Wednesday, 21 March 2012

A terrible example. A moral hazard created by parliament

The principal agent problem is one of the most important breakthroughs in economics. Simply stated, A principal wants the agent to do something, but he has less than perfect information in whether the agent is effective. Hence the agent can get away with cheating the principal, since he has better information but very different incentives (the principal was the agent to work hard, the agent wants to get paid without working hard). One needs to align the incentives of the principal with the agent in order to achieve the best social results.

This idea in economics was forcefully introduced by George A. Akerlof, who used it to explain:
1) Why you often get a bad car (called a lemon in the US) in the second hand market...
2) Because of the risks of asymmetric information (i.e. the agent knows more than the principal)...
3) And as a result the prices of cars in the secondary market are way lower than for a new car.

This idea introduces the problem of Moral Hazard: moral hazard is a tendency to take undue risks because the costs are not borne by the party taking the risk. The principal wants the agent to perform well, but the agent knows that if he fails he will be aided by the principal, who does not want to see his business fall. As a result the agent takes huge risks: He can keep the returns (since he can hide the risk from the principal) and be sure that the principal will bail him out if the risky returns do not work out.

This Moral Hazard underlies most of the moves to help banks in the EU and the US; However in Cyprus the Hazard has been brought in by parliament not to help banks managers but to help investors!

Despite warnings by the central bank that this law will create the a very negative precedent, parliament (legal section not economic committee) has gone ahead and discussed the possibility of a relief towards those who took risky investment loans to speculate (a fancy word for gamble) in the stock-market during the large stock market bubble in 1999-2000 in Cyprus.

A reminder: The stock-market bubble of Cyprus was the largest rise and fall of a stock exchange in a year in recoded history of the world. Many people lost their money, but others made a fortune on the upside by borrowing massively, and refused to pay the banks what they owned them when all came crashing down.

This law is a typical example of creating Moral Hazard: it tells agents that investing in the stock-market is risk free, since the parliament will make sure the risks of the speculation not working will be borne by the Principal (in the case the banks). Its only result would be to further severely limit credit for stock-market activities, depressing further a very anaemic market.

In fact i would say that the whole law "smells". The banks have not been paid since 2000 on these loans, and hence the law seems to try and stop legal proceedings which are ongoing and that they must be reaching their end. It appears that this law is trying to save some big "boys" which are close to finally having the retribution for their investments (if they have not hiding everything away already. We must re-introduce the "let the buyer beware" principle, that keeps principals on their toes and agents, as much as possible, straight and not crooked. This law should not go through.

Malta: The storm is coming? Lessons from Cyprus

Malta is right to congratulate itself and pat itself in the back. It has managed to maintain one of the best preforming economies in a particularly sluggish euro zone area, promoting triumphalist articles such as this "Malta grows faster in the Eurozone". The prime minsiter has been in power since 2004 and he can claim to have brought about the changes that are leading the economy forward: a great investment in IT and IT skills has led to Malta been a leader in technology relating to internet services,and a good relationship of the government with surrounding areas can be in part attributed to the success of Malta absorbing EU and other regional funds. Of course I much rather believe this is the work of institutions such as the university of Malta and the enterprising Maltese business community rather than government, but one must give credit to the strategic plans of the government for offshore business services and for tourism, whereby strategic investors in key services have allowed a move away from the traditional British market.

The success is noted outside Malta too. Very recently the General manager of the Employers' and Industrialists' Federation (OEB) of Cyprus, lambasted the bureaucratic and rigid procedures of Cyprus, pointing at the Maltese government's very successful transition to an on-line and easy to use platform for making business.

Yet I think it is good for Malta to also look the other way to Cyprus and see the trouble it is now in. the following is a list of things Malta can learn from the Cypriot "Fall from grace":
1) business services are not forever: In a competitive world, someone will find the next best place to relocate business services. Hence one must not assume the revenue stream from this section of the economy will remain high and it could very quickly decelerate.
2) contagion in very real in the Eurozone: If Cyprus can teach Malta anything is that trouble in Italy will hurt Malta, even through exposure is less pronounced that Cypriot exposures to Greece.
3) Lack of urgent action makes downgrades of its credit ability certain: Indeed the first slide of the almost inevitable downward pressure for credit markets has begun. Let us not forget Cyprus started at ratings slightly below Malta and ended up in the Junk category. Urgent action is needed to show to markets that the situation that led to the downgrade is being tackled.
4) Small countries find themselves biased due to their sovereign debt pool being small and hence illiquid: Small governments such as Cyprus and Malta are not a liquid market for government debt. Unlike Italy which its debt is so large you can find buyers and sellers, the lack of liquidity means that markets will discount option, quickly raising borrowing rates to prohibitive levels.
5) Domestic savings are not forever. Cyprus has been now locked out of international markets for 18 months, and despite early success in raising capital domestically, such capital is now scare. In fact substantial savings are slowly trickling out of the country as the continual downgrades have led to concern in both the government ability to raise funds and the Cypriot bank's survivability.
6) The above was preventable in Cyprus so long as the government acts fast:
This is perhaps the most important lesson can Malta learn from Cyprus. Now is the time for Malta to act hard to stop debt from becoming a problem. If Cyprus took measures to tackle its fiscal deficit two years ago it could have avoided the worse by having wriggle room to respond to crisis. It did not do so, and hence as a small country the risk on borrowing internationally on such illiquid sovereign bonds, very quickly locked Cyprus out of the international money market.

