The Power and the Money

We been saying this for a while now

 Hey, my blog is a nothing and that is how I like it. So it’s a good thing that Matt Yglesias is pointing out that if Spain suffers lots of capital flight (or otherwise sees its money supply collapse) then the worst effect of ditching the euro will already have happened and there won’t be many reasons to stay in.

Just saying that Doug and I have already made that exact point. More than once. As have, of course, many others.

Presumably the German government will now decide that the E.U. needs a unified system of banking regulation and deposit insurance plus some mutualization of existing debt, wedded to a stability pact and new labor legislation. Obvious!

Or not.

Gasoline is too damn high, but by less than you think

 In the most important sense, the title to this post is incorrect. Gasoline prices do not come close to covering all the social costs of driving. They underprice pollution, especially carbon emissions. They underprice the congestion imposed on other drivers. They underprice the damage done to roads and infrastructure: gasoline taxes are no longer sufficient to fund America’s transport needs. So no, gasoline is not too damn high.

In one sense, however, it is: oil is currently worth more than the marginal cost of getting it out of the ground. Brent is currently trading around $111. The marginal cost of getting a barrel out of the ground ran about $92 in 2011. That leaves a 20% spread: some room for prices to fall (even with current demand) but not a whole lot.

How do you calculate the marginal cost of getting a barrel out of the ground? Well, there are two ways to do it. The correct and complicated way has been done by Bernstein Research. They used the annual reports produced by the 50-largest oil companies for which there are data (sans Russian and Kazakh producers) in order to calculate the marginal cost of a barrel. That is the dashed line on the below chart. As you can see, it’s been rising incredibly fast over the past decade, even as world production has more-or-less stagnated.

There is a quick-and-dirty way to replicate their methodology. I’ll walk you through it. Start with the bottom line, which is the average cost per barrel of actually getting the stuff out of the ground. That has risen from $4 to $21 over the past decade, as more and more difficult oil has come onstream. Now add in depreciation, administrative expenses and marketing costs. That’s the second line from the bottom. (It includes direct taxes and royalties on oil production.) It has risen from $7 to $36 over the past decade.

Bernstein then calculated the amount of capex (including exploration costs) that the companies would need to undertake in order to keep their reserves constant. That is the greenish dashed line labeled “Unit costs + est. capex.” There is a quick-and-dirty way to replicate their results, which is simply to use what the companies actually spent on their capital expenditures. That is the greenish solid line labeled “Unit costs − DD&A + capex.” (It subtracts depreciation before adding back in actual expenditures, in order to avoid double-counting.) The result is more-or-less the same. That number, a simple estimate of marginal cost, has skyrocketed from $11 to $51 over the past decade.

Now here’s the rub: oil companies do not actually earn the Brent price unless they are, you know, selling Brent. In 2011, Brent averaged $111, but the average realized price earned by the 50-largest oil companies was only $66 per barrel. In order to calculate the Brent price at which the companies could cover their marginal costs, you need to add that “realization spread” to the basic marginal cost calculation. That is the dark green line that more-or-less parallels the correctly-calculated marginal cost.

	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
Lifting costs	$ 4	$ 4	$ 5	$ 6	$ 8	$ 9	$ 11	$ 17	$ 13	$ 17	$ 21
Unit costs	$ 7	$ 9	$ 10	$ 13	$ 15	$ 18	$ 21	$ 30	$ 26	$ 30	$ 36
Unit costs − DD&A + capex	$ 11	$ 15	$ 15	$ 19	$ 25	$ 31	$ 34	$ 45	$ 36	$ 47	$ 51
Above + realization spread	$ 21	$ 24	$ 24	$ 28	$ 41	$ 51	$ 57	$ 82	$ 57	$ 75	$ 97
Marginal cost	$ 25	$ 30	$ 36	$ 45	$ 58	$ 54	$ 64	$ 96	$ 68	$ 83	$ 92
Brent oil price	$ 24	$ 25	$ 29	$ 38	$ 55	$ 65	$ 73	$ 98	$ 62	$ 80	$ 111

What does this tell us about the world oil market? Well, the peak oil people seem to have been half-right. Technology has enabled the world to maintain oil production, and the truth is average production looks set to expand. But technology has not enabled the world to maintain production without using increasingly expensive techniques. I was at a dinner the other day with two hedge fund guys, and we calculated on a napkin (using an entirely different methodology) that it was barely worthwhile to drill in the Bakken at current oil prices. Given that the world seems to have an ending thirst for oil, prices may fall, but not by that much.

What does this imply about American energy security? Well, the U.S. may, if it is willing to carry out the right policies, be able to insulated itself from future price shocks that could take oil up to $200+ per barrel. But it will not be able to bring back the days of buck-a-gallon gas. Not even three-buck-a-gallon gas. Absent some sort of radical demand shift (and raising CAFE standards ain’t that) cheap oil is gone forever.

Delta Airlines provides perspective on the CNOOC-Unocal controversy

 In 2005, the China National Offshore Oil Corporation (CNOOC, pronounced “See-knock” by Americans) made an offer for Unocal. The political reaction at home was ferocious. The opposition came from three sources:

1. Fear of technology transfer. CNOOC might be able to acquire new techniques and abilities from its subsidiary. This is a reasonable fear in general, but not in the specific. Unocal was not really on the technical frontier ... and even had it been, all the evidence is that in the oil industry the benefits of propietary technology flow to the shareholders, not the citizenry. In that sense, then, China might have done the U.S. a favor by liberating whatever technical secrets Unocal might have possessed;
2. Fear of foreign control over American assets. This objection never made much sense, as Bernard Guerrero pointed out here. CNOOC assets in the United States fall under the jurisdiction of the American government, and should the U.S. and China ever go to war (even a cold one) the U.S. government can and will easily do to Chinese assets what it did to German ones during World War One;
3. Fear of foreign control over foreign assets. This was Paul Krugman’s objection to the deal. His worry was that the Chinese government might choose to keep oil from, say, Central Asia off the world market. That would drive a wedge between Chinese oil prices and world prices, damaging the rest of the world. The incorrect objection to this reasoning involved putting words in Krugman’s mouth, and assuming that he was discussing only military confrontations. The correct objection to this reasoning was simple: the Chinese government would incur a large opportunity cost from such a policy. Rather than sending cheap oil home, China could sell it overseas and pocket the difference. So absent the ignition of Cold War Two, what would be the point?

That last counterargument was very convincing. You can follow a microcosm of the debate at Crooked Timber. There is a wrinkle involving pipeline construction (short version: U.S. consumers have an interest in preventing China from building pipelines into Central Asia, just as we have an interest in preventing Canada from building them to the Pacific) but it is both minor and irrelevant to the CNOOC-Unocal controversy, simply because China was going to build those pipelines regardless.

End of argument? I would have thought so, but today I read that Delta Airlines was doing something interesting:

Delta Air Lines said on Monday that it had agreed to buy a refinery near Philadelphia from ConocoPhillips to offset the risk of higher jet fuel prices ... Richard H. Anderson, Delta’s chief executive, said the investment was a modest one, equivalent to the list price of a new wide-body plane like a Boeing 777. The company estimated that it would reduce its annual fuel expense by $300 million, once the refinery was refurbished and operating again. To achieve similar fuel savings, Delta would have to buy 60 new-generation narrow-body planes like the Boeing 737, a capital investment that would total $2.5 billion.

