Wednesday, March 23, 2011

Is Industrial Policy a good idea?

Industrial Policy is back—or so Dani Rodrik proclaims. Several European countries openly advocate the government promotion of particular industries, while the World Bank’s chief economist now supports industrial policy for developing economies. America, too, is flirting with increased government intervention in firms, through various green initiatives.
Yet the debate over industrial policy remains simplistic. Advocates frequently point to countries that support industrial policy—such as China or France—and observe that these countries are rich or growing. Industrial Policy is presumed to be the cause of their growth, and it is pronounced a success.

There are many problems with this analysis. As William Easterly notes, it is important to get the comparison right. France might be doing even better if its firms had less state interference. A better analysis would examine all countries that try industrial policy—including the failures—and examine their relative success.

There are also a variety of non-GDP related costs associated with Industrial Policy that are difficult to nail down. To see this clearly: take the contrasting story of cell phones in India and China.

In India, the telecommunication sector shows the success of privatization. As long as a state-run firm handled phones, few people had landline access. Auctions of telecom licenses led to this huge burst of investment and innovation. The so-called “Indian Model,” that resulted delivered the world’s lowest cell phone prices and the mass adoption of cell phone services.
By contrast, China’s telecom policy has been based on the idea of getting state control over the commanding heights of telecommunications. Companies like China Mobile dominate cell phone services, while companies like Huawei are growing giants in telecom hardware. Judged from a pure economic standpoint, this type of state control is compatible with high rates of economic growth. These state-sponsored companies are also highly profitable.

But state control comes at a cost. China has higher cell phone rates, and texting is more popular partially as a result. International corporate acquisitions are also affected. India’s Bharti—a top private mobile operator—has purchased Zain, another private African mobile operator. Bharti plans on exporting its low-cost outsourcing model there, potentially revolutionizing African telecoms. State strategic interests, on the other hand, motivate China’s acquisitions. India’s competitive environment may be better geared towards generating internationally competitive firms.

The hidden costs of industrial policy may not show up on a simple economic ledger. But they are real nonetheless. If the past few years have shown private industry at its worst—think AIG or BP—it’s not clear that injecting more government control would produce better results.

Sunday, March 20, 2011

Bankruptcy Reform and Financial Crises

Mike Konczal has a fascinating idea that he expands in an interview: that the 2005 bankruptcy reform may have contributed to the severity of the financial crisis. The idea is that a change in the law expanded exemptions for derivatives during bankruptcy proceedings. This allowed derivative counterparties to end contracts and seize collateral as soon as bankruptcy was filed, moving to the head of the line among creditors.

There were several problems with this. First, this created incentives to restructure normal contracts, such as agreements to supply fuel to an airline company, in the form of swaps or derivatives. This was a win-win for creditors and debtors. Creditors were assured easy contract termination, even if the firm entered bankruptcy. Debtors were not generally required to post collateral for their contracts, allowing them to operate with a leaner capital structure.

Second, these rules expanded to define mortgage-backed securities as repos for the purposes of the safe harbor. This was potentially a huge change. Gary Gorton has argued that the demand for short-term securities, fulfilled by mortgage-backed securities, was fueled by the demand for information-insensitive, safe assets. Andrei Shleifer has suggested that these sorts of new, exotic securities were mispriced. While both of these may be a part of the story; there is another interpretation. The surge in securitization can be seen as a form of regulatory arbitrage designed to create short-term funding that would hold up in bankruptcy court. Without the penalty of potentially losing assets during bankruptcy, lenders were more willing to provide short-term funding to over-levered Investment Banks.

As Mike’s interlocutor points out: for non-bank institutions, this change was not the end of the world. Quick liquidation of existing contracts is akin to the Chapter 7 process (rather than the lengthy reorganization of Chapter 11). There are often advantages to slowing down the bankruptcy process, but small firms can be liquidated in an orderly manner.

The same is not true for banks. The special treatment of repos and derivatives in bankruptcy resulted in early termination and seizure of contracts by bank counterparties during moments of crisis or bankruptcy. The going-value of a bank—the excess value they have above and beyond the market value of its assets—is crucially dependent on its solvency and liquidity. Illiquid banks, by virtue of their leverage, are forced to sell their assets at fire sales, which can lower prices, which can lower the value of their assets further in a destructive spiral. Ensuring that certain forms of short-term funding and derivatives went to the front of the line in the Lehman case all but ensured that its bankruptcy would be a disaster.

The unintended systemic consequence of this treatment of bankruptcy was illustrated once before, during the failure of Long Term Capital Management. Intervention by the Federal Reserve happened precisely because regulators were worried that the failure of LTCM would cause a disorderly liquidation; a liquidation that would be worse exactly because derivative contracts could be terminated early.

