tag:blogger.com,1999:blog-18144670244851895612024-03-18T02:48:43.792-07:00Euronomist<br><br><big>Blessed are the young, for they will inherit the national debt</big>Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.comBlogger221125tag:blogger.com,1999:blog-1814467024485189561.post-3880245840812763892015-02-17T07:10:00.004-08:002015-02-21T01:20:51.355-08:00Is Europe catching up to the US in MLM/Pyramid schemes?<div dir="ltr" style="text-align: left;" trbidi="on">
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<i>Today I am happy to host a prominent figure in the anti-pyramid scheme movement, Rogier Fentener van Vlissingen. In the text which follows, Rogier gives both a novice introduction as well as a deeper understanding of the most recent developments in the area, pointing the way forward for legislation on the subject. Obviously, any opinions expressed are the sole responsibility of the author.</i></div>
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<span class="im">Clearly,
the world needed a refresher on Ponzi-schemes, and it got Bernard
Madoff. The question will be if the SEC, the USA, or the world, learned
anything. Certainly, Harry Markopolos' book, <i>No One Would Listen: A True Financial Thriller</i>,
highlighted the risks of regulatory capture. Madoff was smooth and
seemingly respectable, and the SEC was not equipped to be looking for an
operation like his, even though in retrospect the red flags were all
over. So the problem becomes that the regulators protect the crooks from
the public, and not the other way around, as Markopolos observes so
succinctly. That is the problem of regulatory capture in a nutshell. The
practical point, from the standpoint of law enforcement is to see that
the appearance of respectability is no guarantee of anything, and a good
fraudster will always try to create an aura of respectability. Madoff
mastered the art, it was all smoke and mirrors.</span></div>
<span class="im">
</span></div>
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<br />
<span class="im"></span><br />
<div>
<span class="im">Pyramid
schemes are somewhat akin to Ponzi-schemes from an economic point of
view. In a Ponzi, the underlying business is either non-existent or
dysfunctional, and cannot produce the returns on capital raised, so that
older investors are being pacified with good returns poached from the
funds of new investors, not business profits, and the venture ultimately
hits the wall, when at some point withdrawals overwhelm the rate of new
investment. Recruiting may or may not play a role, as in the case of
the feeder funds for Madoff, but most business tends to come from
referrals. The argument for regulation stems from the predictability of
the bad outcome, so that intervention by law-enforcement could limit
losses. </span></div>
<span class="im">
</span></div>
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<br />
<span class="im"></span><br />
<div>
<span class="im">In pyramid schemes the business is
recruiting for a venture that is either yet to be launched, or
non-viable, or simply a hoax, and the payments for recruiting are merely
a way of syphoning money from money hungry prospects to the pockets of
the organizers. Classic cases include Galaxy foods, Koscot, Omnitrition,
Holiday Magic, and recently Fortune High Tech Marketing and BurnLounge.
Until the fateful Amway '79 decision, the courts were very clear on the
nature of a pyramid scheme, and why they were illegal. With the Amway
'79 case the lines began to blur.</span></div>
<span class="im">
</span></div>
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<span class="im"></span><br />
<div>
<span class="im">In <a href="http://www.amway79challenged.com/" target="_blank">Amway '79</a>, instead
of dealing with the finding of fact - pyramid scheme or not - the court
allowed itself to get drawn into a negotiation of conditions what would
presumably make Amway not a pyramid scheme, without even noticing that
the conditions it agreed to were utterly unenforceable, and nobody had
the intention of ever enforcing them. It was pure make believe. If a
burglar or a rapist were to negotiate with the court over how many free
passes they should get before they could be convicted for burglary or
rape, the public would be outraged at the stupidity of the judge, but in
the Amway '79 case the commercial equivalent of that negotiation
succeeded. Then FTC Chair Robert Pitofsky, and Commissioner Elizabeth
Dole, accepted the ruling as law.</span></div>
<span class="im">
</span></div>
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<span class="im"></span><br />
<div>
<span class="im">The
MLM-"industry" took flight from then on, and Herbalife became the first
most memorable child-prodigy offspring from that illicit liaison of
courts and criminals, in the form of the judicial error of the Amway'79
court. The culmination of that hubris came when Herbalife was taken
private after that death of its founder, Mark Hughes, from a multiple
drug overdose, for a short time (think legitimizing a scam) its interim
CEO was one <a href="https://francistirelli.wordpress.com/about/" target="_blank">Frank Tirelli</a>, now Chairman and CEO of Deloitte Italy. He held the operation together with an agreement (the "<a href="http://herbalifepyramidscheme.com/media/2014/02/Tirelli-Memo.pdf" target="_blank">Tirelli agreement</a>")
with top distributors that is very likely illegal, but at least highly
problematic, and was the basis for the company subsequently going
public, with Michael O. Johnson as their CEO, and the new pied piper,
showing that in America, crime does pay, and very handsomely. The secret
to a successful crime, is to do it in plain view, right in front of the
cops.</span></div>
<span class="im">
</span></div>
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<span class="im"></span><br />
<div>
<span class="im">Most succinctly, in economic terms, the
problem of MLM is that unlimited recruiting is substituted for sales by
dint of the fact that recruiting incentives are greater than sales
incentives in MLM marketing/compensation programs. The resulting
behavior predictably is that people will recruit, not sell, and only
conscripted consumption ("personal volume" required to qualify for
commissions) will ensure a minimum of cash flow to keep up appearances
for the sake of the regulators. The befuddled participants who even try
to sell, will soon find that if they don't recruit their customers as
distributors, that somebody else will, for the money is in recruiting
not selling. Very soon therefore, retail margins will tend to collapse
to zero, and ultimately product will even be given away as free samples
in order to recruit the next prospect, and the wholesale cost of the
product becomes another tax-deduction, and tax-deductions are the major
product of an industry that produces 99% loss rates among participants.</span></div>
<span class="im">
</span></div>
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<span class="im"></span><br />
<div>
<span class="im">When
the Albanian economy tanked in 1996/1997 because of pyramid schemes,
the IMF did some very helpful work in warning the rest of the world
about <a href="http://www.imf.org/external/pubs/ft/fandd/2000/03/jarvis.htm" target="_blank">the obvious dangers of pyramid schemes</a>,
only to see their work filed away for reference, and ignored in
practice. After all, "we" don't have a pyramid problem. That was just
those dumb Albanians who did not know any better. They just escaped
communism, and they mistook pyramid schemes for capitalism. And the
world went back to sleep.</span></div>
<span class="im">
</span></div>
<br />
<span class="im"></span><span class="im"></span><br />
<div style="text-align: justify;">
Then,
in December 2012, there was a wake-up call, in the form of a short
position initiated by Pershing Square Capital Management, against
Herbalife (HLF), and made very public with a 300+ Power Point
presentation at the Sohn investment conference. PSCM even created two
websites to document their thesis, <a href="http://www.factsaboutherbalife.com/" target="_blank">Facts about Herbalife</a>, and <a href="http://www.herbalifepyramidscheme.com/" target="_blank">Herbalife Pyramid Scheme</a>.
At the time when I read it, my first thought was: "It's a dirty job,
but somebody had to do it," and I felt sort of grateful that the public
listing of Herbalife and the opportunity to short the stock provided the
market incentive to get the ball rolling. What happened next defies the
imagination. In obvious reliance on the idea that Herbalife was
actually a real business, actually an exchange-listed company, with
ostenstibly $5bn in sales, Carl Icahn took the opposing view, and that
is when I took notice, and in my first article on this spectacle on
Seeking Alpha (free registration), <a href="http://seekingalpha.com/article/1808462-herbalife-the-fog-of-war-and-double-trouble" target="_blank">here</a>,
I promptly assumed that Carl Icahn, would soon be facing substantial
losses on the position, and I compared his position to Wil E. Coyote
hanging over the ravine, and realizing he had no ground under foot.
Little did I realize how long it would take for this episode to play
out. I thought at the time my first article on the matter would be my
last, but we're now at thirty and counting. I know now that <a href="http://seekingalpha.com/article/2911856-herbalife-and-the-post-mlm-blues" target="_blank">my last article</a> won't be my last, for when Herbalife finally collapses or gets shut down, a post mortem will be in order. </div>
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<span class="im"></span><br /></div>
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<span class="im"></span><br />
<div>
<span class="im">For
those who are interested, Seeking Alpha has, for better or for worse,
become the locus of some of the best research and analysis on the issue
outside of the astounding material produced by Pershing Square on the
two websites listed above, and by Christine Richard (who did much of the
original research leading up to the Pershing Square short), explained
in part in her own articles on Seeking Alpha, <a href="http://seekingalpha.com/article/2480445-herbalife-whos-consuming-all-those-shakes-and-why" target="_blank">here</a>, and <a href="http://seekingalpha.com/article/2583335-through-herbalifes-venezuela-looking-glass-and-back-again" target="_blank">here</a>.
It should be noted that a short position is a difficult investment
decision, unless you have a very clear trigger mechanism that you can
identify. Government action is not one of those. And, to a degree, Bill
Ackman counted on such action, based in part on his MBIA short (and it
should be noted that Christine Richard wrote the book, <i>Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street's Bluff</i>). Other important contributors on Seeking Alpha regarding the Herbalife developments include:</span></div>
<span class="im">
</span></div>
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<ul style="text-align: justify;"><span class="im">
<li>Matt Stewart, <a href="https://quoththeravensa.wordpress.com/category/the-cult-of-herbalife/" target="_blank">Quoth the Raven</a> and
Matthew Handley, all of whom have short positions, and collectively
they have produced an astounding body of research and analysis,
highlighting both legal issues and financial analysis.</li>
<li>On the
legal front there have been contributions from attorney Douglas Brooks
(of Omnitirition fame), and former Wisconsin Assistant Attorney General
Bruce Craig, who notable won a case against Amway in 1980, just after
the fateful Amway '79 decision that would cripple the FTC for the next
35 years. In the discovery phase Bruce Craig found that of 20,000 Amway
distributors in Wisconsin at that time, the top 200 lost $900 per year.</li>
<li>As
far as business and economic analysis, as well as some of the more
in-depth aspects of the cult-like appeal of pyramid schemes, there have
been important contributions from Bill Keep, Dean of the College of New
Jersey, and Robert FitzPatrick, who runs Pyramid Scheme Alert, as well
as some connecting commentary from myself.</li>
<li>On the tax front, there is the fascinating research of Dave Ritchie, <a href="http://seekingalpha.com/article/2828286-analysis-of-irs-statistics-suggests-a-98_94-percent-financial-failure-rate-for-herbalife-sales-leaders" target="_blank">here</a>,
who confirms the tax research of Jon M. Taylor from IRS records. Loss
rates are typically close to 99%. Tax deductions is the major product of
the industry.</li>
<li>As an additional angle to both the cult aspect of
MLM, and its apparent business/investment promises, there was Kay
Herbert, an MIT-educated mechanical engineer, who drew a statistical <a href="http://seekingalpha.com/article/2509665-what-facebook-herbalife-and-the-plague-have-in-common" target="_blank">analogy between MLMs and the propagation of epidemics</a>,
to explain the "pop and drop" behavior when opening new markets or
introducing new products, that even Herbalife management acknowledges in
their public filings. </li>
</span></ul>
<span class="im">There have certainly been other
contributions, but the above are probably the main ones. Outside of
Seeking Alpha, a few of the sources that should be mentioned include the
following:</span></div>
<span class="im">
</span><span class="im"></span>
<div>
<ul><span class="im">
<li style="text-align: justify;"><a href="http://tjspartners.com/blog/archives/category/hlf" target="_blank">Blog by investor Tom Salvatore</a>,
which has shown very astute analysis and profound comprehension of the
legal, business, and criminological elements that have made up the story
of MLM/pyramid schemes.</li>
<li style="text-align: justify;"><a href="http://mlmtheamericandreammadenightmare.blogspot.com/" target="_blank">Blog by British MLM-critic David Brear</a>,
whose own family was torn apart by the Amway cult, and who has put
forth the most comprehensive body of historical analysis of thought
control with fake "opportunity," going all the way back to beguiling
misrepresentations and advance fee fraud of Hitler in his Volkswagen
program, basing himself firmly on the razor sharp insights of George
Orwell.</li>
<li style="text-align: justify;">The classic sources include Jon M. Taylor's site <a href="http://www.mlm-thetruth.com/" target="_blank">www.mlm-thetruth.com</a> <wbr></wbr>which
includes such gems as his analysis of the tax losses of
MLM-participants, as well as his documentation of regulatory capture of
the FTC, that are masterpieces in themselves. Taylor has researched over
500 MLM companies, and found the structure to be always the same in
effectively syphoning moneys from a multitude of losers to a few at the
top. Robert FitzPatrick's sites are <a href="http://www.pyramidschemealert.org/" target="_blank">www.pyramidschemealert.org</a><wbr></wbr> and <a href="http://www.falseprofits.com/" target="_blank">www.falseprofits.com</a>. A newer voice is that of E. Robert Smith, author of the book <i>Downline... an intolerable potential to deceive</i>, with his website <a href="http://www.amway79challenged.com/" target="_blank">www.amway79challenged.<wbr></wbr>com</a>.
The title of his book was a statement of Paul Rand Dixon, a former FTC
commissioner, which he made in one of his own MLM-rulings. The author's
own conclusion, after five years of 6-figure earnings in MLM was that he
had become a professional liar. He did not like it, and he chose to
write the book instead.</li>
<li style="text-align: justify;">The mainstream press has mostly missed
the story, or failed to cover more than the headlines, but some highly
competent coverage should be mentioned, including a <a href="http://projects.aljazeera.com/2014/multilevel-marketing/mlm.html" target="_blank">five article series on Al Jazeera</a>, which included some powerful commentary by William K. Black, he of S&L fame (<i>The Best Way To Rob A Bank Is To Own One</i>), excellent coverage in <a href="http://www.rollingstone.com/culture/features/selling-the-bro-dream-vemma-20141030" target="_blank">Rolling Stone of MLM-company Vemma</a>, and somewhat older but very worthwhile coverage in a four-part series in The Nation, <a href="http://www.thenation.com/blog/176913/eye-pyramids-part-4-incredible-bread-machine#" target="_blank">here</a> (part
4, and you'll find the links to parts 1, 2, and 3 referenced at the
start of the article). The Nation does a very good job on the regulatory
capture and political corruption aspects of the issue, including how
the GWB-administration put the fox in charge of the hen house in the
form of making Amway-lawyer Timothy Muris head of the FTC, promptly
stopping all MLM-prosecutions, and starting an FTC tradition of
obfuscation in their public policy statements, that misled the public
into thinking there is such a thing as a 'legitimate MLM.'</li>
<li style="text-align: justify;">Finally, there is the incomparable <a href="http://saltydroid.info/" target="_blank">Salty Droid</a>,
whose material provides rich documentation of various scams, including
extensive material on MLM in general and Herbalife in particular.</li>
</span></ul>
<div style="text-align: justify;">
<span class="im">One
of the issues that has gone nearly unnoticed is this matter of
regulatory capture, although it has been well documented. Rationally, it
is the first and most obvious problem in dealing with crime. Only the
latest example is the Dodd-Frank Act in the US, and its offspring, the
Consumer Financial Protection Bureau (CFPB). Effectively, it was a way
of blaming the banks for the political corruption of vote-getting with
the lure of 'low income' home ownership under the Clinton
administration, but with plenty of Republican believers as well. This
issue was recently documented by Peter J. Wallison in a new book, <i>Hidden In Plain Sight</i>.
Personally, I tend to think that the abolition of Glass-Steagal was the
beginning of the problem, but the cynical view of the whole matter is
that the CFPB today is a captive regulator from the outset, to justify
why the root causes of the sub prime scandal were never dealt with. As
William Black put it, <a href="http://america.aljazeera.com/opinions/2014/9/eric-holder-resignationjusticefinancialcrisisfraud.html" target="_blank">Financial Frauds Had A Friend In Eric Holder</a>,
and instead of thousands of criminal prosecutions, as we saw in the
S&L scandal, nobody went to jail. The USA laughed in the 90's about
Japan's inability to deal with the financial engineering by its biggest
corporations, and its failure to deal with the bad banks in a forthright
manner. The US has now officially taken that title. Japan bought itself
two lost decades, sofar. The US has set itself up for two lost
centuries. As author Gore Vidal, the unofficial biographer of the USA,
put it so succinctly, the US has become a country not of laws, but of
lawyers.</span></div>
</div>
<span class="im">
</span><br />
<div style="text-align: justify;">
<span class="im"></span><br />
<div>
<span class="im">The SEC and the FTC have been asleep
at the wheel in relation to MLM/Pyramid schemes, taking only occasional
action, by culling some minnows from the oceans of fraud, but it is a
travesty that pension money should be invested in a complete scam like
Herbalife, or that it should be allowed to be publicly listed in the
first place. This 'industry' has now grown into an international $150
billion dollar fraud. The FTC has only intermittently pursued a few
smaller operations, such as Fortune High Tech Marketing. In the case of
Fortune High Tech case ran for 10 years and had at least 200,000
victims before it was stopped. Herbalife makes 2 million victims a year,
and some of the stories are heart-rending, such as one I learned of
recently of a 72-year old woman who operated Herbalife 'nutrition
clubs,' which are a pyramid within a pyramid, and losing $150,000 doing
it.</span></div>
<span class="im">
</span></div>
<div style="text-align: justify;">
<br />
<span class="im"></span><br />
<div>
<span class="im">One of the interesting side stories is how
the DSA, the Direct Selling Association, was taken over from the inside
by MLM companies, displacing the original Direct Selling companies, and
so to complete the disguise of MLM, as a direct sales company. (This
would make a good definition of MLM: MLM is a pyramid scheme disguised
as a direct sales company.) The DSA was instrumental in corrupting the
political process and the regulators in the US, and internationally the
same has taken place. I received a response to an inquiry to the Dutch
Ministry of Justice, in which they maintained that protecting the
citizens from fraud was not their business, for limiting the freedom of
contract was a priority concern, and the citizens should sort out for
themselves which companies were fraudulent. In short this is the police
protecting the right of the crooks to defraud the public. This view is
only possible if it is assumed that MLM is ever a legitimate business
model, but of course any business method that produces 99% losses for
its practitioners, is not a business mehtod, but a fraud.</span></div>
<span class="im">
</span></div>
<br />
<div style="text-align: justify;">
<span class="im"></span><br />
<div>
<span class="im">More
recently, back in the USA, both Tupperware and Avon have quite publicly
quit the DSA, making it clear that they were concerned it was overrun
by pyramid schemes. However, neither company has (yet?) taken the next
step to seriously reform their business models, and Avon in particular
exhibits a deterioration in its financial results that seems strongly
correlated to its adoption of an MLM model in 2005, which has
predictably cannibalized the traditional sales business of the Avon
lady, with the recruiting madness of MLM. Economically it is clear, that
if recruiting drives the bus, retail sales is thrown under the bus.</span></div>
<span class="im">
</span></div>
<div style="text-align: justify;">
<br />
<span class="im"></span><br />
<div>
<span class="im">It should be noted that a proliferation of public <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact=8&ved=0CB4QtwIwAA&url=http%3A%2F%2Fwww.youtube.com%2Fwatch%3Fv%3D6U9u1wil-Ms&ei=YovfVMnxE8e0ggS2wIDgBg&usg=AFQjCNEdralMxkW_8wXADrJrgqwlWwTChw&sig2=IdE6JkdXykxiSjSxbiYFKA&bvm=bv.85970519,d.eXY" target="_blank">satire about MLM/pyramid scams</a> is
indicative of the fact that the public is getting tired of the scams,
so that even if the regulators continue to be slow in acting, the
population is so scam weary that enthusiasm of these programs is waning.