Huh! It looks like Delta Airlines has decided to do exactly what the economic theory predicted that China would not do. After all, there is an opportunity cost to locking up refined products: instead of selling them cheap to itself, Delta could sell it expensive to others. Moreover, it turns out that Delta isn’t alone. BP is also involved. The reason is simply that refineries cannot product only one product: you always wind up with other byproducts. So Delta will need to swap those other products for jet fuel. It could, of course, sell them and buy jet fuel on the open market, but that’s not what Delta has chosen to do:

Delta said it had also struck a three-year agreement with BP to supply crude oil to the refinery. As part of the deal, the details of which were not released, Delta said it would exchange gasoline, diesel and other petroleum products produced at the refinery for jet fuel from other sources like BP and Phillips 66. Combined with the jet fuel produced at Trainer, Delta said these deals would provide 80 percent of its fuel needs in the United States.

Delta has decided that it makes more sense for it to buy a refinery and sell fuel to itself at less than the market price than it does for it to buy a refinery and sell fuel to other people for the market price, pocketing the returns. Similarly, if the above description is accurate, then BP has also decided that it makes more sense for it to swap jet fuel for other products at less than the relative price it could receive from making that swap on the open market.

This is, it would seem, to be exactly the sort of behavior that people are worried that the Chinese government might engage in on a much larger scale. Two questions, then. First, is Delta making a fundamental mistake? (Many analysts think so.) Second, if it is in fact good for Delta, why wouldn’t it be good for China?

A dissenting view on Argentine resource nationalism

 I am often quite left-wing, especially when it comes to resource nationalism. That said, it is probably clear to anyone who reads this that I think the Argentine seizure of YPF is silly. Justice? No sir, you sold it fair and square ... and for a price much higher than YPF’s most ridiculous claim. Revenue? There is that $1.2 billion per year, and you can raise taxes if that is the problem, and anyway the government says the reason for the expropriation was to increase investment. Investment? Argentina has an export policy that makes development unprofitable, even at sky-high prices ... and the reason YPF paid such high dividends was because of the deal with the Eskenazis forced on them by President Kirchner. And then there is the threat of sanctions. (To be fair, the latter threat is a small one, given the European Union’s fetishization of legal authority, something that, say, would concern much less the United States or People’s Republic.)

In short, nationalizing YPF was a dumb idea.

But here is a counterargument from Mark Weisbrot. I like Mr. Weisbrot, but it seems to me that he has recently become a bit knee-jerk in his defense of Latin American heterodoxy. Still, he might be right, and since this blog has implicitly assumed that the nationalization was a silly idea, we should present the opposing view. And here is another.

What say you?

Greece steps closer to Eurozone exit

 I recommend the Sober Look blog. If you want something scary, go here. The short version is that the European Central Bank has completely lost control of the Greek money supply. It can print euros and buy loads of Greek assets, but all the liquidity drains right out of the country. Basically, nobody wants to hold deposits in Greece. On the flip side, nobody outside Greece wants to lend to a Greek company. In the words of a commentor, “The Greece analogy to a state in the U.S. no longer applies.”

A while ago, Doug Muir and I had a debate about Eurozone exit. We agreed that if the banking system collapsed and capital flight went out of control, then the costs of exit would no longer apply ... because the bad effects of exit would have already happened. The implication of a collapse in the Greek money supply is that absent more fiscal help from the rest of the Eurozone, there is no longer any reason for Greece to stay in.

Other than, of course, warm and charitable Greek feelings towards the rest of the Eurozone.

A short primer on the Ethiopian banking system

 Because this is what I do.

Ethiopia’s banking system is weird. It’s like a throwback to an earlier Africa, the Africa of the 1970s or 1980s. Three reasons.

First, the system is dominated by two big state owned banks. One of them — the Commercial Bank of Ethiopia — accounts for almost 50% of all lending, by itself. Throw in the other one (the Development Bank of Ethiopia) and the majority of lending in the country is being done by state-owned banks. That was pretty common in Africa thirty years ago, when almost everyone had a big state-owned bank or two that dominated the sector. But in 2012, state-owned banks are an endangered species. About half of all African countries don’t even have them anymore. In those that do, the state-owned bank is usually small and specialized, focused on some neglected sector like agriculture.

There are a couple of reasons for this. One is that, historically, African state-owned banks generally didn’t work very well. Another is that the big multinational lenders — the World Bank and the IFC — dislike state-owned banks, and have encouraged African countries to break them up and privatize them, or at least shrink and marginalize them. (For the record, I think this was mostly a positive thing — but like a lot of World Bank/IFC policies, it’s been applied in a rather ideological and ham-handed way. A lot of bad, corrupt, ineffective old state banks needed to go, but a lot of babies got thrown out with that particular bathwater.)

Ethiopia, though. Ethiopia is run by a bunch of former revolutionaries who are very nationalistic and not inclined to trust or listen to the World Bank and its ilk. So they’re keeping their big state-owned banks. But at the same time, they’ve allowed — no, encouraged — the growth of a vibrant private banking sector. There are about fifteen private banks in Ethiopia today, and they account for about 40% of lending and about 60% of deposits. They’re a vital part of the economy already, and they’re growing by leaps and bounds. So the banking sector is a true public-private hybrid. In this, Ethiopia looks a bit like a less-developed version of Brazil, where public banks are common and the BNDES development bank plays a major economic role ... but keep reading.

The second odd thing about the sector is that it’s closed and protected: no foreign banks are allowed. Ethiopia has no Barclays, no Bank of Africa, no Citi or HSBC. That’s also weird and unusual, because in 2012 most African and Latin American countries have opened up their banking sectors to foreign competition. Among other things, you can’t join the World Trade Organization unless you agree to do this — and everyone wants to join the WTO. Out of 54 African countries, all but seven or eight are already WTO members. (The ones that aren’t in the WTO are either oil-rich — Libya, Sudan, Equatorial Guinea — or recluse states like Eritrea, or tiny places like the Comoros. Oh, and Somalia, which doesn’t have a functioning government.) So pretty much everywhere in Africa, from Botswana to Senegal, you’ll encounter a bunch of international banks. But not in Ethiopia.

The third weird thing: the Ethiopian Central Bank? The guys who regulate the banks, control the money supply, set interest rates and all that? The Central Bank is not independent. Doesn’t even pretend to be. It’s an arm of the executive branch. It’s there to do all the normal central bank stuff, but it’s also there to carry out government policy. (In this, Ethiopia is also quite different from Brazil. The Banco Central do Brasil has little statutory independence, but plenty of de facto autonomy.)

Here’s an astonishing example. Couple of years back, the Ethiopian government wanted to build a hydroelectric dam. Huge, huge thing. Going to light up half the country. Also going to displace tens of thousands of villagers and do untold ecological damage, including possibly wiping out Lake Turkana, but do you want electricity or not? — So they want to build a dam, but for various reasons nobody wants to lend them money to build it. (Ethiopia’s credit is not good: Dagong rates the government at CCC, and Moody’s and Standard & Poor’s don’t even bother.) Where to get the money, then?