As Mark Roe points out, the exemption that derivatives and repos enjoyed also warped their incentives to monitor the risk-taking going on at Investment Banks. The rule also possibly artificially increased the amount willing to be lent to banks, and gave them lower borrowing costs.

All of this points to a need to reform the bankruptcy code in order to treat derivatives on par with other claims. While legislative and popular pressure has focused on derivatives as being inherently bad, it would be better to fix legislation that encourages the over-use of derivative contracts and risk-taking; rather than leaving these elements in place, and hoping that other regulatory fixes elsewhere would solve the problem.

Revisionism on Deposit Insurance

One of my personal pet peeves is the existence of Federal Deposit Insurance. Arnold Kling well characterizes the point of view I believe ("revisionist") against the standard position:
The standard view is that banking in a free market is inherently fragile, which makes deposit insurance necessary. In fact, some would argue that the concept of insurance needs to be extended to the so-called "shadow banking system." I think of Perry Mehrling and Gary Gorton as being in that camp.

The revisionist view is that deposit insurance is a case of the government concocting a solution to a problem that was created by government in the first place. That is, the U.S. banking system was unstable due to regulations that promoted small, local banks and inhibited the creation of diversified nationwide banks. Had banks been allowed to branch across state lines or had national bank holding companies been allowed to grow naturally, then (according to this argument) we would have seen few bank failures, even in the 1930's. Hence, there would be no need for deposit insurance.
There are several good reasons to argue against the traditional view that banking is naturally risky and therefore requires deposit insurance:

1. Maturity Mismatching is unnecessary. Japan, for instance, has historically adopted the view that lending of a certain type and duration should be matched with a liability similarly constructed. So instead of using flighty deposits to fund long-term projects, your deposits are funneled into assets with low risks and returns. Without crossing maturity lengths, the possibility of a bank run gets a lot smaller.

2. Absurd populist demands of the 19th century limited the number of branches a given bank could open. That resulted in a very geographically fragmented banking system prone to crisis every time agricultural yields fell in a given area. As a result, banks failed often and the entire business cycle was highly volatile.

Canada illustrates that the problem was exactly those banking restrictions, not banking in general. Canada's banking laws were far more permissive in terms of where banks could open branches, and the country developed a highly concentrated, well-regulated system of banks. By drawing on the deposits of an entire country, tiny shocks were not enough to force bank failure. In fact, the country barely experienced bank failures, and never saw banking panics -- even during the Great Depression. They did not even bother instituting deposit insurance until 1967. Canadian banks again outperformed American ones in the most recent crisis.

3. The past experience of deposit insurance before the 1930s was mixed. As Amar Bhide notes in A Call for Judgement, many of the state deposit plans performed quite badly through the Great Depression, frequently proving insufficient to cover all losses. The Indiana plan worked best by making other bank branches jointly responsible for the failure of a given bank. The national clearinghouse model also provided another vehicle for banks to collectively guarantee their deposits and prevent a panic, without requiring insurance. This sort of collective monitoring was not followed by other state plans, which performed poorly in sheltering depositors from bearing bank losses. Rather, by pushing some of costs of risky lending onto another party, they may have further encouraged bad lending and hastened banking crises.

The eventual adoption of FDIC insurance during the Great Depression drew on the disastrous experience of the standard issue insurance plans, as opposed to the successful mutual responsibility plans. It was was opposed by several interests -- including big banks, FDR, and the Treasury. Many of these actors were concerned by the poor performance of state insurance plans. However, federal insurance had the benefit of further entrenching the power of small banks, which would otherwise be a competitive disadvantage relative to their larger banking peers. We adopted the FDIC not as a part of a well-thought out plan to stem banking problems based on past evidence; but rather to satisfy the small bank lobby responsible for banking fragility in the first place.

4. The moral hazard aspects of deposit insurance have been tested internationally, and the results are fairly negative. A study by Aslι Demirgüç-Kunt and Edward J. Kane finds that countries with the highest coverage levels of deposit insurance are five times as likely to have a financial crisis as countries with low coverage limits. Better institutional quality (presumably leading to more prudential regulation) reduces the moral hazard caused by deposit insurance, but not entirely.

5. It's not clear that a banking crisis from one firm necessarily spreads to other, healthy, banks. The key test for this was the Great Depression, and my understanding is that studies point both ways on this.

At this point, FDIC insurance seems here to stay -- though it's worth pursuing policies to limit the amount of money covered by the insurance (say, at $100,000 per taxpayer, rather than $100,000 at each bank you have money at) or increasing bank co-insurance plans.