I am personally involved in some public education in my area, including
presentations in the Police precinct council meeting of my precinct in
the Bronx, for with fraud, two pennies of crime prevention is certainly
worth more than a pound of cure (never mind a dollar's worth) of cure.</span></div>
<span class="im">
</span></div>
<br />
<span class="im"></span><br />
<div>
<span class="im"><b>Possible Remedies</b></span></div>
<span class="im">
</span>
<div style="text-align: justify;">
<span class="im"></span><br />
<div>
<span class="im">Clearly,
in the US the FTC is supposed to protect consumers, but the only means
it currently has to fight MLM is under section 5 of the FTC act, "Unfair
and deceptive business acts and practices" (UDAP), which works only to a
point, as the FHTM case showed. It makes no sense that these companies
should have the opportunity to run, as in the FHTM case for 10 years,
and make 200,000 victims, before they can be stopped. In the Herbalife
case the total run time up to the present is 35 years, and the victims
are in the multiple millions.</span></div>
<span class="im">
</span></div>
<span class="im"></span><br />
<div>
</div>
<span class="im">
</span>
<div style="text-align: justify;">
<span class="im"></span><br />
<div>
<span class="im">Presumably the SEC would know
enough not to let a Ponzi scheme become publicly listed, but there is a
long list of publicly listed MLM companies, or MLM companies owned by
publicly listed companies, including Warren Buffett's
Berkshire-Hathaway. This means pension funds also own these illegal
rackets directly or indirectly.</span></div>
<span class="im">
</span></div>
<span class="im"></span><br />
<div>
</div>
<span class="im">
</span>
<div style="text-align: justify;">
The good news is that
there still is a strong foundation in US law to pursue these companies,
and in a very interesting development <a href="http://www.aarp.org/content/dam/aarp/aarp_foundation/litigation/pdf-beg-01-09-2013/Torres-SGE-Management.pdf" target="_blank">AARP just filed an amicus brief</a> for
a class-action RICO lawsuit against Ignite/Stream, which is a private
MLM/pyramid company in the de-regulated retail energy industry. The
company had sought to appeal both the RICO and class-action status of
the lawsuit, and AARP is supporting the class-action status. It should
be noted that the RICO dimension in a private lawsuit opens the door for
triple damage claims. The first use of the <a href="http://www.amquix.info/blakey.html" target="_blank">RICO laws against MLM</a> was
by Prof. Robert Blakey in Amway's case with Procter and Gamble, and the
current case against Ignite/Stream will make for an interesting
development. He originally drafted the RICO statute to fight the mafia,
and the similarities with how the MLM industry operates are eerie. The
AARP brief is a masterful summary of the current legal framework in the
US, which still provides ample grounds to pursue these frauds. The
material would be equally applicable to Herbalife in its entirety. </div>
<div>
</div>
<div>
Rogier Fentener van Vlissingen lives in Bronx, NY, and is active as a
consultant in renewable energy retrofits, and an author on finance,
energy, and spirituality. His website is <a href="http://www.vliscony.com/" target="_blank">www.vliscony.com</a>. </div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com67tag:blogger.com,1999:blog-1814467024485189561.post-50721950327416224752014-09-21T03:05:00.001-07:002014-09-21T03:05:20.108-07:00Two-Handed Economists<div dir="ltr" style="text-align: left;" trbidi="on">
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<a href="http://pinchmehard.files.wordpress.com/2009/09/funny.gif?w=780" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img alt="" border="0" src="http://pinchmehard.files.wordpress.com/2009/09/funny.gif?w=780" height="101" title="URL from: http://pinchmehard.files.wordpress.com/2009/09/funny.gif?w=780" width="320" /></a></div>
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"A sign of a good economist is he or she always has two hands" says <a href="http://johnhcochrane.blogspot.ca/2014/06/revolving-door.html#more" target="_blank">John Cochrane</a>. Truth is, there is more to that statements than commonly thought and it is one of the things most forgotten in the economics profession. More often than not, when an economist is asked to provide an opinion on a subject, the assurance of absolute knowledge in his or her words is staggering. It is as if God Himself has come down to earth and bestowed that person with the impeccable ability of perfect foresight. In addition, the economist was also granted with the ability of saying that everybody who disagrees with him is just plain ignorant.</div>
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The problem most economists commonly ignore (maybe due to biases than other things) is that there are actually two sides in everything, from the plainest decision to the most intrigue problem the economy faces. The smart thing would be to recognise both but choose the one with less downside. For example, when the Federal Reserve chose to boost the economy by promoting programmes such as the TARP and large-scale QE they were faced with two options: do nothing and watch the whole economy collapse or do something and risk being told off for inducing moral hazard. Obviously the latter was the worse of two evils. (In case you were wondering, even with the total collapse of the economy the top 1% would still be the top 1%; the inequality would have just been greater- see the certainty I was talking about before?).</div>
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Take another example: what do you think about the government spending more than now? Most who say that this is a good idea are in danger of being labelled as communists while those who say that it is bad are about to be called Austrians. The problem here is that the question is very vague: when, for example would be a good clarification. In times of crises those labelled Keynesians would respond. But again, it depends on where you spend it and how constrained you are. Greece, Italy, Cyprus and Portugal cannot increase government spending as they are too indebted for that. In addition, moral hazard comes in again. If I am due to spend every time things go bad, why shouldn't everyone just be risky? Again, the lesser of two evils is the wisest choice here.</div>
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Probably all issues could be benefited from a two-handedness approach. Even extreme ones such as cartel formation. We all know that cartels are bad, simple because they tend to charge higher prices. Suppose now that we have a situation where a cartel is formed in an industry. In the case where no cartel exists, every firm competes by price and the lowest bidder wins. But in the case where the cartel exists, the firms agree that one of them would win each time and place higher prices. Is this bad for the state? Obviously. Is this bad for the economy? Well, it depends. If, as usual we have returns to scale, it would mean that less people are employed in a single firm than in two similar firms. In this case, the lowest bidder would get all the auctions and everyone else would be left off the market. But, at the same time more unemployment would occur than if all firms were operating as one firm needs less than all the workers! </div>
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As the reader may observe, there is no clear-cut answer to a question. Even in this most extreme of cases such as the one where cartels are involved, what would you prefer if you were a policymaker during a crisis and unemployment was already sky high? High morals and high unemployment with less spending or lower morals and lower unemployment with more spending? My answer is simple: it depends.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com18tag:blogger.com,1999:blog-1814467024485189561.post-51699264465548175172014-08-02T05:59:00.000-07:002014-08-02T05:59:11.243-07:00Comments on the PIMCO report for Cyprus<div dir="ltr" style="text-align: left;" trbidi="on">
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Since the PIMCO report on the Banking System of Cyprus became <a href="http://ftalphaville.ft.com/files/2013/04/reportasws.pdf.pdf" target="_blank">public information</a>, I've actually noticed much less comments regarding it than when it was still considered confidential. The reason might simply be that it is always much more difficult to speculate on something which is available to everyone than something which is supposed to be a secret. Thus, given the lack of comments on the subject, what follows is my take on the report.</div>
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The first thing you notice in the report is that PIMCO did an excellent job in identifying the major features of the Cyprus banking system. The most important of these features are:</div>
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<b>1. The prevalence of asset-based lending practices</b></div>
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In essence, Cypriot banks lent out money only if you had some strong collateral to back your loan (in most cases real estate), with less attention given to whether the client had the ability to actually meet payments. If the borrowers got into trouble, they could always sell their property to repay their loans; as real estate prices increased for a very long time, this practice rarely yielded losses for the banks. Most importantly, borrowers who were not able to repay could always pledge more collateral and actually increase the amount of they borrowed.</div>
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<b>2. Extended foreclosure and legal resolution timeline</b></div>
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Simply put, if a borrower could not repay his loan, then the whole procedure of obtaining the collateral and making a forced sale of the property ranged between 10 to 12 years. Add this to the previous feature and the reader may easily see that a borrower had no difficulty in pledging more collateral and obtaining more credit as there is almost zero downside on his part. This in its turn artificially increases loans and leads to the concentration of bad loans to few people (see land developers, hoteliers, etc).</div>
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<b>3. Different provisioning methodology, impairment recognition and interest income practices</b></div>
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Notably, a fully-secured loan was not considered a non-performing one which makes the value of NPLs depend on the (subjective) valuation of the collateral. In addition, unpaid interest income was also considered to be income as a result of the historically appreciating property prices which made the probability of future losses very few (as also discussed in feature 1). </div>
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In addition to these, a high reliance on the the international banking operations for income and non-residents for funding was also reported. These features resulted in high cure rates for NPLs as well as high re-default rates (since extra collateral means a "cured" NPL but does not mean that the borrower's ability to repay has increased) and subsequently in high probabilities of borrower default but low loss-given-default rates due to over-collateralization.</div>
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The methodology of the exercise, will not be the subject of this article, yet, just simply comment that even though there has been much speculation, PIMCO does not appear to do anything different than standard procedure. The same holds for the base scenario which does not appear unrealistic given the <a href="http://ec.europa.eu/economy_finance/publications/european_economy/2012/pdf/ee-2012-7_en.pdf" target="_blank">European Commission (EC) forecast</a> in Autumn 2012. Actually, compared to the -2.3%, -1.7% and -0.7% EC forecast for 2013, 2014 and 2015 respectively, the -3%, -0.6% and 0.8% is cumulatively much rosier. The same holds for the unemployment rate forecast.</div>
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The finding which most strikes out in the report is that Cyprus banks were unable to meet their capital needs <b>even in the base scenario</b>. In fact, not only would they need additional capital to meet regulatory needs but they would also end up with negative capital in 2015, making an additional case against the validity of the EBA stress test exercises in 2011. Again, I note that this is simply the base scenario. In the adverse scenario, the capital needs increase by more than 3 billion euros for the whole system.</div>
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The PIMCO numbers are supposedly the ones on which the decision on the percentage of the deposits haircut of the Bank of Cyprus relied on. The 3.9 billion shortfall for the bank was very close to the 3.8bn <a href="http://cyprus-mail.com/2013/07/30/cyprus-bows-to-troika-on-haircut-figure/" target="_blank">obtained</a> from the haircut. The problem, however, lies somewhere else: as stated in page 8 of the report <i>"Greek loans represented approximately 40% of the defaulted balances. Moreover, in the adverse scenario [..] Greek loans represent 43% of total expected losses on Cyprus and Greek loans".</i> In numbers, out of the total of 6.6 billion expected losses on loans and advances, around 2.8bn were from Greece. For those who have forgotten, MoU in March 2013 also included the forced sale of the banks' subsidiaries in Greece. This means that the banks were cut off from any potential losses in Greece thus lowering their capital needs. Even if we round the number of the PIMCO report to 2bn euros, the capital needs in the adverse scenario reduce to about 1.9 bn, without even taking into account the reduction in risk-weighted-assets which would further decrease needs.</div>
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Hence, the question which arises from the PIMCO report is: since the forecasts were made using the Greek branches as well, why was the amount employed in the haircut the same? In fact, since the Bank of Cyprus actually required a further <a href="http://www.google.com.cy/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CCUQFjAB&url=http%3A%2F%2Fwww.financialmirror.com%2Fnews-details.php%3Fnid%3D32860&ei=eNjcU7nmB4So0AXHzYDYCw&usg=AFQjCNG95Iq5YnTEis2lzv2ASWeZgjcAmA&bvm=bv.72197243,d.d2k&cad=rja" target="_blank">re-capitalisation</a> of close to 1 bn a few days ago, how low have the PIMCO estimates been? The only major difference which could make the actual outcome worse than the predicted is the fact that unemployment was 16% in 2013 rather than 13.8% in the forecast, while the house price forecast was much more pessimistic than the actual result. The change in the NPL definition does not matter at all, as PIMCO, in page 15, defines a non-performing loan as one which is 90 days past due, regardless of its collateral amount. The good Laiki couldn't have impaired the balance sheet by that much either
since most of the losses were absorbed by the bad bank. Even in the worst case scenario of BoC obtaining all loans from Laiki, the exclusion of the Greek branches leaves capital needs for the domestic Laiki at less than 1bn. Strangely, the
liquidation of Laiki was said to <a href="http://www.reuters.com/article/2013/03/25/us-cyprus-parliament-idUSBRE92G03I20130325" target="_blank">decrease</a> Cyprus's needs by 4.2 billion which is in contrast to the PIMCO report in which the bank required 3.9 billion in total (including the Greek branches).</div>
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Concluding, the big question mark here is not if PIMCO over-estimated the capital needs of the banks, but why its numbers when it came to the Cyprus evolution of loans were so far off. If the BoC actually needed 4.8 bn (3.8bn of the haircut plus 1bn from the re-capitalisation) to pass the October stress tests why was the number less than 2 billion (excluding the Greek branches) in the PIMCO report? </div>
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The PIMCO report, even though it did a great job in identifying and analysing the state of the Cyprus banking system did a very peculiar job in forecasting its capital needs. Truth be told, numbers and reports don't really add up. </div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com117tag:blogger.com,1999:blog-1814467024485189561.post-21041667544392939142014-07-12T04:42:00.002-07:002014-07-12T04:42:31.108-07:00A Marriage Made in Hell: Housing and Foreign Demand<div dir="ltr" style="text-align: left;" trbidi="on">
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In the past couple of years we have seen a surge in the effort to obtain demand from abroad. Current Account negative <a href="http://euronomist.blogspot.com/2013/07/trade-deficits-and-current-accounts-is.html" target="_blank">balances</a>, have provoked many discussions, since in a currency union, in order not to have a Balance of Payments crisis, there is a need for having a stable quantity of money in the economy. The apparent solution of boosting the export sector, as Germany has been doing during the Eurozone crisis, is <a href="http://euronomist.blogspot.com/2013/11/the-german-export-beast.html" target="_blank">no solution for the long-run</a> as without strong domestic consumption the country is prone to shifts in foreign demand. Yet, in the short run, this dependence on foreign demand appears to be great if demand keeps going up. </div>
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The problem is that the same principle does not hold for housing. Picture the following scenario: a person from country Y buys a very affordable home in country X. It goes without saying that most probably country Y is richer than country X, or at least house prices in the latter are lower than the former. (The rationale behind this is that it wouldn't be easy for someone to purchase a home in a country where prices are much higher than in his own country - unless he or she is very wealthy which is what has been happening in London nowadays). Now, if the house is really affordable, others will also want a piece of the housing, and from the supply and demand law we know, prices will rise in the country.</div>
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Is that necessarily bad? The answer is unfortunately yes, most of the times. If the rise in foreign demand occurs during a relatively short period of time (as it usually manifests), then house prices will rise by much more than national inflation rates. The case of Spain is very enlightening:</div>
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="http://upload.wikimedia.org/wikipedia/commons/e/ed/Vivienda_n_jun2009.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img alt="" border="0" src="http://upload.wikimedia.org/wikipedia/commons/e/ed/Vivienda_n_jun2009.png" height="400" title="Source: Wikimedia Commons" width="367" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Yellow line is the price of housing per square meter while the green one is the inflation rate</td></tr>
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The first question which arises is why doesn't the inflation rate rise by as much as foreign demand if that is the main driving force behind the increase. The answer to this is inequality, but not in the Piketty sense: it is not that everyone in Spain benefits from the rise in prices. The "representative" Spanish household has no intention of selling its house and living somewhere else just because prices have gone up (I know that many economists believe that this is what "rational" agents would do, but that is not very realistic). It's the land developers who benefit the most from this expansion of prices, which is followed by an expansion in credit as banks see its profitable to lend to them. Money is still distributed along the economy in the form of credit or increased consumption (the rising trend of inflation in the above graph is indicative of this) but not by as much as the rise in property prices.</div>
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The second question is why does it matter that much. What most fail to see at the time is that this expansion in foreign demand hurts the nationals by much more than we believe. If the average price in Spain was around 1000 euros in 1997, and a part of the population could not afford to purchase a house, then who would argue that in 2008, when it nearly tripled many less would really afford it. If someone doubts this then the following graph should remove all doubt:</div>
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<a href="http://www.tradingeconomics.com/charts/spain-wages.png?s=spainwag&d1=19770101&d2=20141231" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://www.tradingeconomics.com/charts/spain-wages.png?s=spainwag&d1=19770101&d2=20141231" height="182" width="400" /></a></div>
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The increase in wages was less than 70%, when house prices rose by almost 180%. House price in 1997 was approximately 14 times the wage index, while in 2008 it was more than 28 times. Foreign demand for housing has an even nastier side: it assists in the creation of a credit bubble as locals have to borrow more money for property purchasing and land developers borrow more as profit opportunities rise. Spain is again indicative of this behaviour as credit rose by more than 400% since 1998, mostly driven by these developments. </div>
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<a href="http://www.tradingeconomics.com/charts/spain-loans-to-private-sector.png?s=spainloatoprisec&d1=19830101&d2=20141231" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://www.tradingeconomics.com/charts/spain-loans-to-private-sector.png?s=spainloatoprisec&d1=19830101&d2=20141231" height="182" width="400" /></a></div>
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So what makes housing so different?</div>
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The simple answer is that housing is immovable. You cannot really take a
house or an apartment and leave the country as you can do with other types of goods.That makes all the difference since it means that locals and foreigners compete for the same goods. If a producer can sell a banana at home and the same one abroad, then prices are charged accordingly and, if possible, charges foreigners more, given the extra trouble that is required. In the meantime, the producer cannot really charge the foreign price to the local market because there are many other substitutes: buy from another producer, buy an imported banana or buy some other fruit. In contrast, the house is stuck where it is built and there is no local nor foreign substitute for it. In addition, the developer has a very good alternative for local demand: sell it to a foreigner at an inflated price. Which is more profitable? Obviously the latter, and the locals will just have to meet the price if they want to purchase the property.</div>