Well, the government of Ethiopia simply followed the Willie Sutton principle. The Central Bank told the private banks that they needed to start buying dam bonds. Lots of them. In fact, the Central Bank announced that for every dollar lent by a private bank, they would have to buy twenty-seven cents worth of bonds. Since commercial loan rates in Ethiopia are around 12% to 15%, and dam bonds pay just 3%, the banks were not very happy about this. But they had no choice: if they didn’t comply, the Central Bank would shut them down. So they’ve been buying dam bonds — millions and millions of dollars of them. And now the government has money to build its dam.

So, a mixed public-private banking system that’s protected from international competition, run by a non-independent central bank with a history of brutal intervention. How’s that working out?

Surprisingly well. But this may need another post.

Financing the Revolution

 In an earlier post, I marvelled at Hugo Chávez’s mishandling of PDVSA. The same applies, however, to the fellow’s handling of the Bolivarian Republic’s fiscal accounts. There is something truly amazing about watching an oil-rich republic run into severe budget problems at a time of record oil prices. The upshot is that Venezuela might be even less able to thumb its nose at ICSID than people currently believe.

How bad are Venezuela’s budget problems? Francisco Rodríguez, whose work has been mentioned three times before on this blog, has done the dirty work of digging into the Bolivarian Republic’s accounting. That isn’t easy, because Venezuela has increasingly resorted to off-budget accounts, which now account for about a fifth of all public spending.

Let’s take them in turn. The first is Fonden. Fonden is ... well, it’s hard to say. The “National Development Fund” gets part of its money from PDVSA and part from the Central Bank. The Central Bank turns over “excess reserves” to Fonden. What does that mean? Answer: a sneaky way of financing the government by printing money. Consider: the Venezuela central bank prints bolívares and exchanges them for dollars. It then hands the dollars over to Fonden. If Fonden uses the money to import stuff, then the process ends. But if Fonden buys domestic goods and services, then it has to hand the dollars back to the central bank in exchange for bolívares. As of the end of 2009, $30.1 billion of Fonden $58.1 billion has come from the Central Bank. (See page 121.) This is, in effect, borrowing.

The second are the Chinese funds, financed by loans from ... duh ... China. Venezuela has borrowed $12 billion from China, going through PDVSA, and an additional $30 billion that is entirely obscure. (The $30 billion is a 10-year financing facility; it does not seem that the Bolivarian Republic has yet drawn any money from it.) It pays back interest and principal on the $12 billion by shipping back oil. How much oil? Well, PDVSA makes it impossible to tell, by mixing fuel oil and crude in the statistics. (See page 127.) You gotta love that.

On page 9, Rodríguez estimates that the country ships about 89 million barrels to China every year in loan payments. At $97 per barrel, that will be $8.6 billion, so either Venezuela is going to pay that debt off very quickly or China is charging an insanely high interest rate. (Inasmuch as PDVSA is shipping fuel oil instead of crude, the loan will paid off even faster.) Private sources estimate  the rate is LIBOR plus 2.85%, about 4.0% at the moment. That is a very low rate, consistent with a very short payback period for the loans. Nonetheless, I would not discount the possibility that China may be, in fact, running away with the store.

Finally, PDVSA has taken over many state functions directly, and the Bolivarian government carries out a lot of functions outside the official bureaucracy. That increases both spending and revenues.

The upshot, as a % of GDP:

That’s a pretty phenominal level of mismanagement for a country in the middle of an oil boom. The estimate is that the deficit was 7.9% in 2011, and will be 10.9% in 2012. The government will have access to $10.9 billion of central bank reserves (e.g., printed money), $7.7 billion of new Chinese lending, $15 billion of internal debt, and at least $15 billion of external debt. The reason I say at least is because Venezuela does not issue external debt solely to finance the government; Venezuela also issues external debt to prop up its exchange rate. For example, in the first half of 2011, the government needed only $12 billion, but tapped external financing sources totaling $24 billion.

Venezuelan debt financing:

The result is that at least until the country devalues (which would solve a lot of the financing problems, by raising the bolívar value of oil exports) Venezuela will need access to foreign financing. If that is going to come from private markets, then ExxonMobil will be able to attach it in order to pay any ICSID judgments. If that is going to come from multilateral lending institutions, then Venezuela will need to satisfy the U.S. government: Argentina is the only country to have ignored an ICSID judgment, and the Obama administration has declared that it will oppose new lending to that country. (The relevant testimony comes in this video at minute 41:40; more details here.) Venezuela will likely face even greater opposition. Lastly, if the money is going to come from the Chinese government, then China is going to attach strings (or charge quite a bit) ... and it is far from clear that China would want to weaken the existing system of investor-state arbitration.

Either way, Venezuela’s fiscal problems are a bit stunning to behold. It’s an impressive accomplishment, in its own strange way.

European depression watch eases oh so slightly

 The basic problem confronting the eurozone right now is that the European Central Bank refuses to act as a lender of last resort. Outside Greece, most of the other countries are perfectly healthy as long as interest rates don’t rise too high. (Consider Portugal.) Of course, that’s the rub. As interest rates rise, debt levels start to look less sustainable. As debt levels start to look less sustainable, people sell their holdings of the debt. As people sell their holdings, interest rates rise. As interest rates rise, rinse and repeat.

Normally, a central bank would come in and calm things down by promising to purchase new debt at a reasonable interest rate. This is why Britain and the United States have had no problems; everyone knows that their central banks stand ready. Eurozone countries, however, don’t have their own central banks. That makes them vulnerable to self-fulfilling panics.

And here’s the second rub: Germany also lacks a central bank! So why should Germany be immune? To some extent, the country is protected by the fact that it’s the safe haven: when people sell other countries’ bonds, they buy German ones. But that’s only partial. Speculation has hit countries as healthy as Germany, like Austria and Finland. Considering as there still are other places to park your money (U-S-A! U-S-A!), and the European Central Bank is still doing its level best to start a second Great Depression, then there is no reason why German bonds should be invulnerable to the panic.

And lo! Germany just had a failed bond auction. Yields rose from 1.98% to 2.07%, far from a disaster, but not a good thing in economic terms. In fact, it is worse than you think. So what’s the silver lining?

Simply that if Germany starts to be affected, then Angela Merkel will stop being evil.

I should add here that other analysts think that Germany’s pain threshold is far higher than a blip in yields or the collapse of the eurozone’s repo market. “In other words, the time to sell bunds will be when Germany finally realises the game is up and reluctantly props up the Eurozone, probably via the printing presses of the ECB. Unfortunately, that won’t happen until Eurozone has a near death experience with countries threatening to leave the currency union and customers lining up outside banks demanding their money back.”

If that’s right, and it probably is, then we’re in trouble. But I’ll still say that on the margin we’re at least a millimeter closer to sanity than we were yesterday.