But this debate remains very relevant in thinking through the Shadow Banking crisis. One school of thought, best represented by Gary Gorton, feels that the problem there is similar to the issue in normal banking, and the solution lies in making repos -- the equivalent of deposits for Shadow Banks -- effectively riskless. Rather, the perspective above would point out the flaws in maturity mismatching generally, and would push against the institutional aspects of banking that make it more fragile by hiding risks and promoting moral hazard -- for instance, skewed salaries, the end of the partnership structure, and the bankruptcy treatment of derivatives.

Monday, March 14, 2011

Prometheus and Education

Via Sanjoy Mahojan's excellent TED(ish) talk, here is a good quote:
The goal [of teaching] should be, not to implant in the student's mind every fact that the teacher knows now; but rather to implant a way of thinking that will enable the student, in the future, to learn in one year what the teacher learned in two years. Only in that way can we continue to advance from one generation to the next.
-Edwin T Jaynes
Yet this is a goal that's completely absent from any education reform movement of any flavor. Generally, the reformers try to change some aspect of schools or teachers in order to improve proficiency levels variously measured, ie smaller class sizes or merit pay.

What the quote illustrates is a broader point about education: that the process by which we teach must become efficient in time as we gain knowledge, or else our ability to advance the frontier of education necessarily slows down. Otherwise, people will take so long to advance to the frontier of knowledge that they have less time for active discovery, resulting in a Great Stagnation in research.

These teaching efficiencies have somehow happened anyway, at least in the math/science areas, without us being too aware of it. Calculus is now routinely taught in High Schools, while it was once at the frontier of knowledge. I'm not sure what advances in math education have allowed that to happen, but certainly students are being exposed to "deeper" knowledge at younger and younger ages.

I think this points to the importance of figuring out how to develop meta-cognitive tools that allow people to learn more in less time. ie, improvements in teaching pedagogy that really focus on reducing the actual time involved to learn a skill. I think this particular goal -- which aims for a steady reduction in the age at which students master given skills -- isn't really on the radar for any particular group, but it should be.

There are a couple of other creative ways to get at this idea. We can try more tracking-based systems, so children have more time to focus on learning in a particular direction. We can extend the hours that children spent learning, perhaps by using video games. Alternatively, we should be actively pruning the set of things taught in school as various forms of knowledge become less useful. Geometry and trigonometry seem to be widely taught, yet this is due largely to the importance of those tools to practical engineering applications in the 19th century, as well as reflecting the legacy of a particular mathematical tradition dating back to Euclid and beyond. Seems to me they ought be pruned to make way for mathematical tools of greater practical importance today, like statistics or street fighting math. In general, we should focus away from empirical facts (which are growing like kudzu) towards general reasoning; and in particular innovations that allow for rapid growth in the rate of general reasoning skills.

Thursday, March 10, 2011

The Savings Glut

I've ran into a few papers reinforcing the tie between global flows of capital, US monetary policy, and the financial crisis:

- This VoxEU article by Filipa Sa, Pascal Tobin, and Tomasz Wieladek argues that capital inflows, low interest rates, and a greater degree of domestic securitization were all linked to greater housing appreciation.

-Courtesy of David Beckworth, this paper by Rudiger Ahrend argues that persistently low interest rates are associated with larger rises in asset prices.

-Also by Beckworth, this paper by Thierry Bracke and Michael Fidora argues that monetary shocks, or liquidity, explain trends in global financial flows.

All in all, this seems increasingly damning for the Fed. Even if one accepts their excuse that foreign capital flows explain the whole issue, and that foreign preferences for savings and investment explain those flows -- that still would argue for some sort of action to curb capital flows.

Scott Winship and Inequality

Scott Winship has a new post on inequality, arguing that the rising income share of the top 1% are replicated across a host of countries, suggesting that similar trends are driving growing inequality. This takes on arguments that, say, the demise of American unions is driving up incomes for the rich. If instead top earners are making more throughout the world, it seems more likely that some common technological or economic trend is driving that result. Here's his basic chart behind the idea:

This graph measures the share of income held by the top 1%, and the solid black line is America -- which is moving on trend with other countries.

This chart makes the following "correction" -- it assumes that the rise in reported American income after 1986 can be attributed to the 1986 Tax Reform Act, which sharply reduced marginal tax rates, and resulted in a sharp rise in self-reported income. Winship wants to interpret this result as a permanent shift in reported income. However, if you look between ~1983-1998, it looks like a fairly clean linear trend, with a temporary spike around 1986. There is also a small drop in reported labor income to evade the 1993 tax hike. It's possible that the 1986 tax reform only resulted in a transitory rise in reported income; certainly this is the argument in Piketty and Saez, where the US data comes from. Without that correction, the US becomes a slight outlier in terms of top income share.