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Thus, simply put, increased foreign demand for real estate is almost always bad news for the locals. The phenomenon has not just taken place in Spain, housing <a href="http://www.infowars.com/the-northern-and-western-european-housing-bubble/" target="_blank">bubbles have appeared</a> in the <a href="http://www.ft.com/intl/cms/s/0/b0bc12ce-05b3-11e3-8ed5-00144feab7de.html#axzz37Fiki7oA" target="_blank">Netherlands</a>, <a href="http://www.propertyfinance.it/sitoeres/contents/papers/id36.pdf" target="_blank">Greece</a>, <a href="http://cyprus-mail.com/2014/03/20/property-prices-can-only-go-up/" target="_blank">Cyprus </a>and even <a href="http://www.newstatesman.com/politics/2014/04/five-signs-london-property-bubble-reaching-unsustainable-proportions" target="_blank">London</a> as it appears nowadays. So next time you hear about rising foreign demand for real estate in your country be wary, very wary.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com54tag:blogger.com,1999:blog-1814467024485189561.post-33906002229648535602014-06-04T09:16:00.001-07:002014-06-04T09:16:58.412-07:00Does Supply Create Its Own Demand?<div dir="ltr" style="text-align: left;" trbidi="on">
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<a href="http://www.plain-sense.com/wp-content/uploads/2011/09/toles.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://www.plain-sense.com/wp-content/uploads/2011/09/toles.jpg" height="346" width="400" /></a></div>
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Many a policy during recent years have been aimed at making things easier for producers. The rationale has been that if producers can create more goods (or make the same goods with less money) then they will have to hire more people, thus boosting employment, consumption and growth. This understanding is based on what has been commonly known as <a href="http://en.wikipedia.org/wiki/Say%27s_law" target="_blank">Say's law</a>, which states that <i>"the mere circumstance of creation of one product immediately opens a vent for other products"</i>.</div>
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Unfortunately, this "law" does not always hold. In fact, at times it appears to be nothing more than a misunderstanding of how the world works and how businessmen think and operate. Let us consider the following example: Company X creates 100 units of good Y which it sells to the public. Demand is good so that there are no excess goods at the end of the day. However, Company X is not the only company in town; there are dozens of others which produce all kinds of goods, some substitutes of good Y, some complementary and some which are completely irrelevant.</div>
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One terrible day, some shock (say a financial breakdown) causes demand for all goods to drop by 20%. Given that firms employed as much workers as it was enough to meet demand and earn them a profit, they now begin to lay off people, until they once again meet demand, with a lower cost. For simplicity, let us suppose that there are no frictions in the economy and this correction happens very fast. Obviously, letting workers go will mean a further deterioration of demand, but we will ignore this for now and just assume that there has been a drop of just 20%. </div>
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An additional option would be to cut workers' salaries by 20%. Yet, this is unlikely to happen because some workers would remain idle and not be fully used during their employment hours. Having them all work less is a bit unrealistic, thus a combination of wage reductions and less employment appears to be more likely. Now let's say that the government, instead of doing anything else, subsidizes part of the firm's expenses, making the good less expensive. What does this mean: basically instead of earning <span class="st">€1 euro per item, it now earns </span><span class="st">€2. Surely, the company's profits rise spectacularly. But does it mean that it helps the economy? Not really.</span></div>
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<span class="st">The issue here is that f</span>irms, unlike what many people people believe, hire only when they are trying to meet demand and not when profits are rising. Unless dropping the price by <span class="st">€1 means that there is a surge in demand for their goods enough to hire extra workers, then nothing will occur in the economy. As some goods are price inelastic then we know that reducing prices will not change their demand by much. In addition, the economy's reduced income means that people are more likely to hold off purchases, even if they can afford it, a form of buffer against worst days in the future.</span></div>
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<span class="st">What is more, even if a lower price increases demand, there appears to be a problem similar to what we know as the <a href="http://en.wikipedia.org/wiki/Paradox_of_thrift" target="_blank">paradox of thrift</a> or the <a href="http://en.wikipedia.org/wiki/Prisoner%27s_dilemma" target="_blank">prisoner's dilemma</a>: what is good for the individual (here the firm) is not necessarily good for the economy as a whole. For instance, the first firm which will hire new workers must be certain that the demand for its goods will be sufficient to cover wages. Yet, only a very small part of those wages will be allocated to the good the worker is producing (think of it this way: an ice cream maker will not just consume ice cream). This, in its turn, benefits the other firms in the economy by much more: by incurring no expenses, they see demand for their products marginally increased. </span></div>
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<span class="st">It is more than obvious that if a firm starts hiring then others will most likely follow, even though there is a "first mover disadvantage". The disadvantage is mitigated only if demand is persistent and large enough to cover the wages and leave room for profit. This means that Say's law most likely holds if there increased demand for goods. </span><span class="st">The magic word here is demand: even in Say's world, it
takes demand to create supply not vice versa. To what avail are we to
fill the market with trillions of goods if nobody wants to purchase
them? </span><span class="st">Nevertheless, this is very hard to know in advance (given the lower income and reduced trust in the economy) and in addition, the cost is high: unless direct subsidies are employed then the effect of other measures such as reduced red tape or other bureaucratic hurdles is infinitesimal. </span></div>
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<span class="st">Then the big question arises: why should we subsidize firms to create cheaper goods, when we know that the outcome is uncertain, or even if the outcome is favourable, the shift will probably take very long? More so, why shouldn't we just target the demand side, which creates more growth faster and tackles issues such as poverty and unemployment much faster, while in addition it is cheaper? If we let ideological barriers such as thinking that assisting the demand side is "Keynesian/Minskian" and the supply side "Liberal/Free Market/Friedmanite", we just reach the conclusion that we are enforcing the <a href="http://euronomist.blogspot.com/2013/04/are-keynesianism-and-monetarism-same.html" target="_blank">same thing through different ways</a>. The only problem lies in choosing wisely which way suits us better.</span></div>
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<span class="st">P.S. This article strictly refers to established firms.l</span><span class="st"> Start-ups usually do create their own demand for their
(new) goods, but they are not usually the ones to receive government aid as
they are either at infancy level or non-existent during those times.
In addition, their "new" demand lies heavily on whether the public has enough funds to purchase innovative goods, something which brings us back to original demand. Assisting in the creation of start-ups (when times are good but
especially when times are bad) while simu</span><span class="st">ltaneously boosting demand could in fact work wonders for an economy.</span></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com4tag:blogger.com,1999:blog-1814467024485189561.post-52851261739086346462014-05-03T04:09:00.001-07:002014-05-03T04:09:42.037-07:00Why Marx was both right and wrong<div dir="ltr" style="text-align: left;" trbidi="on">
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<i>Note: This article does not include any "capitalism is good/communism is bad" aphorisms and it is not intended for any political discussions. What follows is merely an economic exposition.</i></div>
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When the name of Karl Marx enters a conversation, our minds spring to themes of collective societies, USSR-style governments and hard-headed dictators. What we seldom remember though is that Karl Marx was an economist and one of his most famous contributions (and the one on which he based the Communist Manifesto) was his, interpretation and expansion of the thoughts of David Ricardo and Adam Smith on the <a href="http://en.wikipedia.org/wiki/Labor_theory_of_value" target="_blank">Labour Theory of Value</a>.</div>
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Quoting another <a href="http://www.pieria.co.uk/articles/the_many_straw_men_surrounding_marx" target="_blank">blogger</a>, the labour theory of value simply states that <i>"... the "value" of a commodity
is determined by the "socially necessary labour time" embodied in it
("socially necessary" to avoid the nonsensical idea that somebody who
makes something slowly will contribute more value than somebody who
makes the same thing, but faster)." </i>It should be noted here, that this theory has never been a theory of prices as (under Marx's explanation) even though prices might fluctuate, the overall value in the economy will remain the same. Deriving from this, Marx expounded the notion of the "<a href="http://en.wikipedia.org/wiki/Tendency_of_the_rate_of_profit_to_fall" target="_blank">tendency of the rate of profit to fall</a>", again building on the work of previous economists, who noticed that the rate of return of capital invested in industrial production declined over time.</div>
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Marx concluded that in order for the rate of profit to continue to be as high as before, "capitalists" had to employ other approaches, notably to exploit the labour force under their employment. This, in Marx's opinion, led to frequent crises in the capitalist system, which were caused by labourer's revolting against the low wages brought on by employers who tried to earn more.</div>
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As already stated two paragraphs ago, what makes a product more valuable is the "socially necessary labour time" embodied in it. This simply means that the reason why air conditioners are more expensive than simple pens is that it takes longer to manufacture them. I doubt anyone could actually disagree with that; yet, what is more interesting is what comes next. In order to see where the exploitation of labour comes in, we have to distinguish between two points of view: one where the labourer is his own master and whatever he produces he can sell and another where the labourer is an employee. If what the labourer can possibly earn in the first case can be more than the amount earned in the second, the we can say that we have exploitation.</div>
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Let's start with the following scenario: average Joe can produce X amount of good G, with an estimated value of V (notice we are not talking about prices here). This amount is what Joe is contributing to the economy. Now suppose that capitalist C offers Joe the following plan: he will work the same time as before and earn the same amount of income, but the capitalist will offer Joe some capital (think of it as a machine assisting in the creation of good G), and Joe will be expected to produce amount Y (Y>X). The difference between Y and X, multiplied by the price, is the capitalist's profit (we will consider that the rate of capital here is constant*).</div>
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Given that Joe's job is rather unstable (just like any other self-employed person in the world he does not know whether he will be able to sell all the goods he manufactures), having a stable income is much more preferable (the fact that his wage will be the same as before means that he is not losing any purchasing power). Now, since less effort than before is given into making the same amount of goods, according to the labour theory of value, the value of a unit of good would decline. Yet, would the overall value of goods also decline? The answer here is that it depends: if Y*V2>X*V1 (with V1 indicating the original value and V2 the value after the capitalist offered some capital) then it would not. Thus, if the increase in amount of production, induced by the addition of capital multiplied by the new (reduced) individual value is greater than the original then the economy is better off than before.</div>
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Why should the capitalist care about increasing value in the economy one might ask. The simple answer is because it increases his profit. His profit is Y*V2-W (with W being the wage he pays Joe), meaning that the higher the value, the higher his profits, given that Joe's wages are constant. This is simply increased return on labour and not on capital (we considered that to be constant before). How would the capitalist, in real life, know that it is good to perform that action: simply, trial and error. If the price more than expected and he cannot make a profit then he just shuts things down, or reduces wages.</div>
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Obviously, the rate of return on capital cannot be same, not through time and neither through sectors. For example, the rate of return was huge in the DVD rental industry in the early 2000's, and has taken a nosedive since. Yet, it had nothing to do with labour nor capital. It had everything to do with shifting preferences (from DVDs to pirated movies or Video on Demand). In addition, diminishing returns also imply that adding more and more capital cannot really help you to increase your rate of profit; most of the time they actually decrease it.</div>
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Returning to our discussion, Marx was right: wages might fall and capitalists do earn of what their employees produce. Yet, Marx was wrong on that capitalists have to make misers off their employees to earn a constant rate of return (we, of course, do not argue that regulation is very useful in protecting some form of worker exploitation): they just have to find new ways of being more productive or, even better, generating more demand for their goods. </div>
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The falling rate of profit actually has a meaning of its own: it shows you whether people are actually enjoying your product or if you are going to have a full-blown disaster. If we consider the falling rate of profit then we have to define what it stands for: just commenting that it falls means nothing. It falls either because you are doing something wrong or because you are obsolete. In either case, shutting down a business is much preferable to continuing its operation just for the sake of keeping some people employed at a lower wage. It is also better for the employees, even though earnings new skills to keep them marketable may be hard.</div>
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*A little bit of math: A production function of the Y=K^(1-a) means that we have constant returns to capital of the rate r=(1-a)*K^(-a). Then, if we add labour, we have the Y=L^a*K^(1-a) form, meaning that we add a*L^(a-1) return to the previous, without the return from capital changing. What the capitalist offers is a wage equal to the marginal product of labour, i.e. w=a*L^(a-1). Yet, if the worker's earnings from before were less than w, then the capitalist can profit from that as well. </div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com3tag:blogger.com,1999:blog-1814467024485189561.post-51092099679133676592014-04-26T05:06:00.001-07:002014-04-26T05:07:31.216-07:00Why ELA is not Different from Bank Deposits<div dir="ltr" style="text-align: left;" trbidi="on">
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<a href="http://boilingfrogs.info/files/2012/12/ela-greek-banks.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://boilingfrogs.info/files/2012/12/ela-greek-banks.png" height="246" width="400" /></a></div>
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Truth is, when most of us hear about Emergency Liquidity Assistance (ELA), our minds go back to March 2013 when the Cyprus haircut was first announced; we think of ELA as a trouble indicator, one which signifies that a bank is desperate enough to obtain it from the Central Bank, and subsequently, that the bank which obtains it is about to collapse. Yet, even though some parts of this story are correct, both the conclusions usually reached as well as the consequences we think ELA funding has, are, most of the times, unreasonable.</div>
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First things first: banks operate with deposits and loans, with the available money in the economy. In addition, they also tend to <a href="http://euronomist.blogspot.com/2013/08/the-banking-system-made-simple.html" target="_blank">create money</a> themselves, by the power of credit. What basically happens is that banks, using liquidity (i.e. available money) from their deposits, loan out funds to people. This occurs until the regulatory <a href="http://euronomist.blogspot.com/2013/05/the-real-money-multiplier.html" target="_blank">capital requirement</a> hits. What liquidity means though, is that banks cannot perform their day to day business without money. Imagine going to a bank only to find out that it has run out of money, just like what <a href="http://en.wikipedia.org/wiki/List_of_bank_runs" target="_blank">happened</a> in the US during the Great Depression or in the UK during the 2008 crisis. In order to avoid panic, the Central Bank usually steps in when there is a large outflow of deposits providing liquidity to its banks.</div>
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Here's what should be noted though: running out of liquidity is nothing unusual for banks. That's why <a href="http://en.wikipedia.org/wiki/Interbank_lending_market" target="_blank">interbank loans</a> and <a href="http://en.wikipedia.org/wiki/Discount_window" target="_blank">discount windows</a> exist. In the first case, the bank obtains a short-term loan from another bank with more liquidity available in order to maintain a minimum until more money are returned (via deposits or through loan installments) while in the second case, the same occurs but the bank borrows from the Central Bank. In both cases, borrowing from either source actually has less cost for most banks, especially in the periphery (in countries like Germany and the UK, the interbank lending rate is usually very close to the deposits rate).</div>
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Thus, what liquidity needs mean is that there is a positive shortfall in the assets minus liabilities, and the bank has to cover it; whether this cover-up comes in the form of deposits or interbank/Discount window loans is irrelevant to the bank. Banks however, deal with other banks the way they deal with other customers: if they do not believe that they will repay, then they will not lend. Hence, when banks are not very stable (and this might just be a perception not reality), other banks might refuse to lend them forcing them to turn to the ECB discount window (the same might occur if a bank just thinks that it might need a large amount of funds, regardless of its state). The only issue here is that banks have to provide some collateral in order to receive the loan. This collateral is usually in the form of government bonds; when the bond has been rated as garbage, the bank cannot offer it for collateral.</div>
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At that time, the ELA comes in play: the National Central Bank (NCB), which usually operates in a strange dependent/independent relationship with the ECB, <a href="https://www.ecb.europa.eu/pub/pdf/other/201402_elaprocedures.en.pdf" target="_blank">offers lending</a> and accepts other forms of collateral (e.g. loans). The reason behind this lending is simply that the National Central Bank does not wish for the specific bank to bankrupt, as the costs will be much higher than the benefits (note: the decision of whether to offer ELA or not is 100% up to the NCB. Still, Central Banks do not enjoy making the decision of whether a bank will bankrupt or not so they just offer the funds. Nevertheless, this is not a bad policy in general). While this is a burden for the bank, it actually is much better than the alternative, i.e. deposits. Given the perception (either wrong or right) that the bank is in trouble, it will have to offer huge deposit rates to attract customers; in Greece and Cyprus rates often exceeded 4 or 5%. In contrast, the ELA is offered at Euribor plus 1-1.5%, a total of less than 2%.</div>
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We consider ELA to be troublesome because it is a loan, and because liquidity is something we usually do not understand. How can ELA lending be decreased? Simply by bonds moving from garbage to investment grade categories allowing banking institutions to access the ECB discount window (which is just cheaper, otherwise it is just as lending as the ELA), by regaining the market's trust and have more people trust their money to the bank or simply by increasing the money in the market thus increasing liquidity. The latter can only take place through <a href="http://euronomist.blogspot.com/2014/04/the-irony-behind-npls-and-lending.html" target="_blank">increased bank lending</a>, something which needs both willing lenders and willing borrowers.</div>
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If anything, ELA just signifies trust in the bank: if we believe that the bank is going to make it, then it will be able to repay ELA money with no trouble at all. If we do not and the bank does not receive any deposits or more so money are withdrawn, then the bank will not be able to repay. The same holds from the Central Bank side which is really out of options: it cannot really withheld ELA and allow the bank to fail (see Lehman Brother and the steps taken by the Fed afterwards).</div>
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Deposits and ELA are materially the same thing for the bank. It's trust which distinguishes between the two; market's on one hand and the Central Bank's on the other. If the latter is regained then the bank survives; if not then it fails. In any case, ELA has nothing to do on whether the bank is viable or not in the future.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-48660283919103063842014-04-21T04:54:00.001-07:002014-04-21T04:54:45.055-07:00The Myth of Barter<div dir="ltr" style="text-align: left;" trbidi="on">