Bahamian wages, the limits of small-country Keynesianism, and the Chinese not-empire really is not (yet) an empire

 The Bahamas are not rich by the standards of the United States and Canada. But they are not poor by the standards of the world. There is no desperate poverty, and there are few people cut out of the modern economy altogether. Rather, the country feels like a relatively poor part of the United States. The poor areas are poor, but they are no worse than what you can see all over Florida.

The country’s minimum wage is $4.00 an hour. That’s low by American standards, but high by regional ones: Trinidad’s average wage is only a little higher than the Bahamian legal minimum. “Kitchen helpers” in the hotel industry, one of the lowest-paid categories, average $6.16 per hour. Shop sales assistants make $7.37 an hour. Gas station attendants make $8.00; cashiers $8.40, and housekeepers $10.53. The average hourly wage for all production workers was $13.00, and the average work week was 38 hours. These wages are not low. In fact, average nominal wages in the Bahamas ($13.00) are on a par with Mississippi ($12.83), Puerto Rico ($12.92), and West Virginia ($13.19).

The Great Recession has badly wounded the Bahamian economy, but no worse than several parts of the United States.  Bahamian unemployment remains high at 13.7%. That said, unemployment in Minnesota (14.1%), Nevada (13.7%) and Puerto Rico (16.3%) exceeds the Bahamian level, while the other low-wage jurisdictions in the United States don’t show low unemployment: Mississippi with 11.1% and West Virginia with 9.0%.

What is the Free National Movement (FNM) government doing about the economy? Monetary policy, of course, is mostly out of their hands. Capital controls mean that the government also has some room to use monetary policy — it recently slashed the discount rate from 5.25% to 4.50% — but the peg to the dollar limits its freedom of action. The government has some scope for a Keynesian boost — the budget deficit is only 3.0% of GDP, and they recently sold the Bahamian Telecommunications Company for $210 million — but it is unlikely to be effective. Why? Simply put, the Bahamas is too small and too open. Imports come to 35% of GDP. Much of any stimulus, therefore, is likely to “leak” away in increased imports.

What’s left, then, besides praying for the United States to get out of the doldrums? Well, Prime Minister Hubert Ingraham has decided to try attracting as much Chinese investment as possible. The Chinese government has taken a $2.75 billion equity stake in the giant Baha Mar resort development. It also provided loans to finance stadium and road construction.

The problem? Well, the economic problem is the same as with Keynesian spending: leakage. The Bahamas is a pretty small economy. It doesn’t produce a whole lot of construction material, and while unemployment is high, it doesn’t have that many skilled construction workers. The Baha Mar construction project will bring in 6,150 Chinese construction workers, while the $70 million new airport road has involved another 200. Not all the construction labor force will be Chinese, of course, but construction is estimated to employ only 4,000 Bahamians. The developers have pledged only $200 million in contracts to Bahamian firms although that might ultimately rise higher.

The China State Construction Engineering Corporation (CSCEC) will get $1.9 billion, or 53% of the total value of the project. Some of that may stay in the Bahamas, of course, but probably not a whole lot: Chinese workers are estimated to remit roughly $12,000 per year. They do, of course, eat and drink — but the Bahamas is a large agricultural importer, and so those expenditures will like benefit American agriculturalists. The government estimates about $80 million or so in tax payments from the CSCEC but that isn’t a lot. The highest estimate is that Bahamian contractors will receive no more than $400 million, or 11% of the total project value — and they will, of course, spend a large chunk of that revenue on imported inputs. In short, at least half the stimulus will leak away and possibly as much as 90%.

The Nassau Guardian summed it up: “"The Bahamas has fallen fully into the embrace of China. And the rising empire has been kind with its gifts … What Bahamians must understand is that when China lends, and it contracts its own workers to do the job, a significant amount of the money borrowed goes back to China with the workers who build the project. They pay their workers with money we borrow … The Chinese also keep their workers in self-contained on-site camps when they are sent abroad. We barely get them to visit our stores to spend the money we borrowed when they are working in our countries.”

This is not to say that the project is a bad deal! Once it’s done, it will provide a solid boost to the Bahamian economy. Even if the U.S. economy stays flat, it should be able to attract business away from other Caribbean resorts. It is to say that a tiny country like the Bahamas can’t really do a whole lot to use countercyclical fiscal policy to boost its economy, regardless of whether the stimulus comes from government borrowing or foreign investment.

The U.S. government worried that China might be “using this investment solely to establish a relationship of patronage with a U.S. trading partner less than 190 miles from the United States.” I don’t see it. Sure, the Chinese government will have a big stake in a giant resort development. If there was some evidence that China had used its state power to unfairly obtain contracts from American firms, then there might be cause for concern, but there isn’t. Nor is there evidence that China bribed or otherwise influenced Bahamian officials.

As for Chinese “patronage,” well, patronage in exchange for what? The U.S. already controls large spheres of Bahamian public policy. The Chinese government isn’t about to force the Bahamas to suspend OPBAT, expel the Coast Guard, sever the link to the dollar, seize American property, restrict American imports, replace the Privy Council with a Chinese court, or station nuclear weapons off the coast of Florida. Given the overwhelming dominance of the United States, and its long-standing and multiple links with the Bahamas, I can’t for the life of me figure out what a “patronage relationship” with Beijing would even mean. In point of fact, “Senior GCOB officials privately expressed that China is not their preferred partner and acknowledge that negotiations are difficult.” Moreover, the Chinese government told the Americans that they were unhappy about the need to take the financial lead on the project: “Chinese embassy officials privately told [a U.S. official] the China Ex-Im bank would prefer another investor in the mix to diminish the financial risk.” E.g., Americans just weren’t interested. So much for the rising empire muscling out the declining one.

The only realistic worry I can see is that the Bahamas might serve a pathway for illegal Chinese immigration, a fear shared by the U.S. Embassy in Nassau:  “The continuous arrival of thousands of low-wage Chinese workers in the Bahamas will likely lead to a significant increase in illegal migration of Chinese from the Bahamas to the United States. The GCOB (Government of the Commonwealth of the Bahamas) does not have the institutional capacity to effectively monitor the movements of the Chinese workers nor effectively detect inauthentic travel documents.” But still, that is minor ... and that worry involves the fact that China is still a poor country unable to retain its own people when given opportunities elsewhere.

In short: the Bahamas is rich, small countries have serious economic limitations, and China is still both poor and very far away. Okay, not the deepest conclusions ever, but hey. I am on vacation. And really, any opportunity to reduce the latent China-hysteria in the United States is probably worth taking.

This would be a painful way to end European union

 Over the last two months, family business has kept me away from blogging. Before that, I was in the throes of finishing a first draft of a book manuscript. The family business is over and I’m now in the far more relaxed process of fixing the manuscript, so this time I think I think we’re really back!

In December of 2010, I made a bet with Doug Muir and Omar Serrano that the eurozone wouldn’t make it to March 25th, 2013. If any of the big eurozone economies leave the single currency, I win. The bet is structured so that I will lose even if Ireland, Portugal, and Greece all abandon the euro; it has to be Spain or Italy. The loser will either fly across the Atlantic to meet the winner, or pay for the winner to fly to meet them, and then buy them a steak dinner, with port and cigars.

