge advantages on foreign trade. It scores 100 on trade balance metric and leads the second-place Ireland by 55.54 points. Inflation stability and improved unemployment also support Germany in developing further under the Eurozone system.

France is the worst performer among major Eurozone countries. Unemployment score is the only other score above 50, while the scores in all other metrics are depressed, which show the country suffered from low real GDP growth, increasing government debt, deteriorating industrial production, and decreasing the foreign trade balance. No wonder populism is booming in France. Eurozone system does not seem like a good fit for France. Even though Macron won the presidential election, Le pen’s National Front could grow further in the future if the fundamentals in France don’t change.

Italy scores 42.9 and is one place above France in the rank. As a well-developed country before joining Eurozone, there was not as much potential to improve on retail sales and the unemployment rate. Real GDP growth is the second worst among Eurozone countries with a score of 1.68, and even trade balances got worse. Further, industrial production has completely collapsed under the euro — it has been absolutely butchered – since, after entering the single currency market, Italian firms can no longer offset their high production cost by depreciating their currency. This has been deteriorating their trading competitiveness dramatically and has led to the slowdown of a historically great economy. Facing corruption, fiscal and banking sector issues, and a refugee crisis, it is time for Italy to change. The Anti-Euro Five Star movement is leading the poll at 32%, whereas the center-left Democratic Party is at 26% [3]. It is very likely that the Five Star movement will win the election next year and exit the single currency market soon thereafter.

The creation of Eurozone has its own benefits and flaws. It is crucial to question whether Eurozone is a good deal for all the Eurozone countries. Based on the Economic Scorecard model, the answer is simply ‘No’. Just as Nobel laureate Milton Friedman (1997) wrote: “Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nations, whose residents speak different languages, have different customs and have far greater loyalty and attachment to their own country than to the common market or to the idea of ‘Europe’ [4].” With more exposure of the innate problems of the Eurozone system, the European right-wing is gaining popularity. Structural changes to reshape the Eurozone are unavoidable.

After Brexit, who’s next? My answer is Italy.

 

Citations:

[1] http://www.economist.com/blogs/freeexchange/2011/07/greece-and-euro

[2] http://fortune.com/2014/10/22/why-germany-is-the-eurozones-biggest-free-rider/

[3] https://www.ft.com/content/ff14351c-3572-11e7-99bd-13beb0903fa3

[4] https://www.project-syndicate.org/commentary/the-euro–monetary-unity-to-political-disunity