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Admitting that a story which has been around for long is wrong is not an easy task. Yet, it is one of those stories for which the counter argument actually makes much more sense than the original. The first time I saw the argument about barter never taking place in primitive societies was when going through the <a href="http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf" target="_blank">Chicago Plan</a> (a nice refutation of which can be found <a href="http://coppolacomment.blogspot.com/2012/10/the-imf-proposes-death-of-banking.html" target="_blank">here</a>). Although this made some sense, I could not really claim full understanding of the whole issue until I read David Graeber's <span class="a-size-large" id="productTitle">"<a href="http://www.amazon.com/Debt-The-First-000-Years/dp/1612191290" target="_blank">Debt: The First 5,000 Years</a>" (and a book review of which I hope to write soon).</span></div>
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<span class="a-size-large" id="productTitle">The book's argument on barter can be summarized in the following: In small, prehistoric societies, barter never existed; there are no anthropological evidence to support this theory. In fact, credit (even though not in the way we understand it now) was the only way through which activities were taking place in such societies. A simple way to understand how this makes sense is by imagining that the only people in the world are you, 3 of your best friends and your spouses, a total of 8. Now, let's say that one of your friends is good in setting traps, the other is a great gatherer, you are a great hunter and the last is an amazing farmer. At the end of the day, each of you will have collected some amount of food, be it large or small. If your gatherer friend had just a small amount of food would you let him starve to death because on a single day he could not have come up with enough food?</span></div>
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<span class="a-size-large" id="productTitle">The answer here is no. First of all, you are friends and friends don't let each other die of hunger. Second, you need a gatherer in the group just in case everyone else has trouble finding food; even though your friend might not die tonight, starved people are more prone to diseases and other ills. Then, you need the extra person just in case some beasts attack you, or in case someone else is sick. Therefore, it is against both your personal as well as societal interest to let your friend starve. If you are going to offer your food to the other members of your group, and reciprocity is innuendo here, then there is no point in employing any source of measurement for what you offer. In two day's time, you will not wonder whether the meat you offered your friend was more than the grapes and apples offered in return. Just having them at the time is much more important.</span></div>
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<span class="a-size-large" id="productTitle">What should be the juice of the above paragraph is that money has no place in a small society, where everyone knows everyone. Money only arises when we have to deal with strangers, whose ability to reciprocate we cannot know of. Still, it might have been easy to propose a rather complicated system of goods with equal value, for example, a chicken worth 3 kilograms of sugar or 4 kilograms of flour, just like <a href="http://en.wikipedia.org/wiki/Mesopotamia" target="_blank">Mesopotamians</a> used to do. </span></div>
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<span class="a-size-large" id="productTitle">Yet, the use credit was much easier than the use of any kind of money. I owe you 2 chicken, you some other person 3 kilograms of rice and so on. In ancient times, debts was the currency in circulation not money. The reason might have been just that money has to be something that everyone can use and accept or that money by John (i.e. credit) might not be accepted by Jill if she believes he is not creditworthy (obviously, some collateral was to be placed in case the person offered the loan could not repay: even people were at times traded in exchange for debt write-offs).</span></div>
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<span class="a-size-large" id="productTitle">Enter the state. Imagine a sovereign ruler, so powerful that some consider him to be a deity. Nothing is now easier than the use of this power as a means of generating profit to fund a war or any other construction within his empire. Creating money was simply taking an amount of gold, stamping the face of the ruler and then giving it for payment to soldiers or anyone else who deserves payment for a price much higher than the what it cost to manufacture it. Why gold or silver and not anything else one might ask. The answer lies in (albeit denounced by Graeber) <a href="http://www.jstor.org/discover/10.2307/1826989?uid=2&uid=4&sid=21103901251007" target="_blank">Paul Samuelson</a>: it is simply because they are useless in any other form than creating pretty (and expensive) objects. Having copper as a metal during those times would have been an incentive for someone to use them to build arms or anything else if he could get them cheap enough. Gold would not offer the same incentives.</span></div>
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<span class="a-size-large" id="productTitle">The reason for creating money is, as the book states, the facilitation of both trade and state transactions. Offering the state's guarantee on something has a much greater bearing than that offered by John or Jill and creating a market is easier when money is employed than when it is not. In essence, you need states (or at least some sort of regulator) for markets to exist. (For an argument against fully free markets Graeber points out to the situation after the fall of the USSR in the 1990's and the chaos which followed.)</span></div>
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<span class="a-size-large" id="productTitle">In brief, the story is this: barter did not exist in the way usually portrayed by economics textbooks and money did not evolve as a consequence of bartering (i.e. people exchanging goods with others and having trouble keeping up with accounts). Barter was non-existent in prehistoric times and credit arose much before money did. Markets are in fact heavily reliant on money and money is non-existent without the state.</span><span class="a-size-large" id="productTitle"> Recent experience with Bitcoin also shows the same; without any backing from a state or any regulations behind it, it is <a href="http://www.pieria.co.uk/articles/coin_all_the_way" target="_blank">evolving</a> into a commodity rather than a means of transaction.</span></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com3tag:blogger.com,1999:blog-1814467024485189561.post-6630357793946127802014-04-05T05:08:00.001-07:002014-04-05T05:08:34.483-07:00The Irony behind NPLs and Lending<div dir="ltr" style="text-align: left;" trbidi="on">
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This post could actually be summarized in one sentence: If you want Non-Performing Loans (NPLs) to fall, then you have to increase lending. Still, I don't really hope that I will be able to convince many just by stating this. Thus, what follows is an exposition of why the amount of loans (and more so of new lending) matters when it comes to NPLs and, in addition, when bank regulatory capital requirements are concerned.</div>
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NPLs are loans for <a href="http://en.wikipedia.org/wiki/Non-performing_loan" target="_blank">which</a> "payments of interest and principal are past due by 90 days or more". There is nothing more rational than to think of the rise in NPLs as an outcome of the crisis. This, nevertheless, is where most stop their arguments; the problem is that asking "why?" matters the most when it comes to policy. The answer is again so simple everybody has thought about it: it's because people lose their jobs and cannot repay their mortgages or other consumer loans, because there's no investment and no consumption forcing businesses to default and putting more people on the dole. </div>
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The correlation is obvious as can be seen in the case of Greece:</div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="http://cdn.www.ceicdata.com/sites/default/files/na_19.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" src="http://cdn.www.ceicdata.com/sites/default/files/na_19.png" height="261" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: <a href="http://www.ceicdata.com/en/blog/ceic-newslert-non-performing-loans-greece-surge-record-high" target="_blank">CEIC Network</a></td></tr>
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi-TFCjntmn5S-3L3FVsmx6KQDST4wF8HktDELhcatn1PkGrUv2x73fNBZMz6BdJfsjaIeejbhdWStziZWgRh5nmrI-19ElwB1yrJizcwpK61SkdV217wbO4R3O4eAlCnWDRxwJzUbXwRE/s1600/NPLs.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi-TFCjntmn5S-3L3FVsmx6KQDST4wF8HktDELhcatn1PkGrUv2x73fNBZMz6BdJfsjaIeejbhdWStziZWgRh5nmrI-19ElwB1yrJizcwpK61SkdV217wbO4R3O4eAlCnWDRxwJzUbXwRE/s1600/NPLs.jpg" height="262" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">NPLs as a percentage of total gross loans. Source: <a href="http://www.indexmundi.com/facts/greece/bank-nonperfoming-loans-to-total-gross-loans" target="_blank">Index Mundi</a></td></tr>
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The additional problem here is that crises usually come around when banks are already contracting their balance sheets, so the hit in consumption and investment is even harder: less consumption, less demand and less money to go around as well. As a consequence, firms face serious trouble meeting up with their obligations. If they cannot make ends meet, then their loans enter the NPL category. When more NPLs are created, then the bank is more constrained by its regulatory capital needs as bad loans are assigned a <a href="http://en.wikipedia.org/wiki/Standardized_approach_%28credit_risk%29" target="_blank">higher risk weight</a> than before. Thus, the higher the NPLs the lower the banks' ability to <a href="http://euronomist.blogspot.com/2013/05/the-real-money-multiplier.html" target="_blank">lend out more</a> money.</div>
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The problem resembles the one of austerity: we need a government budget surplus but we cannot do it since by cutting expenses and transfers (e.g. pensions) we are reducing consumption and thus government income. Similarly, we want smaller banks, but we cannot do it without <a href="http://euronomist.blogspot.com/2013/09/the-banking-system-part-ii-repayments.html" target="_blank">retracting money</a> from the economy. As money is reduced, consumption and investment become more scarce and business struggle for survival; many go bankrupt. Driven by this lack of funds, unemployment rises resulting in even more NPLs.</div>
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<a href="http://www.tradingeconomics.com/charts/greece-loans-to-private-sector.png?s=greeceloatoprisec&d1=20030101&d2=20141231" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://www.tradingeconomics.com/charts/greece-loans-to-private-sector.png?s=greeceloatoprisec&d1=20030101&d2=20141231" height="182" width="400" /></a></div>
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How can we get out of this mess? The solution (ironically) is not that banks have to decrease their exposure. It's that they have to increase their lending in order to get the economy going again. If the economy does not have enough funds to pull itself out then countries experiencing these issues will face Greece-like situations: prolonged measures to make things better, but only making them worse (here's looking at you austerity!). When lending is increased then more investment is created; subsequently, more jobs and more consumption, leading to an increase in income and a decrease in the loans which cannot be repaid. When people have more money, loan payments which could not be paid before are met now. Nobody wants to lose their house, and no bank want to be stuck with one. In addition, less NPL's actually mean less capital needs, thus more funds to lend, thus more profit for the firm. Still, instead of lending and preventing this from happening, banks are forced by regulators (and themselves as well) not to lend out funds.</div>
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As <a href="http://euronomist.blogspot.com/2014/04/does-qe-mean-money-printing.html" target="_blank">said before</a>, there is a time and place for everything. Just like it wouldn't make sense to continue expanding fiscal policy in a boom (see the <a href="http://www.adamsmith.org/blog/politics-government/ten-myths-about-margaret-thatcher-0" target="_blank">UK experience</a>), or performing QE operations when times are good, it does not make sense to use austerity measures when times are bad (Greece, Spain, Italy, Portugal, Ireland). Similarly, banks should not be pressured to reduce their credit exposures during downturns. Yet, unfortunately, policymaker decisions do not appear to be counter-cyclical.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com2tag:blogger.com,1999:blog-1814467024485189561.post-52681503236711146552014-04-01T03:18:00.001-07:002014-04-01T03:18:21.829-07:00Does QE mean money printing?<div dir="ltr" style="text-align: left;" trbidi="on">
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Although the debate on the effects of QE <a href="http://coppolacomment.blogspot.co.uk/2013/05/inflation-deflation-and-qe.html" target="_blank">on the economy</a> and whether QE is <a href="http://euronomist.blogspot.com/2013/05/is-qe-deflationary-conjecture.html" target="_blank">deflationary</a> or inflationary has (at least in my mind) been settled, there seems to exist a rather going "concern" on whether the buying of government bonds from the Central Bank equals money printing. Whether it does or it does not have separated people into two camps: those who believe that too much QE can lead to hyperinflation and those who believe that it will cause nothing of this kind.</div>
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But first things first: QE, although usually defined as the purchase (by the Central Bank) of government bonds in the possession of commercial banks. Yet, there is also an additional point: the one where the Fed purchases new bond issues. To see why this points holds see the following breakdown:</div>
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As it is obvious from the above, the only major change in the categories is the increase in foreign demand for US debt and the increase in the Fed's share of debt. Essentially, as many have argued <a href="http://qedebate.blogspot.co.uk/p/welcome.html" target="_blank">before</a>, when QE is initiated, collateral in the form of government bonds becomes more scarce in the economy. This is supposed to make the banks focus their funds elsewhere, meaning an increase in lending. These operations are usually conducted by the Fed either at the expiration and the re-introduction of a bond or by direct "investment" in the markets.</div>
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The point to be made here is that if the bonds are purchased from the pile of existing bonds then QE is nothing but an asset swap: cash is exchanged with bonds (both at zero risk for the bank). This does not mean an increase of the money supply whatsoever. Yet, if the government decides to issue additional bonds (remember the whole "<a href="http://en.wikipedia.org/wiki/United_States_debt-ceiling_crisis" target="_blank">raising the debt ceiling</a>" debate?) then the Fed is essentially creating new money by purchasing some of them.</div>
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<a href="http://euronomist.blogspot.com/2013/04/are-keynesianism-and-monetarism-same.html" target="_blank">Remember</a> that in order for newly printed money to enter the market it has to either be channeled through government spending or by throwing these amount off a helicopter. (If we choose the former then Monetarism and Keynesianism are essentially saying the same thing.) Thus, if the Fed purchases bonds from new issues, then it is essentially creating new money to enter the market via the government spending channel. Here, we are talking about money which did not exist before. Again, if it was a bond rollover then we would be talking about an accounting increase in cash and a decrease in government bonds (both on the asset side of the balance sheet) which have no effect on the money supply. If the money is lent, then we have an indirect increase in the outstanding amount of money in the economy, via the <a href="http://euronomist.blogspot.com/2013/05/the-real-money-multiplier.html" target="_blank">money multiplier</a>, yet, this is <b>not money printing</b>. It is printing only if the Fed purchases new bond issues.</div>
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Now suppose that the Fed buys some new bond issues. Should we experience hyperinflation? The answer is no and not because increasing the money supply does not mean an increase in inflation. It is simply because of timing. Since the money base (M0) is just about 1/3 of the broad money in the economy (MZM) the effects of a rise in M0 just offset the decrease in MZM due to deleveraging. This is the major reason why the money supply in the US has been increasing over the last year despite the decrease in loans. It is just now, that the increase in bank lending has returned to its "normal" growth rate, that QE has began tapering.</div>
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<a href="http://research.stlouisfed.org/fredgraph.jpg?hires=1&type=image/jpeg&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=13&txtcolor=%23444444&drp=0&cosd=2009-02-01&coed=2014-02-01&width=670&height=445&stacking=&range=5yrs&mode=fred&id=AMBSL&transformation=lin&nd=&ost=-99999&oet=99999&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=&mw=3&mma=0&fml=a&fgst=lin&fq=Monthly&fam=avg&vintage_date=&revision_date=&chart_cosd=2009-02-01&chart_coed=2014-02-01" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://research.stlouisfed.org/fredgraph.jpg?hires=1&type=image/jpeg&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=13&txtcolor=%23444444&drp=0&cosd=2009-02-01&coed=2014-02-01&width=670&height=445&stacking=&range=5yrs&mode=fred&id=AMBSL&transformation=lin&nd=&ost=-99999&oet=99999&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=&mw=3&mma=0&fml=a&fgst=lin&fq=Monthly&fam=avg&vintage_date=&revision_date=&chart_cosd=2009-02-01&chart_coed=2014-02-01" height="266" width="400" /></a></div>
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<a href="http://research.stlouisfed.org/fredgraph.jpg?hires=1&type=image/jpeg&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=13&txtcolor=%23444444&drp=0&cosd=2009-02-01&coed=2014-02-01&width=670&height=445&stacking=&range=5yrs&mode=fred&id=MZMSL&transformation=lin&nd=&ost=-99999&oet=99999&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=&mw=3&mma=0&fml=a&fgst=lin&fq=Monthly&fam=avg&vintage_date=&revision_date=&chart_cosd=2009-02-01&chart_coed=2014-02-01" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://research.stlouisfed.org/fredgraph.jpg?hires=1&type=image/jpeg&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=13&txtcolor=%23444444&drp=0&cosd=2009-02-01&coed=2014-02-01&width=670&height=445&stacking=&range=5yrs&mode=fred&id=MZMSL&transformation=lin&nd=&ost=-99999&oet=99999&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=&mw=3&mma=0&fml=a&fgst=lin&fq=Monthly&fam=avg&vintage_date=&revision_date=&chart_cosd=2009-02-01&chart_coed=2014-02-01" height="266" width="400" /></a></div>
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<a href="http://research.stlouisfed.org/fredgraph.jpg?hires=1&type=image/jpeg&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=13&txtcolor=%23444444&drp=0&cosd=2009-03-19&coed=2014-03-19&width=670&height=445&stacking=&range=5yrs&mode=fred&id=TOTLL&transformation=lin&nd=&ost=-99999&oet=99999&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=&mw=3&mma=0&fml=a&fgst=lin&fq=Weekly%2C+Ending+Wednesday&fam=avg&vintage_date=&revision_date=&chart_cosd=2009-03-19&chart_coed=2014-03-19" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://research.stlouisfed.org/fredgraph.jpg?hires=1&type=image/jpeg&chart_type=line&recession_bars=on&log_scales=&bgcolor=%23e1e9f0&graph_bgcolor=%23ffffff&fo=verdana&ts=12&tts=13&txtcolor=%23444444&drp=0&cosd=2009-03-19&coed=2014-03-19&width=670&height=445&stacking=&range=5yrs&mode=fred&id=TOTLL&transformation=lin&nd=&ost=-99999&oet=99999&scale=left&line_color=%234572a7&line_style=solid&lw=2&mark_type=&mw=3&mma=0&fml=a&fgst=lin&fq=Weekly%2C+Ending+Wednesday&fam=avg&vintage_date=&revision_date=&chart_cosd=2009-03-19&chart_coed=2014-03-19" height="266" width="400" /></a></div>
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Is QE a panacea? Obviously not. As already <a href="http://euronomist.blogspot.com/2013/05/is-qe-deflationary-conjecture.html" target="_blank">said</a>, it may cause short-term asset bubbles and disinflation as a result of increased investment in the stock market. Still, those are just short-term effects and compared to the contrary (in the case of the US, a huge depression). In addition, just like fiscal stimulus, it can only be implemented when times are bad. In booms, QE and fiscal stimuli can cause private investment "crowding out" thus forestalling growth and creating additional inflation. In booms, the latter two tend to cause more damage than good. The two camps referred to at the beginning of this article can both be right but at different times: when times are good, QE can cause high inflations. When times are bad, it does not.</div>
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Overall, QE remains a good idea, despite its short-term side effects. The big question of whether the ECB will be able to apply something like it in the Eurozone remains to be answered.</div>
</div>
Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-43302357577867688272014-03-29T07:32:00.004-07:002014-03-29T07:32:50.336-07:00Understanding ECB Comments: How Central Bankers (Should) Think<div dir="ltr" style="text-align: left;" trbidi="on">
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Central Banking should come with a warning: Anything you do, will be the cause of major criticism. When I usually see reactions on comments by ECB officials, it usually of the "they know nothing/understand nothing kind". The job is not easier for the US Federal Reserve either; it has a long been a while since I've heard no reactions to policy
changes. When the Fed initiated QE, Cassandras said it would drive
inflation rates sky high; it didn't. When tapering started, Cassandras (different ones I hope!)