The big question, of course, is how a government could leave the eurozone. Now, Nick Rowe has proposed a way. “Eurozone governments and banks that cannot pay their obligations in euros may end up paying their obligations in a scrip that is not pegged to the euro. A scrip issued by each national government that is worth whatever people think it is worth. And if people start using that scrip as a medium of exchange, and medium of account, it becomes a new money. Sure, Greek supermarkets might prefer payment in euros, but if their customers can only pay in New Drachmas, then it’s either accept New Drachmas or let the vegetables rot on the shelves. And the supermarkets’ suppliers might prefer payment in euros, but it’s either accept New Drachmas or let the vegetables rot in the fields. And the workers picking the vegetables might prefer payment in euros, but it’s either accept New Drachmas or nothing.”

Sounds almost painless! Matt Yglesias implied so. But it wouldn’t be! It would be a mess and cause the economy to cycle the drain until the government defaulted on its debts anyway. Moreover, it would not cause the scrip to drive euros out of circulation.

Consider, for a moment, what Spanish obligations consist of. In part, they are debt payments. Spain’s debts, however, are denominated in euros and will remain denominated in euros no matter how many nuevas pesetas are printed unless the Spanish government withdraws altogether from the European Union. Rather, the obligations which the Spanish government can insist on paying in nuevas pesetas are the obligations that it owes to its own citizenry: salaries, pensions, unemployment benefits, etcetera. The nueva peseta would trade at a discount against the euro, of course, but that is the idea.

Except ... the incomes of Spaniards would drop in terms of euros. They would be increasingly earning in discounted nuevas pesetas. The problem, of course, is that they would then be paying less taxes in terms of euros. But the Spanish government owes debts denominated in euros! The debt burden would rise. The more the debt burden rises, the more the government needs euros to pay it. The government would, of course, trade nuevas pesetas for those euros. That would increase the discount on nuevas pesetas, further driving up the size of the debt burden, further increasing the discount on nuevas pesetas. (While this is going on, the interest rate on Spain’s euro debt would skyrocket, of course, unless it is by then owed to the European Union rather than private investors. In that case, however, it is very unlikely that Spain would be going around issuing scrip to pay salaries.) At the end of the story Spain’s income in euros falls enough to force the government to default on its euro debts, but only after setting off an inflationary spiral.

There’s a second problem. Rowe wrote, “Greek supermarkets might prefer payment in euros, but if their customers can only pay in New Drachmas, then it’s either accept New Drachmas or let the vegetables rot on the shelves.” That, however, isn’t correct. Government employees might be paid in new drachma, or nuevas pesetas, but they can exchange those pesetas for euros. The supermarket cannot be required to accept those pesetas unless Spain leaves the eurozone. If the owner insists on being paid in euros, then the customers will swap their pesetas for euros in the market and he or she will be paid in euros. This is a process that has occurred in many high-inflation countries, where people abandoned the local currency for the dollar ... and in most of those countries, the dollar was not legal tender! In short, the logic breaks down at that point: it is not clear why the pesetas would replace the euro as a medium of exchange ... except, of course, to make tax payments.

Of course, it isn’t clear that Spanish government employees (or pensioners, or students, or the unemployed) would want to receive devalued nuevas pesetas in lieu of euros. They would, quite rationally, perceive it as a pay cut. Anyone who owed money would be doubly hit: their debts would still denominated in euros.

Finally, such an action would be perceived (correctly) as a prelude to formally leaving the eurozone, precipitating the mother of all capital flight. Without leaving the eurozone (in fact the country would have to leave the European Union altogether) the government would have no way of combating that flight.

In short, introducing scrip would be a terrible way to exit the eurozone. It would run a high risk of triggering a depression, and it would certainly worsen the country’s debt burden. Professor Rowe is, I think, incorrect. History bears this out: the issuance of patacones (or créditos) in Argentina around 2000 did not result in the creation of a new Argentine currency or stave off default. Rather, they contributed to the depression, and quickly inflated away.

There are many ways in which the eurozone could fail. The issuance of a parallel currency for any length of time strikes me as one of the worse ones. Is there a hole in my logic?

La competitividad de la madre patria

 Edward Hugh brought my attention to the strange fact that Spanish export prices have risen 5.4 % in the past year, versus 4.3 % in Germany. This is not what should be happening in the middle of a brutal recession! Spanish costs should be falling, not rising. At the very least, they should be falling relative to booming export economies, like Germany.

But then Detlef Guertler ‎dug up some more detailed figures, which told a more nuanced story. Spanish export prices were rising faster than German ones in beverages, textiles, paper, chemicals, metals and metal products, pharmaceuticals, non-metal products, electrical equipment, machinery and furniture. The only places Spain was gaining was in food and cars. In food, Spanish prices rose 3.5% versus 9.0% in Germany, and in cars Spanish prices fell 0.7% while they rose 2.0% in Deutscheland.

It sounds grim, but I would venture that these numbers tell a positive story. Spain’s overall trade deficit didn’t budge last year — from €50.2 billion to €52.4 billion, for a small rise of €2.2 billion — but its trade surplus in food rose by €1.0 billion and its surplus in cars rose by €3.1 billion. (In percentage terms, the surplus in food rose 13% and the surplus in cars rose 48%.) That was not enough to offset a deterioration in the country’s energy trade balance of €7.5 billion, but that was driven by a big run-up in energy prices that hopefully won’t be continued.

In short, Spain seems to be gaining competitiveness where it has a comparative advantage. As long as its imports of the stuff in which it does not have a comparative advantage refrain from rising as quickly (which is what has been happening) then there is a positive chance that the country will be able to pull out of its slump into a cars-and-food driven recovery. (Plus, of course, tourism, which was not in these statistics.)

Or I could be wrong. Edward?

This is (really not!) how European union ends: Germany awakes?

 It appears that Germany may be awakening to the disaster that would follow the collapse of the eurozone. Der Spiegel has an issue explaining the disastrous effects on Germany. They divvied them into actual costs (of printing up and distributing a new currency), export collapses, unemployment, and a loss of international power. The article lumps in the problems for Germany’s banks in the unemployment section, which is fair enough: the problem with having Germany’s banks take massive losses on their lending to de-euroized countries is not that the banks would lose money. It is that the resulting increase in risk premiums would cause a credit crunch, drive illiquid-but-solvent firms to the wall, and kill jobs.

To be fair, it is much more likely that the euro would collapse as other countries peeled off in the wake of banking crises. So their first cost is a bit of a red herring, since even an extreme eurocollapse would certainly still leave a rump euro used by Austria, Finland, Germany, the Netherlands, Luxembourg, Slovenia, Slovakia, and (probably) France. That said, for Germany the costs of reintroducing would be small.

That is not true for the countries likely to decide to leave the single currency. They would face massive adjustment costs. My friend Doug thinks they can be avoided. He is right ... if the banking systems in those countries have already collapsed. If the banking systems have gone under, then abandoning the euro is all gravy. The new central banks can reflate and keep domestic depositors whole, while the inevitable fall in the value of the new currency triggers an export boom. There will still be legal issues, since the governments of the countries with collapsing banks will have already likely imposed de facto capital controls (at the very least, a bank holiday of sorts), and that is against European law.  