It is much more difficult to reduce government expenditure when incomes are falling. If the government of Malta undertakes a wage freeze, balances its budget and starts saving a small sovereign fund to have ready for any potential problems down the line, Malta can avoid or even reverse the process that led Cyprus into the gates of EU assistance. Tough decisions today meant that no one needs to take even toughter decisions in the future.

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Sex and Economics: Yep there is a paper on that too!

I am always fascinated by two things in economics:
1) the ability to not be aware of our limitation in mathematical theory and empirical econometrics can be used to answer all issues under the sun.
2) The lack of understanding that causality is not significance and vice versa [See "The Cult of Statistical Significance" (2008) by Ziliak and McCloskey.

I am still a huge fan of the economic method, with worries more about the accuracy of its claims than any other social science. Yet i am not sure if these authors realise how subversive they are with their papers. By providing seriously robust results to issues that are not seriously rational or linked, both papers show the fallacy of our attempts to understand everything in the world through our rather limited economic tools.

The papers deal with sex - not a new topic for economics since the Matlhusian prediction was that sex will always trump food production, and hence man is doomed to the level of subsistence. But even Malthus did not think of sex in exactly this way.

The first paper by Hugo M. Mialon sees faking orgasm as a rational decision in the act of lovemaking. Using a very good and large dataset, the orgasm survey, he argues robustly for why people tend to fake orgasms.

The second paper by Tatu Westling looks at the relationship between economic growth and penis size. In the best indication that correlation does not imply causal relationships, the author robustly ans statistically indicates that the is a relationship between economic growth and a reverse U of penis size. In fact this brings a new level to the Kuznets reverse U on environmental and inequality issues; all these three issues seem to have a relationship where the peak is related to average income levels.

I do not know if this authors are serious but their research is solid and it argues for something that economists forget: don't put too much trust on our instruments as they are only one part of the way we can explain the world so fully.
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Why is Hayek not the best selling author of Greece?

I must personally admit that this economic crisis and the near universal incompetence shown by governments globally in dealing with the repercussion has shaken my ideological belief (since we are whether we admit it or not, part of a particular idealogical genre)as an economist who sees a limited role for government in providing stability.

Governments have up to know willingly or unwillingly been dealing with the repercussion of this crisis wrongly. Some banks (both in the US and in Europe) have been given the ultimate insurance of knowing that they will receive all the profit when times are good, but be insured from looses when times are bad through nationalizations-in-all-but-name and massive injections of cheap loans, either from the Federal Reserve or the European Central Bank. Trillions of dollars and Euros were given to banks that made wrong choices at little to no interest, in the vain hope that the banks will then re-invest them in funding US states or European countries in trouble. It a no brainier for any bank: borrow from the ECB at 1% and re-lend to Italy at 6% and use the large revenue to fix my past errors of judgement? SURE!

I still believe that governments can sometimes provide better answers that the market; I just lost faith that governments will ever reach the correct decisions. Hence I strongly believe that smaller governments is part of the answer to the our problems.

What I feel is not something new: it is felt by many citizens of southern Europe, and Greeks in particular. The average Greek citizens desires the state to provide him with all sort of benefits, but seems to distrust the state in being fair in his provision or competent of the delivery of the benefit.

And yet the ultimate expression of the ills of allowing government to make choices, Hayek and the "Road to Serfdom", is missing from the debate in Greece:almost no one in Greece (with the exception of the excellent blogger and good friend lolgreece ) is proposing actions that would be in the vain of those proposed by one of the greatest economists of the 20th century, Friedrich von Hayek.

Hayek was deeply suspicious of governments and his economic work was mostly focusing in how governments, and central banks in particular, can create and amplify business cycles through their expansion of credit. This idea, with such great explanatory power over the situation we know experience, has not filtered so well in Southern Europe. It seems that the distrust of government so evident in the thinking of many Southern Europeans, has not been given the natural idealogical mechanism of expression: the demand of a smaller government, that does much less.

In class discussion I find that Hayek's "Road to serfdom" is very appealing to students. Hayek's dystopia is described and updated to current understanding, and not in the classic 1943 framework of a dictatorship (for the original but simplified framework see this). I try to explain it in something like these terms:

1) The government mobilizes people to sacrifice something for the common good (for example welfare benefits)
2) The government, through the electioneering and propaganda of politicians keep promising more welfare benefits to the people, that necessitate more and more to be sacrificed by the individual.
3) Pretty soon the government becomes so big that it dominates the life of the individual, and relations with the government at hand dictate welfare more than the individual skill of a person.
4) Intense political rivalries occur in how to move failed government welfare provision forward. Confidence in planners fails and people are clamouring for something to be done.
5) A strong man is appointed to "get things done", and he goes ahead in planning our life --> The unsustainable welfare provision collapses and it is rolled back, taking with it the welfare provision invested by the individual through contributions to the state.

Students find this ideas powerful. Yet as soon as it is explained to students that this is liberalism and that the answer is smaller government there is revulsion. Although most can agree that the government is the problem, they seem to believe that it can be corrected to provide for their needs, if only more competent people are in power.

I can not answer what is the cause of that optimism, since empirical evidence of years of elections seem to always bring more misery in terms of governmental mismanagement. Hence my title - Why the heck is not Hayek and liberalism more popular in Greece? I do not know the answer, but it does mean that a valid and useful aproach is totally exluded from a voice in traditional media and in the puplic area, to the great shame of all.

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