Regardless, this data seem to support the idea that dynamics are very different within the Anglosphere and elsewhere. Canada, America, the UK, and Ireland all saw a sharply rising share of top 1% income in the past few decades. Countries like France, Germany, Sweden, and Japan also saw rising inequality, though not to the same degree. This points to winner-take-all dynamics operating within the large linguistic zone of English-speakers, as top talent moves smoothly between these countries. It's also notable that several of these countries have seen seen a comparatively greater role of Finance in recent years. From a paper by Reshef and Philippon:

It's telling that the drop and rise in relative wages in Finance mirrors the experience of top income inequality for the US as a whole. It's interesting to think through why the presence of the financial sector would alter income distributions for whole economies around the world. One explanation is that the role of leverage and arbitrage allows a select group of highly-skilled managers to concentrate a far greater share of income. Another possibility is that this reflects the role of opaque markets, information asymmetry, or some broader mispricing that is penalizing the real economy.

Another set of arguments this take on are those (ie, like that by Rajan) that argue for a causal role of income inequality in fueling the recent financial crisis. If instead inequality was broadly rising around the world, it becomes a more complicated story why the crisis began here.

Monday, March 7, 2011

Teacher Incentives Don't Work

From Roland Fryer's new paper:

Financial incentives for teachers to increase student performance is an increasingly popular education policy around the world. This paper describes a school-based randomized trial in over two-hundred New York City public schools designed to better understand the impact of teacher incentives on student achievement. I find no evidence that teacher incentives increase student performance, attendance, or graduation, nor do I find any evidence that the incentives change student or teacher behavior. If anything, teacher incentives may decrease student achievement, especially in larger schools. The paper concludes with a speculative discussion of theories that may explain these stark results.
There really don't seem to be very many scalable ways to boost student performance at this point. Smaller class sizes or schools, early childhood education, even some school choice measures; all don't seem to improve test scores in a systematic way. Add to that now merit pay -- which, if anything, reduces scores.

If anything, this points to the edu-nihilist point that what goes in classrooms doesn't seem to impact what children know very much. Perhaps peer effects or family background are more important, or else variation across teachers just isn't very informative. One logical strategy in response to this information would be to forget about trying to raise test scores, and settle for providing schooling services at minimum cost.

Tuesday, March 1, 2011

Sticky Budgets and Inflation

One of the benefits touted for having an inflation rate higher than 0% (but lower than, say, double-digit inflation) is that it corrects for the “sticky wages” problem. In some sense, we’d like to have wages vary by the business cycle. Workers should get paid more when times are good. When times are bad, workers should get paid less (rather than simply firing some workers, and keeping the rest at the same wages). However, for a variety of reasons, wages tend to stay sticky. So instead we allow inflation to happen. Then, by employers keeping wages constant during recessions, we can get some wage flexibility by diminishing the real purchasing power of labor (presumably, allowing capital to fire fewer of them).

But many other prices in an economy are also sticky — in particular, many forms of government spending. Here, for instance, is a graph of defense spending via Marginal Revolution:

Defense spending is an extreme example, but another way of stating this is that the government rarely cuts the dollar amount going to most programs. So if you want to cut back one program, or shift resources from one government department to another; that’s impossible.

What you can do is manage this tradeoff when prices in general are rising. Then, merely by capping the budgetary allocations for defense, you can cut real defense spending — this is what happened during the ‘90s. Another example of this principle comes from the recent Indian budget. This budget actually increased government spending, by 3.3%. However, in the context of rapidly rising domestic prices (resulting in rapidly rising tax revenue as well), this amounts to a sizable cut in the budget deficit. Economic growth is strong too, which also makes this easier, but so does high inflation. In fact, as far as I can tell, the announced deficit cut here - 1.6% in one year - is larger than that most developed countries undergoing “austerity” budgets. This sort of fiscal balancing would be politically impossible to impose if prices were in fact constant. It’s true that, for several reasons, this degree of fiscal tightening may never happen. Yet the simple fact that it was entertained at all points to the power of inflation in enabling real government expenditure cuts.

One of the chief attractions of higher inflation, from a Tea Party point of view, is that it would make budget cutting that much easier. Right now, with low inflation, to get lower real government spending you actually have to cut programs. That’s hard. It’s easier to let prices rise, lower the real value of all government spending, and then cap the level of additional spending. That’s a whole lot easier.