But if the banking system is still alive, then the Eichengreen logic holds: the run-up to de-euroization would see the mother of all capital flight. Everyone and their second cousin tried to get their money out of the de-euroizing country. Yields on government debt would spike to impossible levels; likely debt auctions would actually fail. The result of that would be massive massive government cuts in the run-up: imagine workers paid in IOUs instead of cash. Finally, anyone with paper euros would hoard them, driving the economy back to barter. This all happened in Argentina.

The reason why I think the euro is now 50-50 is that I can imagine things getting so bad that leaving the currency would in fact have few costs, but I want to be clear: the reason that it would have few costs is that they would have already been paid, not that they would not exist. Only the benefits would remain.

If that is not correct, then I think there is an opportunity to make some money explaining why to the Irish, Greek, Portuguese, and Spanish governments. Over to you, Doug.

This is (not) how European union ends: options

 Ireland is in trouble. Kevin O’Rourke has written an despairing piece on the country’s woes that is, I think, well worth reading. There is a good analysis of the situation up on Crooked Timber; the comments are well-worth reading. There seems to be some question about the extent of German banks’ exposure to Irish debts, private and sovereign. That matters: the less exposed the foreign banks, the easier a solution. (And yes, that is back-asswards from what you would think.) Tyler Cowen thinks the situation is doomed; he even thinks that a unified banking market (which would have helped a lot) is probably now off the table.

Interestingly, the bars in Southie are not full of discussions about the recent Irish loss of sovereignty, as opposed to an older one.  

 

Yesterday’s Financial Times had a nice recap of the E.U.’s options on page 2. Here they are:

1. Step up ECB bond purchases: this seems to have happened, according to today’s front page. They have succeeded in driving down the interest rate on Portuguese debt by 50 basis points, to 5.82%, and on Irish debt by 25 points, to 8.30%. What I doubt is that the ECB will do enough of this to actually produce any inflation, which would, if there was enough of it, solve the problem. Internal devaluation made easier in the periphery, deleveraging made easier everywhere. But German public opinion hates the idea, so what can you do?
2. Increase the size of the E.U. rescue fund: The fund is not big enough to allow Greece, Ireland, Portugal, and Spain to all simultaneously refinance their sovereign debt, let alone adding Belgium and Italy. (Estimates are that it is short €140 billion.) But Germany is opposed to expanding it, so that’s that. Plus, an expansion could trigger a crisis, by indicating that officials think a Spanish crisis is imminent. In other words, it should’ve been two or three as big to start with.
3. Issue eurobonds: Here the idea is that the E.U. countries would issue collective bonds for which they would all be responsible in some fashion. Basically a bailout in any other name. But as the FT author writes, “They would be seen as an unacceptable large step towards ...”
4. Greater fiscal union: Fiscal union is not going to happen. Even if it did, there would still be the problem of uncompetitiveness in places like Portugal and Spain ... although those could be worked out the hard way if the countries didn’t have to worry about sovereign defaults and the subsequent banking collapses that they could cause.
5. Nothing: “If none of the above works, talk could grow about the eurozone breaking up. But no eurozone policymaker seriously believes an exit by a country such as Greece would make its predicament any easier. ... Even if Germans became fed up with their neighbors, a return to the D-mark would also be economically catastorphic: the currency would soar, pricing its exporters out of business.”

Now, the part about Greece is not quite right. In the short-run, exit would be a disaster. But it would lead to an export boom down the line, and if the banking system had already collapsed then the costs would be relatively low. That however, is really a fairly weak nothing-left-to-lose argument: if we ever reach the point where leaving the eurozone is costless for a country, then that country has already been plunged into something as severe as the Great Depression. The real money line is the one about Germany, as discussed in the previous post: a wave of eurozone exits would devastate the German economy.

I had an idea for another option, but it slipped my mind. Anyone know what it might have been?

This is how European union ends: badly

 In my previous post, I wrote, “The problem seems to be the German government’s unwillingness to explain that Germans benefit more than anyone from the eurozone. Break it up, and German banks go kaplooie, German exports become uncompetitive, German wages become unsustainable, and the German people get blamed.”

 

One reasonable objection might be that Germany depends relatively little on the rest of the eurozone for its export revenue. (See the above chart for German exports in billions of current dollars.) In 2009, the eurozone took only 41% of all German exports. Moreover, much of the eurozone is likely to survive any crisis. The six countries whose new currencies are likely to collapse in the event of a breakup (Belgium, Greece, Ireland, Italy, Portugal and Spain) took only 17% of German exports. Those statistics certainly make it seem that Berlin could afford to let the European Union go hang.

Except ... well ... Germany depends a lot on exports. Exports to the Notorious Six may come to only 17% of German exports, but Germany exported 38% of its GDP in 2009. Exports to the Notorious Six, therefore, came to 6.6% of German GDP. In addition, imports from the Notorious Six came to 5.0% of German GDP. Imagine, then, a devaluation that caused German exports to those countries to drop by a third, while imports from them rose equivalently. The total negative shock to Germany’s economy would come to 3.9% of GDP. That is, I think, quite large. Depending upon the multiplier, the shock could be even larger.

Add to that the negative effect from the collapse of all those German banks that invested in the Notorious Six (plus the huge rise in uncertainty that any European collapse will entail) and the negative effect is likely to be much much larger than 4.9%. Six percent? Eight percent? Your guess is as good (and likely better) than mine. But the numbers look to be at Great Depression levels, unless the German government proceeded to throw its current rulebook out the window and deficit spend as if there was no tomorrow. (1931 all over again!)

Will German voters prefer to pay that price rather then pay to resolve the credit crises currently besetting (or threatening to beset) the Notorious Six? I do not know. I increasingly suspect that they would. Buckle up; we seem to be in for a rocky ride.

This is how European union ends

 I never held much truck with analysts like George Friedman, who believed that the European Union is doomed. Unfortunately, new facts have caused me to change my mind.

 

One new fact, actually: the European decision to charge the Irish government a market rate on its “bailout” funds. WTF? Here is where I want to go out and shake a German: the IMF is the good guy in this story! You heard me right. The IMF suggested that Ireland basically default on the debt incurred to rescue the banks. That would be fine. Cut everyone’s debt level, let firms and individuals escape via bankruptcy. That would make it much easier to slash prices and wages without squeezing living standards. “Internal devaluation,” in other words.

But the German government, the same government that (sensibly) wants private-sector haircuts after 2013 nixed the idea because its own banks are too exposed, and Berlin does not want to admit that its banks were as caught up in the foolishness as Irish ones. Instead we get a non-bailout bailout that does nothing to improve the situation and forces the Irish public to transfer 10% of its income to the rest of Europe for the foreseeable future.

Maybe as the possibility of disastrous disorderly defaults looms ever-larger, German politicians will get their act together. A European version of the Brady bond is one possible solution. A raise in the ECB’s inflation target would help. Low-interest E.U. loans are a great idea. And a complete unification of European banking regulation (I suggest they just adopt Canada’s rules and be done with it) is long overdue. Internal devaluations made as easy as possible, reforms in the places that need it (of which Ireland is not one), and the dream of European unity held together.