complained that it would have a severe effect on the economy; still
nothing. Yet, while the usual aphorisms on Central Bank statements and actions
have been going around for a while, what is usually the problem is that do not see things from
their point of view: that of a person/institution who have a great effect on the economy.</div>
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Whether we like to admit it or not, Central Banks do have a lot on their minds. When times are good they have to be careful to prevent bubbles from forming and when times are bad they have to act in order to make them better and be careful not to make them worse. A clear example of the Central Banker's power and the strong grip he or she has on the economy, are reactions to verbal statements. When Alan Greenspan spoke of <a href="http://en.wikipedia.org/wiki/Irrational_exuberance" target="_blank">irrational exuberance</a> for the first time in 1996, markets tumbled; when Mario Draghi gave the "anything it takes to support the euro" speech in August 2012, this is how the Forex Market reacted:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgyN-Uo8_DnD2vkUTjQaCrQDGHpibBux_tQ3D80tkpW_VKZkk-vJ4pu0JMPSQJXKPpC9ggT1D9ZI_-TfMTyI0-EpuTkpw_JFIQ7TWS_v-LzOOVLR3OrtZdkAZu9LxuuWXpGD6f_ktQwuQ/s1600/EUR-CAD.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgyN-Uo8_DnD2vkUTjQaCrQDGHpibBux_tQ3D80tkpW_VKZkk-vJ4pu0JMPSQJXKPpC9ggT1D9ZI_-TfMTyI0-EpuTkpw_JFIQ7TWS_v-LzOOVLR3OrtZdkAZu9LxuuWXpGD6f_ktQwuQ/s1600/EUR-CAD.png" height="237" width="400" /></a></div>
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It is really not a question whether the Central Bank has an effect on the economy, it's about how big it is and the answer is that it's huge. Even if policies do not drastically change market conditions in the short-run (they usually change them in the medium-run), comments and speeches do have a stronger effect since they affect investor confidence. This is why Central Bankers are very careful of what they say and this is why they should (and do) never speak of bad news.</div>
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As we know, the ECB, through its <a href="https://twitter.com/Schuldensuehner/status/449847814068391936" target="_blank">Board</a>, has denied that deflation is a problem. Jens Weidmann has <a href="http://www.reuters.com/article/2014/03/29/ecb-weidmann-idUSB4N0M001320140329" target="_blank">stated</a> that the drop in inflation is nothing but temporal. Whether he actually believes that or not, is something we will never find out. Now, dear reader, imagine what would happen if the ECB or it's board began to talk of deflation being a problem in the Eurozone. As a first reaction, markets would drop and the euro would rise making exports harder. Investment would gradually be reduced and the whole economy would <a href="http://euronomist.blogspot.com/2014/03/real-life-effects-of-deflation.html" target="_blank">enter</a> a vicious cycle of decreased consumption, drops in wages and less investment. More so, the whole procedure could actually be initiated just by the Central Banker admitting that deflation exists, as most people "know" that deflation is a <a href="http://euronomist.blogspot.com/2014/03/real-life-effects-of-deflation.html" target="_blank">problem</a>.</div>
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Then, with regards to ECB reactions and comments, what would the reader, an ordinary citizen of the Eurozone prefer: a Central Banker denying the existence of deflation thus allowing the markets to continue without paying attention to what he says, or a Central Banker admitting or warning about the dangers of the current deflation and forcing a deflationary cycle on the economy? If you ask me, the former is much better than the latter, if only for employment reasons.</div>
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Who knows: maybe the ECB does know something more than we do when it comes to deflation. If not, then measures to counter deflation can be expected at the next meeting. Still, too much truth can actually harm the economy at times. In fact, I would even go as far as claiming that a Central Banker
should act like Titanic's orchestra: even when the ship is shipping (s)he
should calm everyone down and tell them that it's all going to be all right.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-90989264649619955732014-03-25T03:29:00.002-07:002014-03-25T03:29:33.663-07:00Real Life Effects of Deflation<div dir="ltr" style="text-align: left;" trbidi="on">
Deflation is defined as the decrease in the level of prices:<br />
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<a href="http://www.tradingeconomics.com/charts/greece-inflation-cpi.png?s=gkcpnewy&d1=20130101&d2=20141231" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://www.tradingeconomics.com/charts/greece-inflation-cpi.png?s=gkcpnewy&d1=20130101&d2=20141231" height="182" width="400" /></a></div>
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As economic theory dictates, the causes are a fall in the money supply, in addition to (in the short-run) a fall in wages and salaries.</div>
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<a href="http://www.tradingeconomics.com/charts/greece-loans-to-private-sector.png?s=greeceloatoprisec&d1=20130101&d2=20141231" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://www.tradingeconomics.com/charts/greece-loans-to-private-sector.png?s=greeceloatoprisec&d1=20130101&d2=20141231" height="182" width="400" /></a></div>
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="http://sdw.ecb.europa.eu/servlet/quickviewChart?node=bbn3116&SERIES_KEY=119.ESA.A.GR.N.1000.D10000.0000.TTTT.V.U.A" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" src="http://sdw.ecb.europa.eu/servlet/quickviewChart?node=bbn3116&SERIES_KEY=119.ESA.A.GR.N.1000.D10000.0000.TTTT.V.U.A" height="253" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Compensation of Employees (aggregate) Source: <a href="http://sdw.ecb.europa.eu/quickview.do;jsessionid=9A33AD41F433EB2243F66124EE7F80A0?node=bbn3116&SERIES_KEY=119.ESA.A.GR.N.1000.D10000.0000.TTTT.V.U.A" target="_blank">ECB</a></td></tr>
</tbody></table>
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Just like any other economic happening, there are those who claim that any type of deflation is disastrous and should be avoided at all cost while others believe that it is wonderful (since it lowers prices) and we should embrace it. As usual though, they are both wrong. The answer, simply put, is that it depends on the severity, duration and the overall state of the economy at the time when deflation is manifested. What follows are three points on the effects of the current rates of deflation on the real economy of the Eurozone.</div>
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<b>1. As long as deflation is not severe and not persistent then the effects on consumption are small.</b><br />
There is no person who would be willing to forgo a month's consumption of food just because it would get cheaper next month. Parents do not tell their children "you will not attend university now because it will be 2% cheaper next year". We have some basic needs which we will continue to satisfy as long as the deflation rate is not so severe so that an apple will be worth 50% less tomorrow than it does today. Prices fluctuate every day and a deviation of 1-2% <b>per annum</b> for a short period of time (e.g. 1-2 years until an economy gets back on track) does not really change our incentives for non-durable consumption.<br />
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Nevertheless, there is an effect on what we call durable goods (e.g. houses, automobiles, etc) but these are just a <a href="http://research.stlouisfed.org/fred2/series/PCEDG" target="_blank">fraction</a> of what we purchase (approximately 1/3 of our purchases are of durable goods). Even though 1/3 may appear to be large, remember that the reduction in price is more severe in some sectors than in others; automobile prices have not dropped by much (if any) while real estate prices have sunk compared to 2006. In addition, when a person has lower income than before, the first thing he stops purchasing is durable goods, not everything else. Thus, the drop in durable goods consumption can be seen as a natural reaction to the overall drop in confidence, investment and subsequently wages. Still, if deflation persists and becomes even higher in 2014-2015, a large drop in the consumption of durable goods might signify a reduction in investment, resulting in more wage losses and thus creating a vicious cycle.<br />
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<b>2. Deflation has a stronger effect when households and non-financial corporations are heavily indebted.</b><br />
The reason is simple: given that aggregate wages have dropped, prices also drop, triggering another round of wage drop and so on. Although this is an issue for durable consumption as discussed above, it is also a problem when it comes to debt as it takes more money in real terms to repay the amount owed. Thus, if in a country most of its citizens are over-indebted (see all periphery countries) deflation is bad because it makes repaying that debt even harder. Not only that, but it also creates a "<a href="http://en.wikipedia.org/wiki/Paradox_of_thrift" target="_blank">death spiral</a>": the more people try to repay their loans, the less they consume and thus prices and wages fall even further making the real amount they owe even higher. This is exactly what happened with austerity policies: less spending means less consumption thus less income for the state, leading to higher deficits and debt and forcing new austerity measures once again.<br />
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<b>3. Deflation equals lower prices but it does not mean it's good for us.</b><br />
This is one of the most common fallacies ever: if prices fall then it is great. It is most of the times but it always depends on the reason prices fall. If they do because raw material are cheaper or because of a productivity rise then great. But if they happen because people have less money than before then your purchasing power is most likely hurt in the short run (prices usually do not respond fast to shifts in consumption, even if those are permanent). In addition, if we shift from inflation expectations to deflation expectations then what we will see is less and less consumption, leading to lower wages and then lower production. This is the time when deflation gets serious as, with higher rates, we can actually see the economy reach a halt. <br />
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What should be noted is that the severity of deflation has a direct
effect on the magnitude of the above. If deflation is at a very moderate rate of 1%
per annum for a year or so, then most likely its effects on consumption and loan repayment will be very small; more or less of the same extent of what happens in the economy during every other recession. Only if deflation persists, becomes larger and is embedded in expectations will we need to seriously start about the future of the economy.</div>
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In order not to come to the worrying part though, policy (here's looking at you <a href="http://euronomist.blogspot.com/2014/02/european-policy-at-zlb.html" target="_blank">ECB</a>) should be re-addressed so that confidence in the region is re-instated. Otherwise, we will soon see if markets can adjust fast enough not to cause any major casualties.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com1tag:blogger.com,1999:blog-1814467024485189561.post-60124116992568153192014-03-15T07:54:00.002-07:002014-03-15T07:54:22.628-07:00Banks vs SME's: Who's the economy after all?<div dir="ltr" style="text-align: left;" trbidi="on">
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The title of Wikipedia's <a href="http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308" target="_blank">article</a> on the crisis stars with a word which sums it it all up: Financial. What this means is that unlike others mishaps of the <a href="http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States" target="_blank">past</a>, this time the trouble was mainly brought by financial institutions who could no longer survive. And since banks are not just like any other institution in the economy (in the sense that they provide the service of moving funds from one place to another, addition to lending) their importance was not big news to most (it was to some who believed that rescuing them was bad. Truth is, if Bernanke hadn't then we would be far worse than the 1930's).</div>
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In Europe, even though some of the troubles in the periphery are attributed to excess government spending, the truth is that the financial sector has also been a major cause of pain in at least half the economies in the EU (note that it has also been a problem in the UK, Germany, the Netherlands and Belgium, countries which do not often get the bad publicity of being in trouble). As in the US, governments in the EU rushed to save the banks, in most of the times with good reason. Yet, the emphasis on the banking sector has not stopped there; policymakers' preferences shifted to paying more attention on what the banks need instead of what is necessary for <a href="http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/index_en.htm" target="_blank">99%</a> of Europe's businesses: SMEs.</div>
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Unlike large businesses, who usually have ties with multiple banks, usually both domestic and abroad and have open lines of credit reaching hundreds of millions, SME's are faced with small business loans and very small credit balances. The increased capital requirements forced on banks and the now extremely picky procedure for securing a loan has brought many SME's to their knees. As the number of loans to the private sector is reduced, the SME owner finds himself without any sources of funding; while the data show that banks are doing better with regards to their loan portfolio, the market has in fact been suffocating.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEieU3Xyj2SxizI7Tp4wxSlMPilgFCr7YDK2u9SZ4XWZZayxBpKAtAxKLe9wQQJqIKtnwO20ueKPyIvcKPlUEFt7Dy6z2dDwa9CSHNC0QAgpFDr-4ZZPCTz0wmagfP2BO1R6e7kmzfFdDzA/s1600/M3.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEieU3Xyj2SxizI7Tp4wxSlMPilgFCr7YDK2u9SZ4XWZZayxBpKAtAxKLe9wQQJqIKtnwO20ueKPyIvcKPlUEFt7Dy6z2dDwa9CSHNC0QAgpFDr-4ZZPCTz0wmagfP2BO1R6e7kmzfFdDzA/s1600/M3.jpg" height="115" width="400" /></a></div>
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The sad truth is that while we favour the survival of banks, we should remember that these institutions are mere intermediaries; it is true that the economy will freeze if banks collapse, but the same will occur if more and more SME's bankrupt day after day. Big businesses do not see their lines of credit diminished, but those who count the continuance of their day-to-day operations on checks who take days to clear, struggle with the reality of dying any time soon. Troubles are many, starting from the number of days required for a check to either be
returned or cleared varies significantly among countries, (when it could
essentially be done in less than a day in most), the increased fees required by banks to either send money abroad (even though SEPA is a major improvement) or to maintain certain accounts and finally the lack of any additional funding are major causes of headaches for people who do not have.</div>
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Since the emphasis is on the banks and not on the businesses, <a href="http://euronomist.blogspot.com/2014/02/deflation-inflation-and-expectations.html" target="_blank">confidence</a> that the economy will do better in the future is hard to build. How can the average Joe (and it is on his spending and his investment that we really count on) be convinced that things are doing better when he sees his company in the red, his friends and associates losing money and the business environment he lives in become harsher every day? We cannot de-emphasize the importance of banks but banks are nothing more than a small part of the economy; and since lending is limited (even in the best case scenario) we cannot be just focus on them and expect everything to go better. </div>
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I've said it before: we are at the <a href="http://euronomist.blogspot.com/2014/02/european-policy-at-zlb.html" target="_blank">ZLB</a> so monetary policy is out of the question and our governments are constrained on spending making fiscal policy is not an option. All we are left with is confidence; yet, it cannot be raised if banks will not lend and make life miserable for millions across the continent. Yes, we need banks for the economy to move; but banks and the economy need businesses even more if we are ever going to see better days.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-88132410550434715032014-03-08T06:15:00.001-08:002014-03-08T06:15:13.909-08:00Policy and Self-Fulfilling Prophecies<div dir="ltr" style="text-align: left;" trbidi="on">
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I've been raging about confidence for a while now. Since any other form of stimulus is either unproductive (e.g. monetary policy due to the <a href="http://euronomist.blogspot.com/2014/02/european-policy-at-zlb.html" target="_blank">ZLB</a>) or infeasible (e.g. QE or government <a href="http://euronomist.blogspot.com/2014/02/deflation-inflation-and-expectations.html" target="_blank">spending</a>), the only way we could actually see growth in the region is via an increase in confidence, which basically means an improvement in our current expectations about the future. Simply put, if I am going to either spend or invest more, I have to know that I will continue to have a job in the near future or that the overall situation in the economy will be better than now.</div>
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The problem is that many of us (especially journalists) take a particular liking to bad news; it appears that they sell more than good ones and that is why we tend to emphasize on that (disclaimer: I may have fallen into that trap myself <a href="http://euronomist.blogspot.com/2013/03/cyprus-following-day.html" target="_blank">at times</a>). This wouldn't necessarily be hurtful to the economy if we did not live in a world where we somehow create it ourselves. In physics, bad news about a specific group of atoms would not cause all other atoms to stop obeying natural laws. In economics though, bad news about some may cause others to react badly as well.</div>
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Think for example what happens when austerity measures on the public sector are imposed: although it may be right that some workers in some countries are overpaid, lowering their wages in a recession comes at a cost. As civil servants lower consumption, the private sector sees its demand fall and reduces investment, causing unemployment to rise. Then, until we adjust to the situation, the economy moves in cycles of reduced demand and investment, causing unemployment to rise and incomes to fall. In the Eurozone, we are now experiencing the time where most of the adjustment has already taken place and even though demand is weak and investment is low, we are much better off (expectations-wise) than a year ago.</div>
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Yet, some still point out to the bad things; while, for example, the outflow of deposits from Cyprus appears to be stabilizing with the overall amount registering ups and downs in the past couple of months (compared to huge decreases before), <a href="http://cyprus-mail.com/2014/02/27/private-sector-deposits-in-cyprus-banks-tick-down-in-jan-ecb/" target="_blank">some</a> focus on the downs. The problem of over-focusing on the bad news is that it creates another cycle of uncertainty, one which, on its own, can cause more damage than policies can. You see, if I am bombarded with constant emphasis on how bad the economy is doing (it's not doing good by the way but it does certainly fare better than last year) then I will be more than skeptical to invest or spend. The cycle, as described in the previous paragraph, is indicative of what will happen when confidence falls; the issue here is that over-exposure to "bad" news means that these will turn out to be true if people believe them to be. It is the equivalent of fiat money: it works just because you trust it, nothing more and nothing less.</div>