That looks ever-less likely. Instead we may get collapsing banking systems, chaotic defaults, German taxpayers bailing out German banks at high cost, and a reckless euro-breakup with horrible consequences for the world economy. It would also, as best as I can see, leave a residue of massive anger aimed, rightly or wrongly, at Berlin.

The problem seem to be the German government’s unwillingness to explain that Germans benefit more than anyone from the eurozone. Break it up, and German banks go kaplooie, German exports become uncompetitive, German wages become unsustainable, and the German people get blamed. Instead, though, it seems that the narrative of hard-working Germans selflessly sustaining the rest of Europe is too good to resist. And so, we slouch towards catastrophe. (The optimist in me says that it will turn out much better than the 1930s! The pessimist says, yeah, so did the 1980s in Latin America.)

I hope that I turn out to have been right the first time. Can somebody talk me down?

Race, roads, or regulation? Canadian and American cities

 When asked why Canadian cities are so built-up compared to American ones, Martin Wisse of the Netherlands suggests, “No white flight.” It’s an appealing answer, given America’s massive urban ghettoes, but it’s almost certainly wrong.

 

Consider the differences between Seattle and Vancouver. For an American city, Seattle is very white and disproportionately childless. The city, however, splatters across the horizon, with few high-rises outside the central business district, while Vancouver is relatively compact and its proliferating residential towers reach to the sky. All this despite geography in Seattle that should encourage density!

The Seattle-Vancouver comparison alone should make you doubt the validity of the “white flight” hypothesis. There are other reasons, however, to reject it. Until 1990 none of Canada’s metropolitan areas declined in population — the country didn’t see shifts in economic geography like what turned cities like Buffalo, Detroit, New Orleans, Flint, Akron, Pittsburgh, Dayton, and Syracuse into what they are today. (The 1990s recession changed that, but the places that shrank tended to small, and located in Atlantic Canada or northern Ontario and Quebec.)

More importantly, white flight can’t explain why the nonblack sections of American cities look rather different from their Canadian counterparts. Nor can white flight (by itself) explain why American suburbs strongly resist residential high-rises, whereas Canadian ones (Montreal excepted) take to them with relative zeal. For example, Chicago’s North Side does not look like Toronto, save for a belt along the lake. Nor does Boston’s central and northern urban area — Back Bay, South End, North End, Southie, Brookline, Allston, Brighton, Cambridge, Somerville, Chelsea, Watertown, Arlington, Belmont, Charlestown, and East Boston — look much like East York or Scarborough. It is true, of course, that the great American ghetto is an American phenomenon, created by America’s strange racial caste system, but racial tensions don’t explain why Houston looks very different from Calgary.

So if isn’t race, then what is it? Another possible culprit is roads. American cities have a lot more freeway-miles per capita than their Canadian counterparts. The logic is not that freeways destroyed the neighborhoods that they cut through. I’m sorry, but speaking as someone who grew up in neighborhoods that had roads driven through or beside them, that argument is just stupid. (Yes, this applies to Toronto.) The plausible logic, rather, is that inner city neighborhoods were always relatively undesirable, but without subsidized freeways it would have harder to leave them for lower-density suburbs.

I am sympathetic to this argument, but I have some doubts. (Not least that my wife and I prefer dense inner city neighborhoods to the suburbs.) It is almost certainly true that American-style sprawl requires massive investment in freeways. Fewer freeways, more density. More density, more high-rises. The problem? If density the key, why does Los Angeles look so different from Toronto despite being denser? The 11.8 million people who live in Los Angeles’s urbanized area (that is, the area defined by the lights visible from space at night, minus fringe areas with a population density below 1,000 people per mile) are packed in at 7,068 per square mile, whereas their 4.6 million Torontonian counterparts live at 6,835 per square mile. Perhaps it is the freeway net that allows Los Angeles to splatter its density more uniformly than Toronto, but that feels ad hoc as an explanation, especially since Toronto’s suburbs are actually very densely-populated compared to Boston, Chicago, or New York.

The other possible explanation is regulation. In this view, roads may have contributed to American sprawl, but zoning is what really keeps it in place. For this view to be correct, Canadian zoning has to be less strict than American zoning. Are Canadian cities more likely to approve density, allow smaller lots and narrower streets, require fewer parking spaces, and permit higher buildings? This is not hard to believe, considering the far greater control that provincial governments exercise over municipalities in Canada, but I do not know the answer.

 

In point of fact, the “roads” and “regulations” hypotheses may be hard to disentangle. If a lack of roads drives up land values (by limiting the effective supply of land), then there will be more political pressure to allow dense development. After all, people need places to live. On the other hand, if it is easy to get out to the burbs (via all those freeways) then there will be less political pressure on inner-city areas to permit taller buildings. Cambridge, for example, saw a high-rise boom in the 1970s, which the city deliberately stepped on. As a result, the Central Square subway stop (where we live) is stupidly surrounded by two-story buildings instead of 20-story towers. Our building was built in the early 1990s, and was effectively capped at five floors. Without Boston’s two ring roads (I-95 aka “Route 128” and I-495), the pressure to build up in places like Cambridge would have been harder to resist.

 

In fact, however, it is possible to disentangle between “roads” and “regulations,” by testing for the effect of zoning changes on land values. Of course, it’s never that easy — endogeneity is always a problem. Ed Glaeser has a paper suggesting that zoning is determinative in shaping American cities in California and the East Coast north of Virginia. He has a particularly-detailed study of Boston that supports the zoning hypothesis: market forces (given the existing road net) would make Greater Boston rather denser were the regulations less restrictive. (Newton would look like Brookline; Brookline would look like Brooklyn; and Boston itself would be filled with high-rise towers.) On the other hand, his same work implies that in most of America it is the road net what produced sprawl, and not race or land-use regulation.

In short, most American cities sprawl because the federal government built roads out to the horizon. The exceptions are along the coasts, where U.S. cities would look more like Canadian ones in the absence of tight zoning laws. The increasing segregation of immigrants appears to be an effect of the above, rather than a cause. Of course, the great American ghetto is a striking and horrible thing, but we would have had them with or without freeways and zoning.

You probably didn’t need me to tell you that Portugal is neither Greece nor Ireland

 Why am I bullish on Portugal, do you ask? Consider the scenario in the below graph. It assumes that interest rates stay high for two years, a double-dip recession next year, annual GDP growth never passes 2%, and Portuguese politicians never balance the budget. That pessimistic scenario stabilizes the country’s net debt (the light green line shows the debt-to-GDP ratio on the right axis) within four years.

 

That is not to say that there isn’t a lot that could go wrong. The markets might panic. The E.U. might fail to calm them. Portuguese politicians might fail to cut the deficit at all. Growth might stall out at less than 2 percent. The ECB might fail to keep inflation at the 1.7% these projections assume. But that’s a lot of mights.

Something to note is that with the exception of financial corporations, Portuguese companies borrow at better terms than the Portuguese government. If the markets believed that a Portuguese default was really going to impose crushing taxes on Portuguese companies and wreck their access to capital, then this pattern should not hold. But it does! Of course, I don’t believe much in efficient markets, so I take no solace from that.