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This kind of over-emphasis can actually derail many of the countries already in a bail-out agreement. Biased information about Greece is what made Greeks believe that they are faring worse than expected, pushing the vicious cycle of austerity deeper into the economy. Now that they are faring much better, biased <a href="http://www.zerohedge.com/news/2014-02-02/third-greek-bailout-package-finally-deck" target="_blank">information</a> and vastly exaggerated <a href="http://www.project-syndicate.org/commentary/daniel-gros-asks-why-the-greek-economy-remains-mired-in-recession" target="_blank">opinions</a> are still appearing on popular websites. While I am certainly not a fan of irrational optimism (remember I was one of the <a href="http://euronomist.blogspot.com/2012/07/cyprus-bailout-and-austerity-measures.html" target="_blank">first</a> to note that the Cypriot economy was badly in need of a rescue package in 2012 and that Spain is not really out of its <a href="http://euronomist.blogspot.com/2014/01/spains-sucess.html" target="_blank">trouble</a>) I do think that we should really think before we offer an opinion, especially if it is bound to affect millions.</div>
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The bottom line is simple: be very careful of the information you use to make decisions. Emphasis on what could go wrong never really helped anyone; and neither it will in the future </div>
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P.S. As far as forecasts are concerned here are my own (obviously biased) ones: Greece will need no more loans after 2014, but she will most probably not exit the bailout programme by year-end as the Greek PM has <a href="http://euobserver.com/news/122612" target="_blank">predicted</a>. Cyprus will have a tough year but it may actually show us some quarter-to-quarter growth in late 2014. Spain will be rather stable with a slight increase in GDP compared to last year but the big question is what will happen in Italy and whether Slovenia will opt for a bail-out. On the latter two we just wait and see.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com1tag:blogger.com,1999:blog-1814467024485189561.post-61805744142388124152014-02-28T22:30:00.000-08:002014-02-28T22:30:00.110-08:00European Policy at the ZLB<div dir="ltr" style="text-align: left;" trbidi="on">
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The zero lower bound (ZLB) has moved from a theoretical possibility in the 1980's to a <i>modus vivendi</i> in the 1990's Japan, the late 2000's US and the 2010's Eurozone. The ZLB does not mean that the interest rate is necessarily at zero, but it does mean that it has reached <a href="http://www.pieria.co.uk/articles/facts_we_should_remember" target="_blank">a low</a> beyond which it cannot fall. The problem with this situation is that monetary policy, as is commonly practiced by manipulation of the interest rate, becomes inefficient as, by definition, the interest rate cannot fall any further to accommodate for declining demand. This situation challenges policies and ideas in the economics profession as, over the last 50 years and with the prevalence of monetarism as the world's leading school of thought, economists believed that just controlling the interest rate could cure every recession possible.</div>
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It does not; the problem with the ZLB is that, just like any other activity which involves agents and forecasts, it becomes embedded in expectations. That is, if people see the interest rates not being able to fall further, they believe that the situation will be continued in the near future, which means that base their decisions on that, making the ZLB a <a href="http://en.wikipedia.org/wiki/Self-fulfilling_prophecy" target="_blank">self-fulfilling prophecy</a>. The issue here is that the ZLB does not just mean that interest rates are low; it comes with an additional problem the one of <a href="http://euronomist.blogspot.com/2014/02/deflation-inflation-and-expectations.html" target="_blank">dis-inflation</a> or, in extreme cases, the one of deflation (<a href="http://www.forbes.com/sites/francescoppola/2014/02/26/deflation-is-not-benign/" target="_blank">Frances Coppola</a> has an excellent article on why deflation is something we should worry about).</div>
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In addition, the ZLB does not come alone, but brings its friends along with it: low interest rates mean that even though most banks can they are unwilling to lend and, as if that wasn't enough, most businesses are unwilling to borrow. Even if the rates are low, people are still unwilling to spend due to the simple reason that they expect the situation to remain unchanged in the future; with spending being low and the overall money supply either contracting or just slightly increasing why should they assume the risks? This is the situation <a href="http://www.ecb.europa.eu/press/pdf/md/md1401.pdf" target="_blank">we have been experiencing</a> in the Eurozone over the past year (the large change in M1 is just an outcome of the shift from long-term deposits to overnight deposits):</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEieU3Xyj2SxizI7Tp4wxSlMPilgFCr7YDK2u9SZ4XWZZayxBpKAtAxKLe9wQQJqIKtnwO20ueKPyIvcKPlUEFt7Dy6z2dDwa9CSHNC0QAgpFDr-4ZZPCTz0wmagfP2BO1R6e7kmzfFdDzA/s1600/M3.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEieU3Xyj2SxizI7Tp4wxSlMPilgFCr7YDK2u9SZ4XWZZayxBpKAtAxKLe9wQQJqIKtnwO20ueKPyIvcKPlUEFt7Dy6z2dDwa9CSHNC0QAgpFDr-4ZZPCTz0wmagfP2BO1R6e7kmzfFdDzA/s1600/M3.jpg" height="115" width="400" /></a></div>
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The only remedy for the situation is what has been known as unconventional policies: QE, OMT and so on, yet these cannot be applied in the Eurozone <a href="http://euronomist.blogspot.com/2014/02/ecbs-omt-qe-and-why-they-wont-matter.html" target="_blank">at the moment</a>. In addition, increased government spending is a midsummer night's dream in most countries, which are tormented by bail-out agreements forcing tight budgets, meaning that it's up to the ECB: either it does something in the next meeting, by which I mean a large boost package, or the situation will remain as terrible and uncertain as it is now.</div>
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And remember, uncertainty is always worse than bad news.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-13127503285834690132014-02-25T03:01:00.001-08:002014-02-25T03:02:14.711-08:00Deflation, Inflation and Expectations<div dir="ltr" style="text-align: left;" trbidi="on">
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7LJ1Ut2caw3BBGaVqgkpeGmx76rHZrTEZiI1DuLxcIdgxqJT68HCjDSG9IzzHVhcoa_TrSrk0GN1I-njMxVphSNsJgoOlRTVbR04SNrMRi6QQo9ZWsHFn_96qGioT9Yx8PK2CXifdgYk/s1600/Inflation.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7LJ1Ut2caw3BBGaVqgkpeGmx76rHZrTEZiI1DuLxcIdgxqJT68HCjDSG9IzzHVhcoa_TrSrk0GN1I-njMxVphSNsJgoOlRTVbR04SNrMRi6QQo9ZWsHFn_96qGioT9Yx8PK2CXifdgYk/s1600/Inflation.jpg" height="157" width="400" /></a></div>
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That dis-inflationary pressures have been observed in the Eurozone over the past year is nothing new. They have been so common elsewhere in the world (for example <a href="http://coppolacomment.blogspot.com/2013/05/inflation-deflation-and-qe.html" target="_blank">Japan</a> or the <a href="http://ftalphaville.ft.com/2013/05/08/1491842/inflation-is-falling-everywhere/" target="_blank">US</a>) that news of higher inflation are now being heralded as the dawn of a new, happier era (even though some are more exaggerated than <a href="http://noahpinionblog.blogspot.com/2014/02/japanese-inflation-isnt-as-high-as-you.html" target="_blank">other</a>). Even though deflation has expanded to <a href="https://twitter.com/EZR_news/status/438258321997709312" target="_blank">other measures</a> of prices, the main focus is that we are moving towards higher inflation, with deflation no longer being an issue of concern; at least that's what the ECB <a href="http://www.reuters.com/article/2014/02/25/us-ecb-praet-idUSBREA1O0BI20140225?feedType=RSS&feedName=businessNews" target="_blank">is saying</a>.</div>
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Trouble is, almost no-one sees it the same way. Tim Hartford, for example, <a href="http://timharford.com/2014/02/low-inflation-can-be-a-disease-not-a-cure/?utm_source=dlvr.it&utm_medium=twitter" target="_blank">notes</a> that the persistence of low inflation may mean trouble for borrowers, leading to more bankruptcy risk and, God forbid, more non-performing loans to banks. In addition, what I fear most is that low inflation, just like high one, can be embedded in expectations and remain for much longer than we would normally expect, with all the known consequences. This is not just a doomsday scenario; expectations matter <a href="http://www.newyorkfed.org/research/staff_reports/sr234.html" target="_blank">much more</a> than we most of the time think when it comes to policy.</div>
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A simple example of how much expectations matter is what is usually referred to as <a href="http://en.wikipedia.org/wiki/Reflexivity_%28social_theory%29" target="_blank">reflexivity</a>, a theory that simply put, means that we are in fact creating a part of the world we are trying to forecast; a very similar notion to what has been known as the <a href="http://en.wikipedia.org/wiki/Lucas_critique" target="_blank">Lucas Critique</a> in economics. As the world of economics is not governed by the hard rules of physics, what people believe about the future will in fact affect it. In addition, the only way they can make an educated guess on the future is by viewing current events and basing their judgement on experience, meaning that in a way, the future affects the past as well (to be more precise, expectations about the future affect what we do now). </div>
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This is what has been going on at the moment: people see low inflation and have every right to expect low inflation since no measures have been taken against it (the rate cut in late 2013 was really nothing special). It can be seen in the consumer expectations:</div>
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Italy's Consumer Confidence Sales (Feb) M/M 97.5 vs. Exp. 98.5 (Prev. 98.0)<br />
— Fabrizio Goria (@FGoria) <a href="https://twitter.com/FGoria/statuses/438252284385198080">February 25, 2014</a></blockquote>
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This is led by something more than just expectations about the inflation rate. Peter Praet, (aka Captain Obvious) noted "<span id="articleText">Weak demand and high unemployment <b>could</b> also be playing a role". You don't say! This is exactly how inflation falls: lower supply of loans from banks means lower demand (for the monetarists out there this means reduced money velocity ); adding high unemployment to that equation means even lower demand. This is not a matter of what affects what; it's a matter of everything affecting everything as, whether policymakers like it or not, people are the economy. It is only if we can convince them that are going to get better that they will.</span></div>
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<span id="articleText">Here is where the ECB is wrong: people, even subconsciously, trust what you do and not what you claim. As Lech Walesa once said<i> </i>"</span><span class="st"><i>The supply of words in the world</i> <i>market is plentiful but the demand</i> is <i>falling". </i>Saying we are not in danger from deflation or dis-inflation does not change anything, unless you get people to believe it. And if they are rational (and on average they are as they can see what goes on in the real world), then they won't buy it that easily.</span></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com3tag:blogger.com,1999:blog-1814467024485189561.post-81975827806333921802014-02-21T22:30:00.000-08:002014-02-21T22:30:01.535-08:00Road Plans for Privatizations<div dir="ltr" style="text-align: left;" trbidi="on">
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Probably the most discussed issue in bail-out agreements is that state-owned organizations in the countries receiving the Troika money should be privatized. The issue was first presented in <a href="http://www.minfin.gr/portal/en/resource/contentObject/id/2f09efef-f916-4450-8236-de0606f1e12d" target="_blank">Greece</a>, where the country had to present a plan to fully privatize, among others, the state-owned post-office (ELTA) and the water and sewage (EYDAP) companies. The same has been asked for <a href="http://www.reuters.com/article/2014/02/13/us-cyprus-privatisations-government-idUSBREA1C1CZ20140213" target="_blank">Cyprus</a>, and in order to avoid a bail-out, <a href="http://online.wsj.com/news/articles/SB10001424127887324694904578601580866285870" target="_blank">Slovenia</a> is planning to privatize many of her companies in 2014.</div>
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There have been many arguments against these actions, most of them pondering about the job security of the companies' employees once they have been privatized or whether natural monopolies (such as EYDAP) should be privatized. Yet, even though these questions are obviously of great importance (especially since they both affect the welfare of the citizens), the biggest question comes when the decision for a sell-off has been made: at what price should these companies be sold off so that the state will not lose any money as a result of the distressed sale?</div>
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For example, consider the following (very simplistic) scenario: a state-owned company is currently (year 0) earning 200m per annum and is expected to earn the same ad infinitum. If the discounting rate is, say, 2.5% the price for that organization would be 8 billion (200/0.025). Yet, if the earnings are now depressed because of a recession (as is the case in most countries forced to sell-off their state-owned companies) or next year (year 1), due to increased marketing efforts or less competition increase to 230m a year, with the discount rate at 2.75% and are expected to remain at that level for years to come, then the company is worth 8.363 billion, which if brought to year 0 is 8. 16 billion, resulting in a loss of 160 million for the state (obviously depending on the amount of shares it sells).</div>
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In order to avoid this situation, the state will have to take specific measures, meaning that it should impose a clause which will entitle it to any profits over and above a threshold which will be considered as hurting state finances. For example, let's assume that the threshold is set at 4%, meaning that a fluctuation in permanent earnings under 8 million in the example of the previous paragraph, will cause no claim of funds from the state and that the state sells off 40% of the firm including management. Yet, if profits in year 1 rise to 220 million, then the discounted value is at 214 million (220/1.0275) and the excess of 6 million should be paid to the state, over and above the required dividends of the 60%.</div>
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What happens if things go bad one might ask. In the case where permanent decreases in earnings are made, then these will be offset by any future proceeds until one exceeds the other by some extent at which both are satisfied with. An additional issue which often arises is who should purchase these companies. My take is that their employees should have the first take in purchasing these shares, either directly through personal accounts or indirectly through provident/pension funds. This is mostly a sign of trust: if an organization's employees do not trust that their company is worth something, then nobody else will. In addition, these companies should be made publicly traded in the country's exchanges, allowing the markets to reflect their own valuation in the stock price, indicating whether the increase in profits has been considered as a permanent or a temporary situation.</div>
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Summing up, it is imperative to safeguard the state's interests when it comes to selling off assets. The fact that the timing of the sale occurs in a recession means that the price will be less than what it is really worth and the state will stand to lose a significant amount of money. Under the proposal described above (even though many details still have to be spelled out), the state will be sure that it leaves no money at the table, while at the same time the interests of the buyer are only harmed by little.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-18297388066805311162014-02-20T01:23:00.001-08:002014-02-20T01:23:43.285-08:00Incentives: Why Ukrainians have a just cause<div dir="ltr" style="text-align: left;" trbidi="on">
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<i>Note: One of the very few political articles written on this blog. </i></div>
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<a href="http://news.bbcimg.co.uk/media/images/73072000/jpg/_73072978_9a21a91d-3a06-495d-a91e-6af52d3906a5.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://news.bbcimg.co.uk/media/images/73072000/jpg/_73072978_9a21a91d-3a06-495d-a91e-6af52d3906a5.jpg" height="223" width="400" /></a></div>
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First of all, I have to declare that I am not in any way a political scientist and neither do I proclaim any vast knowledge on the subject. I am, as most of my regular reader know, an economist. Yet, the first thing an economist learns (or at least should learn) is that people do what they do because of incentives. There might be a spark which lights the fire, but the underlying material is already there. The same has happened with Ukraine.</div>
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Even though I do not profess to have extensive knowledge of neither the country nor the region, I can still compare the anti-austerity protests with those in the EU periphery over the past couple of years (or, in the case of Greece, since 2010). Their main distinction is that even though there was the occasional violence, which at times got very bad, this was not of the extent now witnessed in Ukraine. There have been wounded protestors, use of teargas or Molotov cocktails, yet people were not as persistent nor as willing to sacrifice their lives like the ones in Kiev.</div>
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In my mind, this only means that protestors in the periphery knew (albeit deep down) that austerity measures were "necessary", or even better that their governments were out of options (this is not to say that I am endorsing austerity, in fact the reader should know I am in the <a href="http://euronomist.blogspot.com/2013/12/new-years-change-of-mind-was-cyprus.html" target="_blank">opposite camp</a>). The demonstrations took place because people have had enough with poverty and declining living standards, yet they saw the situation as being forced to them due to the mistakes made by their own country; and here is where Ukraine is different.</div>
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When people decide to put their lives at risk and refuse to surrender when even when many of their compatriots have already been killed, the perspective is different. As already said, I do not know the reason behind the takeover of the Maidan square, but the spark was that the Ukrainian president preferred to remain under Russian influence. Yet, when the incentives to change are so strong that people are willing to give up their lives for it, it usually means that there is something wrong with the current situation. It may be corruption, it may be that the presidency feels like a dictatorship or whatever, but the reason is there; and it is strong.</div>
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In fact, the situation strongly reminds me of the<span dir="auto"> <a href="http://en.wikipedia.org/wiki/Athens_Polytechnic_uprising" target="_blank">Athens Polytechnic uprising</a> in 1973 where students decided to fight against the military junta, an effort which ended in violence when a tank forced its way into the University, much similar to what the Ukrainian authorities <a href="http://www.theguardian.com/world/2014/feb/18/ukraine-police-storm-kiev-protest-camp-live-updates" target="_blank">have done</a> in the past days. The message, is simple: when people are prepared to die for what they are fighting for, then most of the times, their cause is just. </span></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-59832497566324705762014-02-12T01:50:00.000-08:002014-02-12T01:50:09.180-08:00ECB's OMT, QE and why they won't matter<div dir="ltr" style="text-align: left;" trbidi="on">
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The biggest news on Friday was that the German Constitutional Court had passed on the examination of whether the Outright Monetary Transaction (OMT) scheme proposed by Mario Draghi in August 2012 was legal under the ECB mandate, to the European Court of Justice. This story was considered as a win by most on the pro-ECB camp, under the assumption that the ECJ would actually approve the scheme. The problem is that whether it does or not, it makes no difference. </div>
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As Frances Coppola <a href="http://coppolacomment.blogspot.co.uk/2012/08/its-currency-stupid.html" target="_blank">noted</a> at the time of the Draghi announcement (and has recently <a href="http://www.forbes.com/sites/francescoppola/2014/02/11/its-the-euro-stupid/" target="_blank">repeated</a> to all those who haven't been listening), the whole idea of the OMT is not to protect the Member-States but to protect the Euro. Even more, the OMT is best used as a threat rather than actual implementation. Market reaction to the threat was as <a href="http://euronomist.blogspot.com/2013/11/why-euro-hasnt-depreciated.html" target="_blank">predicted</a>: pressure on the euro started to decline and soon the currency was much stronger than before. Yet, as many know, in this case, the threat is stronger than anything else.<br />
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You see, even if the ECJ approves OMT, it will do nothing to ensure that the crisis ends. The main function of the scheme is to purchase bonds in countries which are paying high interest rates (and are in bail-out agreement). As of lately, no country is paying especially high rates; even Greek bonds have shown significant signs of <a href="https://twitter.com/YanniKouts/status/433192171181576192" target="_blank">decrease</a>. Thus, even if the scheme passes, no country will benefit.<br />
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Another idea, (one which I have to disgracefully admit that I thought was rather interesting before thinking it through) was a European Quantitative Easing. The problem here is how the markets that the ECB will purchase bonds from will be defined. It's easy in the US and the UK as there is just one market with sovereign bonds; what happens when you have 17 of them, each faced with its own issues? Clearly, QE is not the answer.<br />
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In order to find the correct answer, we have to make sure we are facing the right question, and the one in our case is how to stimulate demand. Forget of all the "competitiveness" and "supply liberalizations" which some think will cure everything. As stated <a href="http://www.pieria.co.uk/articles/facts_we_should_remember" target="_blank">before</a>, supply does create its own demand but not all the time; and this time it's different. The problem is that the usual stimulants, i.e. government intervention (either in increasing demand or decreasing taxation), are constrained in the bailed-out countries, and many others by their debt-to-GDP ratios and fact that they are in a currency union. The other usual way, of increased bank lending, is again constrained by either the banks' inability to lend or the peoples' <a href="http://euronomist.blogspot.com/2014/02/austerity-strikes-back.html" target="_blank">unwillingness to borrow</a>. <br />
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Thus what is left one might add, if supply won't help and banks and governments are constrained? The magic word here is confidence and expectations. As recent research has shown, expectations matter more than we usually thought; the recovery from the 1929 Great Depression was most likely driven by a shift in expectations as Eggertson (2008) <a href="http://www.econ.brown.edu/fac/gauti_eggertsson/papers/Great_Exp_AER.pdf" target="_blank">suggests</a>. So what shifts expectations is the big question?<br />
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Simply put, it's the willingness of the governing authorities (whether those be politicians or policymakers) to stick to their agenda of reforms and promote the idea that inflation will increase in the future, or <a href="http://en.wikipedia.org/wiki/Forward_guidance" target="_blank">forward guidance</a> in the central bank parlance (something that BoE's Mark Carney is famous about). The problem is that just saying so doesn't really change anything, you have to stick by what you claim and make efforts to keep them in line with peoples' expectations.<br />
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How to do that is rather simple: either the ECB should issue fresh money and channel them to the countries (most likely via the EIB) at a scale larger than ever before or boost bank lending in countries where banks are willing to lend (but are constrained) and people are willing to borrow, most likely by decreasing the ELA rate. I see no other solution to the current problems: either the banks are supported and they are allowed to lend, and more investment is brought forth directly from the EU or the shift in expectations will take much longer to manifest, just like it did in the 1930's. Trust me here, we do not want a repetition of history.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-77803701862786522972014-02-07T22:30:00.000-08:002014-02-07T22:30:01.537-08:00Austerity Strikes Back<div dir="ltr" style="text-align: left;" trbidi="on">
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The tale of the hard-working North vs the lazy South has been cited again and again during the past couple of years, mostly from Northern politicians who saw the on-going crisis as an opportunity to promote their own agendas. At the core of this "argument" was the self-assuring conviction that "we do not need them (the South), they need us". Through an array of measures mostly aimed at austerity in order for state financials to regain their vigor, the North is surprised at the increasing debt-to-GDP ratio in the short-run and is accusing some of the South for not pushing through enough reforms.</div>
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As has been explained <a href="http://euronomist.blogspot.com/2012/10/greece-will-not-make-it.html" target="_blank">before</a>, when GDP goes down, debt has to <u>decrease by much more</u> in order for the debt-to-GDP ratio to remain constant. Yet, this will obviously not be the case as the economy contracts much faster than the GDP can be reduced. In addition, when policies are based on austerity, results are usually much harsher for citizens than when they are <a href="http://euronomist.blogspot.com/2013/12/new-years-change-of-mind-was-cyprus.html" target="_blank">not</a>. Even though many have failed to see it at the time of implementation, austerity measures in the periphery also affect the North. The simple rationale behind this is that the North was (until now) basically exporting while the South was largely importing goods; the heavy reliance on each other was more than evident as in <a href="http://epp.eurostat.ec.europa.eu/cache/ITY_OFFPUB/KS-SF-12-003/EN/KS-SF-12-003-EN.PDF" target="_blank">2010</a>, no country in the Eurozone had less than a 57% share of intra-EU exports.</div>
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Yet, <a href="http://www.ft.com/intl/cms/s/0/821fbcba-41b1-11e3-b064-00144feabdc0.html#axzz2sWg5zJ2N" target="_blank">many</a> continued to think that a heavy reliance on exports was a sign of a "vibrant economy" which would lead to higher wages and higher domestic demand. The brief answer is a big fat no. You see, the issue here is that heavy reliance on exports means heavy reliance on the well-being of your neighbours; if your neighbours are poor it means that they buy much less from you than if they were rich. Simply put, reliance on exports means that if they go down, they take you down with them. </div>
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The issue is not new. Some of us have already discussed this <a href="http://www.pieria.co.uk/articles/facts_we_should_remember" target="_blank">in detail</a>, and warned that this situation cannot go on forever. We were (unfortunately for the citizens of the North which are not to blame for the mistakes of their governments) correct. The latest data show something quite startling: Retail trade in December 2013, the month which generally signals the peak in consumer spending, has decreased by 1.6%, compared to November.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-lIsqySI0zu4JELQmyPKtvlAoLw_a-P5JJRZHDZNPz2B_ZxFumia5S0dE8KY0va5FjGAM_eQaB7xo1ts0x6LVubIoZQ8-sFGpXiYF7JtWRqGx4qLenYgLC0h6vb6n_LO-ty38BDcQX1Q/s1600/trade.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-lIsqySI0zu4JELQmyPKtvlAoLw_a-P5JJRZHDZNPz2B_ZxFumia5S0dE8KY0va5FjGAM_eQaB7xo1ts0x6LVubIoZQ8-sFGpXiYF7JtWRqGx4qLenYgLC0h6vb6n_LO-ty38BDcQX1Q/s1600/trade.jpg" height="243" width="400" /></a></div>
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In monthly terms, Portugal and Spain were the leaders in the drop, although this did not come as a surprise. The "surprise" is that Germany, Austria, Belgium and Finland have also seen a sharp drop in retail spending. What is even more astonishing is that on a year-to-year basis, Germany, Belgium and Finland lead the race in the drop. As if this wasn't enough bad news, the bank de-leveraging procedure which has been going on in the periphery appears to have started in the North as well. Germany, Austria and France saw total bank loans to non-financial corporation reduced by 1%, 1.1% and 1.5% respectively, and even if this is not large compared to what happened in the periphery (and Slovenia with the extraordinary 23.8%) it is indicative of the worsening situation in the region.</div>
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<a href="http://qzprod.files.wordpress.com/2014/01/change-in-bank-loans-to-non-financial-corporations-in-euro-zone-year-to-dec-13-rate_chartbuilder.png?w=1024&h=814" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://qzprod.files.wordpress.com/2014/01/change-in-bank-loans-to-non-financial-corporations-in-euro-zone-year-to-dec-13-rate_chartbuilder.png?w=1024&h=814" height="317" width="400" /></a></div>
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As a result of de-leveraging and the decrease in spending, <a href="http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-31012014-BP/EN/2-31012014-BP-EN.PDF" target="_blank">inflation</a> in the Eurozone has dropped to 0.7% on an annual basis. Even though just <a href="http://epp.eurostat.ec.europa.eu/inflation_dashboard/#" target="_blank">4 out of 28</a> countries experience deflation, the rest are barely above 1%; only Austria is close to the ECB mandate of 2%.</div>
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North's problem can be reduced to two simple words: no demand. You see, as others also <a href="https://twitter.com/georgiemark/status/431362803299930112" target="_blank">note</a> as well, while banks are not currently in a large need for de-leveraging and are more than willing to lend their excess funds, they cannot do it in their domestic markets as people, in contrast to what most monetary authorities would suggest, are not willing to borrow even at near-zero rates. Less borrowing means less spending, or in economic terms less demand. This results in deflation, which in its turn ends up being a self-perpetuating situation (unless this is stopped as Irving Fisher <a href="http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf" target="_blank">noted</a> in 1933). As consumption comprises more than 2/3's of GDP, output falls when consumption is reduced.</div>
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The situation has begun evolving in <a href="http://www.stat.fi/til/ktkk/2013/11/ktkk_2013_11_2014-02-05_tie_001_en.html?utm_source=dlvr.it&utm_medium=twitter" target="_blank">Finland</a> where output decreased by 1.1% in November 2013 compared to the previous year, with the same thing occurring in October 2013. The 0.4% contribution to GDP growth led by net exports in the country in 2012, is unlikely to be repeated until demand in the South picks up. With the main forces of the decrease in the <a href="http://ec.europa.eu/economy_finance/eu/forecasts/2013_autumn/fi_en.pdf" target="_blank">2013 GDP</a> being domestic demand and inventories (both driven by consumption and demand) the path appears to be same as Germany where net exports are expected to take growth <a href="http://ec.europa.eu/economy_finance/eu/forecasts/2013_autumn/de_en.pdf" target="_blank">down</a> with them in 2014. Even though the country's trade balance has also <a href="https://twitter.com/FGoria/status/431689070197354497" target="_blank">fallen</a> in December, the effect of local demand, which fell by 1.6% has taken its toll in <a href="http://www.bloomberg.com/news/2014-02-06/german-factory-orders-unexpectedly-decline-on-domestic-demand.html" target="_blank">factory orders</a> in the last month of 2013.</div>
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As the gains from trade are not translated into higher domestic demand (either by credit or directly), these have to be tunneled somewhere: <a href="https://pbs.twimg.com/media/Bfx5nSmCYAElGpd.jpg:large" target="_blank">housing prices</a> in Germany have soared by at least 25% (in some cases more than 35%) since 2008. The Lehman story has taught us that housing bubbles are not a good thing; actually Deutsche should remember its experience better. With the rest of the Eurozone decreasing imports and domestic demand where does the North expect to ship that 20% of GDP in intra-Eurozone exports and how is it going to sustain the level of GDP currently obtained if domestic demand is also shrinking?</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEicjrvpmezRWpZf11VLaOTSRU1gckDythIUdD3-HoZ0ni3f4ZkSqlX3m-1dvWxuNeWhoDJFXv2INDBbfPShkPEdP4qIPZQJwvPjnPuor_rlKBJvFHpniQm6_LIHG-iA34WTfyeHtaosYEk/s1600/perce.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEicjrvpmezRWpZf11VLaOTSRU1gckDythIUdD3-HoZ0ni3f4ZkSqlX3m-1dvWxuNeWhoDJFXv2INDBbfPShkPEdP4qIPZQJwvPjnPuor_rlKBJvFHpniQm6_LIHG-iA34WTfyeHtaosYEk/s1600/perce.jpg" height="400" width="331" /></a></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-15859608884171202892014-01-31T22:30:00.000-08:002014-02-01T07:04:15.521-08:00Health and Taxes<div dir="ltr" style="text-align: left;" trbidi="on">
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One of the longest-lived debates in the world is whether it is worth having a state-funded health sector or not. Those who prefer the latter (e.g. the US), believe that it does not make sense for the state to pay for the health of its citizens because they will be more heavily burdened by tax, and a larger amount of their taxes will be spent in health, when there might be better use for their hard-earned money. The countries who favour the former though, do not believe that this is the case. Have a look at the following graph on total per capita expenditure on healthcare, obtained from <a href="http://www.oecd.org/els/health-systems/oecdhealthdata2013-frequentlyrequesteddata.htm" target="_blank">OECD data for 2011</a>(measured in dollars, PPP):</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiLuQ9LrCtJm_A_75Ft4blOSDnkorHuGzS-2DVRiftPw9g2njKBYKzWkbV5iilgu5WrBKECs89v-i7Z-Z3_3jq4qvRRDPeA4Gpi7d_poU7072JVy2lMV9CVzYKphivTIXm5y18jZaj4kDg/s1600/Graph.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiLuQ9LrCtJm_A_75Ft4blOSDnkorHuGzS-2DVRiftPw9g2njKBYKzWkbV5iilgu5WrBKECs89v-i7Z-Z3_3jq4qvRRDPeA4Gpi7d_poU7072JVy2lMV9CVzYKphivTIXm5y18jZaj4kDg/s1600/Graph.jpg" height="261" width="400" /></a></div>
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The United States appears to have the largest per capita expenditure on the health sector, nearly double of what other developed countries are spending. In addition, even though these are per capita numbers the reader should remember that these do not reflect the whole population of the country, just like they do in most European ones. The reason is that not everybody is covered by insurance in the US and thus the amounts registered are those which belong to people under insurance schemes (and some others who both have enough money and are willing to spend it to get back to health). While he above graph shows total expenditure in health, the two below show how much is spent by the private sector and how much by the public on health:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgVYoahUqhadWLVYwuT6UCMXmhXMPhq2_5vJs5d4deAjRsS7wlRgmT-Dc8ePVEOhMvaG9_Rkh4Hr2TXyhW2sbN0nNVnVSPs2dwwIEx13kFxJlO7SdjfyDUmb6hHzk-hd2J8-vu6VqbPQaE/s1600/Public.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgVYoahUqhadWLVYwuT6UCMXmhXMPhq2_5vJs5d4deAjRsS7wlRgmT-Dc8ePVEOhMvaG9_Rkh4Hr2TXyhW2sbN0nNVnVSPs2dwwIEx13kFxJlO7SdjfyDUmb6hHzk-hd2J8-vu6VqbPQaE/s1600/Public.jpg" height="261" width="400" /></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgiiHVLzVa4BsHWyXddya4gw323Tam-QCID2FPyHIWuaSVsrrr4HrAF_kpqxLuPJRusWidpunvwP5GAtdF6ivl9Cnlnq14UDQdk77tRqytP9RgWlsNahS9z6F-bMJn_PXUHsKJhYnO8dUA/s1600/Private.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgiiHVLzVa4BsHWyXddya4gw323Tam-QCID2FPyHIWuaSVsrrr4HrAF_kpqxLuPJRusWidpunvwP5GAtdF6ivl9Cnlnq14UDQdk77tRqytP9RgWlsNahS9z6F-bMJn_PXUHsKJhYnO8dUA/s1600/Private.jpg" height="261" width="400" /></a></div>
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In the public expenditure, the US only lags behind Norway and Netherlands (where 85% of health expenditure is by the public sector), but in the private health expenditure it surpasses its closest country (Switzerland) by more than 2.5 times, leading again to higher overall spending on health. The questions here are two:</div>
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1. Why is spending so high in the US?</div>
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2. How much extra taxes would it take to cover everyone?</div>
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The first question is rather easy, although at times it appears to elude most of the proponents of the private-funded health system. Imagine now that you have an insurance policy under a certain company and you get sick. The doctor (and the hospital in general) who examines you, knows whether you have insurance or not. The problem here is that almost any amount the hospital asks, the insurance company is willing to pay (obviously up to some specific amount over which the insurance company
will deny to pay as it will consider it to be very large). This is
actually profit-maximizing behaviour from the part of the healthcare
providers, meaning that nobody could actually condemn the hospital for
acting this way under the circumstances. Thus, they ask for higher prices than they possibly could had there been no insurance cover for everyone since its not the consumer who will pay the money (he does, indirectly though). How about those who do not have cover you might ask? Well, the hospital is "forced" to charge the same price for them as well, for the simple reason that if they charged them less then those who had cover might find it more profitable to lose cover, save the premium, and then pay the lower price at the hospital. </div>
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What's present here is free market with many frictions which are actually not allowing it to function smoothly. Insurance companies are distorting incentives and "forcing" hospitals to increase their fees, thus increasing the overall cost. When hospitals are public and healthcare is free, then prices in the private sector also fall. The reason is again simple: there exists a competitor and the competitor is a perfect substitute. For example, an oncologist working having a private practice would face the direct competition of a colleague working in the public sector. The two services are almost inseparable, meaning that the patient is indifferent as to who gets him better (so long as he gets better). Yet, if his competition is not charging anything, the only way for the private MD to charge high amounts of money is to make sure that he is providing a higher quality of service. Yet, the charge is somewhat capped: he cannot ask for as much as he wants, since everyone will shift to the public sector if he does. As you may easily see here, it is an issue of paying for extra quality; quality which is not debatable as people would not be paying all that money for a private doctor if he wasn't worth it (For those who do not think that this price change really happens have a look at this interesting <a href="http://www.nytimes.com/2013/08/04/health/for-medical-tourists-simple-math.html?_r=0" target="_blank">article</a> from the NYT comparing prices in the US and Belgium).</div>
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Moving on to the question on how much it would cost the US to move to state-funded healthcare, the answer is that it wouldn't cost as much as most people think. Let's say that it ends ups costing 20% more than it does to Norway (even though this is a hugely inflated amount), at $6802 per person. Then, deduct the amount already spent on healthcare by the state, currently at $4066, leaving us with $2736 per person. That's too much taxation a person might add. Is it really? Every person in the US spent $4441 on healthcare in 2011, i.e. more than 60% than the $2736 of taxation in the extreme case. </div>
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Readers might wonder how the reduction in cost will occur if the US shifts from private healthcare to public healthcare. As already mentioned this is simple supply and demand, with competition forcing prices down. At the moment, hospitals are acting like cartels, meaning that they have a strong incentive to hold prices up and nobody is willing to leave that situation. If more hospitals are funded by the state, then competition in prices is increased, forcing prices down. There will be some variation in prices, obviously; yet, this will reflect differences in the quality of healthcare or other local factors (e.g. higher prices in New York than Nebraska). Even more, the consumer will be more assured that higher prices actually mean higher quality.</div>
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If the case is so simple then why aren't things changing in the US? The answer is two-fold: first there are those whose interests are being hurt (doctors, private hospitals, insurance companies) and do not wish for the situation to change. Second, people do not enjoy change. The reason is that we learn to adjust to the current situation, whatever that might be, and we are afraid to change, even if it is for the better. All it takes in most of the times is a shift in mentality; not an easy task though.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com49tag:blogger.com,1999:blog-1814467024485189561.post-84151969587695446162014-01-29T23:42:00.002-08:002014-01-29T23:42:12.317-08:00Assumptions in Empirical Economics<div dir="ltr" style="text-align: left;" trbidi="on">
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When a theorist in
economics first presents a model to others, the first thing he usually presents
or the first question usually asked by those who are attending his presentation
concerns the assumptions made when formulating the model. The rationale behind
that is straightforward: the assumptions one makes are the building blocks of
the model. If they are solid and make sense, then we can trust the outcome more
than if they are based on something cooked up in the researcher's mind. </div>
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A simple example
showing the importance of assumptions is the following:</div>
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Suppose that I want
to show that in an economy where only beef and cheese are produced, the
production of cheese is economically disastrous. Then, assuming a utility
function (a measure of how happy I am by consuming) of U=(Consumption of Beef -
Consumption of Cheese)^(1/γ) I could use some derivations to show that cheese
will not be good. Why? Because, as the reader may observe in the utility
function, cheese consumption lowers my potential happiness. Thus, the only way
for me to be "happier" is not to consume any cheese at all. By
imposing an unrealistic assumption (even if this might hold for a very small
percentage of the population) I can prove practically anything.</div>
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Obviously,
economists are smarter than this and thus try to avoid such issues. Even more
commonly, they just try to mask the lack of a coherent relation between the
world and what they assume by imposing more elaborate assumptions, such as the
ones Paul Pfleiderer <a href="http://www.gsb.stanford.edu/sites/default/files/research/documents/farfe%20panel%20pfleiderer.pdf">shows</a> in his deconstruction of some
peer-reviewed papers. A notable example is one where "the intermediary can
threaten not to contribute his specific collection skills and thereby capture a
rent from investors". This might sound a bit appealing: if I can threaten
to stop being the middle man and they cannot do it on their own, then I can get
people to pay me for doing it. </div>
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Read the rest on <a href="http://www.pieria.co.uk/articles/assumptions_in_empirical_economics" target="_blank">Pieria</a></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0tag:blogger.com,1999:blog-1814467024485189561.post-5728298567905316222014-01-24T22:30:00.000-08:002014-01-24T22:30:01.558-08:00What Secular Stagnation?<div dir="ltr" style="text-align: left;" trbidi="on">
<i>Note: this is probably the shortest post I've ever written</i><br />
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According to Larry Summers, <a href="http://www.economist.com/blogs/freeexchange/2014/01/secular-stagnation-1" target="_blank">secular stagnation</a> is supposed to be reflected in the continuous decrease of bond yields since the early 1980's (the increase before can be explained in a simple way-inflation):</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOYhwD3E_uo61k-8sMVB5AQ1XJxwTOGIrarfrNQOnEXOciX7cg61bPHcJeI8YlwiA9aclPXEhbM7TlKrhi6bUklfLt4_yCWi_B3pSGh_2Pt7Uun5ihT9uov8DDoE8dEqj4G-5anH4GcVM/s1600/10-year+Gov+Bond+Yields.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOYhwD3E_uo61k-8sMVB5AQ1XJxwTOGIrarfrNQOnEXOciX7cg61bPHcJeI8YlwiA9aclPXEhbM7TlKrhi6bUklfLt4_yCWi_B3pSGh_2Pt7Uun5ihT9uov8DDoE8dEqj4G-5anH4GcVM/s1600/10-year+Gov+Bond+Yields.png" height="240" width="400" /></a></div>
Yet, we usually forge to have a look at these:<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMhhxPk-F_Qar5EqMWpSCAjw9mh2DPTa-qAfWu-ZeeYifwGZA6oEoyk6xhsjAoiys8G064AlOEkjvYziKha36gCDRMg1oDPiGjU9-NXiiIT5VPJexe4PXA1kheVlVEO9E59oIGfDZ43zc/s1600/Pension+Plan+Assets.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMhhxPk-F_Qar5EqMWpSCAjw9mh2DPTa-qAfWu-ZeeYifwGZA6oEoyk6xhsjAoiys8G064AlOEkjvYziKha36gCDRMg1oDPiGjU9-NXiiIT5VPJexe4PXA1kheVlVEO9E59oIGfDZ43zc/s1600/Pension+Plan+Assets.jpg" height="268" width="400" /></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgg2SNN9UcRib0Cu8G3gCQY8b_DSkh6daXLdMODhXeS8g8c1qcs2AdjSxauOVCaUHQfoY13okcTWrzb23QqzUHyOPdNN69H-z3VdV9RmjucyLysreO9cb_Pm4zWMiO4KnUt8gTnL7WoFZ8/s1600/Loans+and+Leases.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgg2SNN9UcRib0Cu8G3gCQY8b_DSkh6daXLdMODhXeS8g8c1qcs2AdjSxauOVCaUHQfoY13okcTWrzb23QqzUHyOPdNN69H-z3VdV9RmjucyLysreO9cb_Pm4zWMiO4KnUt8gTnL7WoFZ8/s1600/Loans+and+Leases.png" height="240" width="400" /></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEir-5P7d9nzJQWhwyApaK2-ST3g5guiStaJMV7N4Wn1PJKzqaYuarA0DdPHzgEpEXU4P8SL-3kMlOYnIohxx3mxWR5RANdl_PalwK1_QfCSHVOeyDmL1s1MqHPm1yZl6UXPOhNDiZSVUac/s1600/Bank+Capital+to+Total+Assets.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEir-5P7d9nzJQWhwyApaK2-ST3g5guiStaJMV7N4Wn1PJKzqaYuarA0DdPHzgEpEXU4P8SL-3kMlOYnIohxx3mxWR5RANdl_PalwK1_QfCSHVOeyDmL1s1MqHPm1yZl6UXPOhNDiZSVUac/s1600/Bank+Capital+to+Total+Assets.png" height="240" width="400" /></a></div>
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Now remember where bank capital and most of the funds of the pension funds industry are (most times forced by legislation) invested: Bonds. I'd also like to remind some of the supply and demand premise in economics: when supply of funds increases then price increases and thus the yield decreases. And we are on a continuous search for safe assets to invest in. As the safest of all are government bonds (explained <a href="http://euronomist.blogspot.com/2013/06/do-deficits-matter.html" target="_blank">here</a>) the increase in life expectancy has forced pension funds to invest more and more assets in the bond market (for a more detailed view of pension systems and population read <a href="http://euronomist.blogspot.com/2013/11/pension-systems-in-declining-populations.html" target="_blank">this</a>).</div>
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Concluding, I do not believe that stagnation can be inferred from bond yields. Declining returns just mean that the supply of funds for bonds has been stronger than demand and this is what's driving yields down. Now if that can affect the economy is a different story (one which I do not really trust to be honest since the US has been growing steadily since the 1980's), yet it does not indicate stagnation on its own. It just shows that when times are bad, people come up with a lot of explanations about what's at fault. But then again, I might be wrong and <a href="http://www.washingtonpost.com/blogs/wonkblog/wp/2014/01/14/larry-summers-on-why-the-economy-is-broken-and-how-to-fix-it/" target="_blank">Summers</a> could be right; time will tell.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com1tag:blogger.com,1999:blog-1814467024485189561.post-11488496842899548642014-01-21T00:08:00.003-08:002014-01-21T00:08:59.725-08:00Facts we should remember<div dir="ltr" style="text-align: left;" trbidi="on">
Joint post with <a href="http://coppolacomment.blogspot.com/" target="_blank">Frances Coppola</a><br />
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There are some things which are obvious to many people. There are others
which need constant reminder, even though they are perhaps more significant
than the more obvious. In both cases though, remembering is important: it
allows us to understand how things work, and when they do not work it allows us
to understand how to fix them. Yet, the caveat here is that nothing works all
the time; there is no panacea and we have to re-examine whether our
understanding fits what we are trying to resolve. Here are some of the facts we
should remember.</div>
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<b>1. The Zero Lower Bound (ZLB) does not mean rates are necessarily zero</b></div>
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As <a href="http://www.pieria.co.uk/articles/can_labour_markets_be_too_flexible" rel="nofollow" target="_blank">Frances
Coppola</a> stated, the point of the ZLB is not that the interest rate is very
close to zero. It’s the fact that actual interest rates for some reason cannot
fall further even though the equilibrium rate of interest is <a href="http://www.jstor.org/discover/10.2307/591?uid=2&uid=4&sid=21103230357921" rel="nofollow" target="_blank">lower</a>.
This renders monetary policy ineffective. In the ZLB theory, the assumption is that the
existence of physical cash means that interest rates cannot fall much below
zero, since people will start to hoard physical cash to avoid the negative
rates. But in the Eurozone, the same effect occurs even though real rates are
much higher. </div>
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Read the rest on <a href="http://www.pieria.co.uk/articles/facts_we_should_remember" target="_blank">Pieria </a></div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com1tag:blogger.com,1999:blog-1814467024485189561.post-75027844749464364212014-01-17T22:00:00.000-08:002014-01-17T22:00:02.431-08:00CEO compensation and Worker Job Security<div dir="ltr" style="text-align: left;" trbidi="on">
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That CEO's are earning big money is nothing we didn't know about. Yet, the size of their paychecks is at times enough to make those who are not earning 6-figure salaries furious. In the <a href="http://www.businessinsider.com/15-highest-paid-ceos-in-america-2013-10?op=1" target="_blank">list</a> of the top 15 earners for 2013, the lowest CEO compensation is at $36 million. It is true that their earnings fluctuate with the earnings and general performance of their firms. In fact, they have done a wonderful job tracking the S&P 500 especially since the 1990's:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhYMII5LUIHIQdXcPaG4EqI107GrpFfpFa5arfwrKCXpAB47VEcZzeNy44ncjqXn3pJnywITSd-wMfQmBEIivkGc7N4fHn1Z_09xgULWTICun8YfGU8_ooY9YLsJobceXOuKY93CWZorx0/s1600/Compensation+and+SP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhYMII5LUIHIQdXcPaG4EqI107GrpFfpFa5arfwrKCXpAB47VEcZzeNy44ncjqXn3pJnywITSd-wMfQmBEIivkGc7N4fHn1Z_09xgULWTICun8YfGU8_ooY9YLsJobceXOuKY93CWZorx0/s400/Compensation+and+SP.jpg" height="276" width="400" /></a></div>
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As the reader may observe, CEO compensation was not following stock market development right from the start. In fact, for the first 10-15 years since the 1960's, the upward trend in compensation was not an outcome of a strong stock market; the S&P was on a long downwards trend during that time. Yet, in modern times, CEO's more than made up for their losses. In 1978, the CEO-pay-to-worker ratio was 26.5-to-1; in 1995 it went to 136.8-to-1 and in 2012 it was 202.3 times the typical worker's salary as the <a href="http://www.epi.org/publication/ceo-pay-2012-extraordinarily-high/" target="_blank">EPI</a> reports (the peak of this ratio was in 2000 when it reached 411.3-to-1).<br />
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The difference is astonishing. Most of us would (rightly) think that we have overemphasized the importance of a CEO: she/he may be worth a lot and have much more worries than the average worker, but try working a day without him and another without 200 typical employees and see which is more important for the firm. Still, what is more interesting is not that, since the 2000 peak, the ratio of CEO pay to average worker has decreased, but the timing and reason behind that. For example, look at the following table from the same publication:<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJTdXcVh3XyFl8FDjL4DL1wX-0ymC09sJWI-B6E4OykhZ8idN3Z-xy-b4vo4yvoxWEmCDjgu1QsYSCbDJgTF9TxUI6PN7RBr4co7aH1hAqkjuj_aiCBuNcFW2Jj6AqCljkNKjSqh0d9eo/s1600/Table.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJTdXcVh3XyFl8FDjL4DL1wX-0ymC09sJWI-B6E4OykhZ8idN3Z-xy-b4vo4yvoxWEmCDjgu1QsYSCbDJgTF9TxUI6PN7RBr4co7aH1hAqkjuj_aiCBuNcFW2Jj6AqCljkNKjSqh0d9eo/s400/Table.jpg" height="213" width="400" /></a></div>
Note the two highlighted numbers: CEO compensation has actually decreased in 2011-2012, by approximately 7.1% while the decrease for workers has been a much lower 0.6%; the ratio of earnings during that period narrowed by about 6%. The problem here is worker wages are also falling during a crisis. Thus, even though CEO compensation is falling, the fall is reduced from the worker wage reduction (this is the same as debt-to-GDP ratio analysis where if GDP falls even when debt falls the ratio may remain unchanged). This isn't just the case for the US mind you; the same gap (albeit not so exacerbated) also exists in <a href="http://economia.elpais.com/economia/2014/01/14/actualidad/1389697075_511493.html" target="_blank">Spain</a> (where higher salaries continued to grow through the crisis, with 2009 being the only exception) and most likely every other EU nation. As the article on Spain notes, there are two possible explanations: either CEO salaries were the first to go down so the first to go up, or firms are focusing on people who, in their opinion are bringing the greatest value in the organization.<br />
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Defendants of CEO pay might argue that since their compensation varies widely through time, indicating more risk, it makes sense that these people get more money in return. Yet, when there is mostly an upwards trend, a few points indicating a decrease hardly matter. In fact, <a href="http://stevereads.com/papers_to_read/executive_compensation_and_corporate_governance_in_the_u.s._perceptions_facts_and_challenges.pdf" target="_blank">Kaplan</a> notes that the historical average of CEO compensation is in the mid 1990's: the figure for 1995 is 6,303 and the ratio at 141.1-to-1. Thus, even though CEO compensation has been falling since 2000 the fact remains that at its peak it was much higher than expected. Just like the dot-coms at the time, it was a bubble itself.<br />
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A more important point is that their compensation, although decreased at times of recession (contemporaneously as the data show; see 2007-2009), the value of their money was not reduced by as much, given the <a href="http://www.tradingeconomics.com/charts/united-states-inflation-cpi.png?s=cpi+yoy&d1=20050101&d2=20141231">deflationary pressures</a> of the time. Yet, the defendant might comment that worker wages increased during that time. This is the most interesting part of the analysis: it appears that, in 2007-2010, worker wage was increasing (a total increase of 5.6%), while CEO compensation fell by 11.8%. In contrast to what many might believe, it appears that worker compensation declines only long after the event, indicating that wages are sticky (for details see <a href="http://euronomist.blogspot.com/2013/09/what-have-we-learned-from-crisis-so-far.html">this</a>). The bad part here is that unemployment isn't.<br />
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In fact, <a href="http://www.tradingeconomics.com/charts/united-states-unemployment-rate.png?s=usurtot&d1=20040101&d2=20111231">unemployment</a> in the US soared to 10% from less than 5.5%, in 2008-2010. It was only after unemployment peaked, at the start of 2010, that firms decreased wages. This brings out a more important topic: that after all, worker wage is not only volatile, but workers also face the extra uncertainty of becoming unemployed. For the CEO's higher pay means that the cost of being replaced is accommodated, as is the cost of higher volatility. The problem is that the cost of being replaced isn't covered by the wage increases of the average worker.<br />
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This doesn't just happen in the US though; it is also the case in <a href="http://www.tradingeconomics.com/charts/spain-wages.png?s=spainwag&d1=20110101&d2=20131231">Spain</a>, and <a href="http://euronomist.blogspot.com/2013/09/what-have-we-learned-from-crisis-so-far.html">Greece</a> and other countries. The point is that we compensate CEO's for the higher risk of getting fired or higher volatility in earnings. Still, the wages they earn are sufficient enough for their children to live in luxury. The average worker not only does not earn that much, but also faces the increased probability of being fired at a time when it is most difficult to encounter another occupation, just because of wage stickiness.<br />
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What we have been arguing basically reduces to one of two options: either we start thinking that we are overpaying CEOs or that we are underpaying workers. I'll leave it up to you to decide. But if you ask me, lowering the ratio to the early 1990's levels would be much better.</div>
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Euronomisthttp://www.blogger.com/profile/09172739717345263308noreply@blogger.com0