You know who should take solace in the pattern, though? The European Union! More precisely, Angela Merkel and crazy German public opinion. If markets panic over Portuguese debt, and yields start to spike, then the E.U. should happily lend Portugal the money it needs to tide it over. They will almost certainly come out ahead.

Moreover, as the markets suggest, the Portuguese economy has some green shoots ready to sprout. Renewable energy and smart systems are the biggest. But there is also a government that aims to preserve infrastructure spending, which bodes well for future growth. Of course, the New York Times would portray that latter as a bad thing. It wrote: “The government’s failure to rein in spending — and its decision to spend on yet more highways and toll roads instead of investments that could produce direly needed economic and export growth — has soured relations with the opposition Social Democrats.” 

Huh? Of course, this is the same newspaper that in the same issue was stupid enough to write the following about Mayor Bloomberg’s nominee for chancellor of the public schools: “She has shown a common touch as president of Hearst Magazines since 1995 by riding in yellow cabs rather than black limousines.” So you shouldn’t take their misgivings too seriously.

In short, Portugal is not Greece, and I’m bullish on their prospects. Of course, “bullish” is relative. In absolute terms, Portugal’s prospects aren’t that great. But they are much greater than the doom the markets are predicting, and in this case, I’m willing to take the bet. As is East Timor.

A depressing thought for a sunny Tuesday

 Below the fold, Brad DeLong argues that what he calls the “Barrington Moore problematic” is no longer a useful way of ordering the social sciences.

What is the Barrington Moore problematic, you ask? (Yes, I had to google the name.) In short, it is the search for the answer to why 20th-century states gave rise to regimes like Nazi Germany and the Soviet Union. In an advanced industrial society and a backwards industrializing one, regimes arose which killed millions of people. And even without those horrible ideologies, the First World War showed modern states using nationalism to mobilize for slaughter on an unprecedented scale. Understanding why drove research agendas for a long time; it certainly provided a useful way to organize undergraduate education.

DeLong argues, with good reason, that this no longer dominates. Modern Western societies mobilize rapidly against even relatively mild forms of racism or authoritarianism. Other societies sometimes (but ever less) give rise to tinpot dictators or self-proclaimed socialists, but they are simply not the same.

Al-Qaeda is not about to seize control of any state. Hugo Chávez may be leading an increasingly authoritarian regime, but he is no Joseph Stalin: he isn’t even a Fidel Castro. (Heck, these days even Fidel Castro isn’t much of a Fidel Castro.) And for all the attention to the threat of chaos, embodied by nihilistic terrorists or drug cartels, neither has really been able to do much damage inside functioning modern democratic states.

We need, therefore, to find a new overarching question to bind together the social sciences.

Except ... well ... in one field, economics, a lot of people believed that we had achieved a Great Moderation. Depressions were a thing of the past. Well, not so much. In political science, many believed that we had a pretty good handle on what politics looked like under first-past-the-post. Again, not so much.

Do we really understand why the world hasn’t been turning up many Stalins lately? Are we sure that Communism and facism and future things like them are dead? Is it in fact time to abandon the study of dictatorship and democracy because things look like okay, right now?

Well, probably yes. That said, I worry that in a few years or decades the below essay (under the fold) just might (perhaps) look a little bit like the literature on the Great Moderation, or the Westminster system, or worse yet the positivism that preceeded the First World War. Maybe, just maybe, after the resurgence of problems that so many thought were dead, we just might not yet want to abandon the search for the roots of totalitarianism.

And it sure wouldn’t hurt to keep undergraduate education focused on it.

What’s the case for dollarization?

 This is not a post about organized crime in Mexico, although I will be returning to the topic shortly. This post asks simply: given all the things that can go wrong with a fixed exchange rate, let alone a currency union, why do so many countries continue to return to them? After all, when they go wrong, they can go very wrong. You can get horrible explosions like Mexico in 1994 or the Asian currency crashes in 1998, or you can slow grinding meltdowns like the depressions in Argentina around the turn of the century or the Baltic States today. 

Yet countries continue to do it. All the West Indies save Jamaica fix to the dollar. Ecuador, El Salvador, and Panama have dollarized. The Baltic States have already been mentioned. Denmark fixes to the euro. The euro itself has no shortage of suitors, even now. In fact, even with the Eurozone’s problems, countries want to form currency unions. East Africa wants to form a currency union. Why? 

Well, history is a big reason. The CFA franc, for example, exists and is linked to the euro because of the French non-empire also known as Françafrique. A similar thing can be said about the West Indian links to the dollar. These historical links make it very hard to figure out the effects of a currency link. Maybe countries link to countries with which they trade. Or countries trade more and link with countries with whom they have special political links. All that would make it hard to tell whether exchange rate certainty has a big effect on trade, because causality could run both ways. That didn’t stop Andy Rose from trying, but the results were still highly contested.

Jeffrey Frankel came up with a neat natural experiment. In his own words:

“The long-time link of CFA currencies to the French franc has clearly always had a political motivation. So CFA trade with France could not in the past reliably be attributed to the currency link, perhaps even after controlling for common language, former colonial status, etc. But in January 1999, 14 CFA countries woke up in the morning and suddenly found themselves with the same currency link to Germany, Austria, Finland, Portugal, etc., as they had with France. There was no economic/political motivation on the part of the African countries that led them to an arrangement whereby they were tied to these other European currencies. Thus if CFA trade with these other European countries has risen, that suggests a euro effect that we can declare causal. The dummy variable representing whether one partner is a CFA country and the other a euro country has a highly significant coefficient of .57. Taking the exponent, the point estimate is that the euro boosted bilateral trade between the relevant African and European countries by 76%. It is not doubling, and the timing is not perfect. But it does suggest that the effect on trade among small countries is very substantial even after correcting for endogeneity.”

It is true that the CFA franc is in a fixed exchange rate with the Eurozone, not a currency union. Still, as fixed exchange rates go, this one is very strong. It’s supported by the French treasury and not just the governments of the countries in question. Moreover, these countries are dependent on France in umpteen ways, and their governments would find it very difficult to leave the zone without risking economic and political collapse. So there doesn’t seem to be a strong institutional reason to reject the results. It isn’t quite a currency union, but it is close. So what happened in 1999 between the CFA countries and the Eurozone wasn’t quite an accidental currency union, but it was close. And even if it isn’t a real currency zone, the experiment can shed a lot of light on fixed exchange rates. 

So fixed exchange rates promote trade! Great news for those of us with strong intuitions that fixed exchange rates and currency unions should be good things for small countries. Problem is, the quantitative results are a little odd:

First, the effect starts in 1997, not 1999. It is possible that expectations of the fixed rate with the rest of Euroland caused the trade boom, but that seems a little ad hoc. Second, the effect seems to have faded out by 2006. Neither result lets one say with confidence that dollarization (or even fixing to a bigger currency) is a good thing for poor countries. Either the result from the CFA-Eurozone experiment is stronger than it looks (maybe 2005-06 were just bad years, or the authors failed to correct for some important factor), or fixed exchange rates only have brief and transitory effects. 

We still have a mystery. Thoughts? 

The privatization of American government

 Texas can be a truly awful place. A reservist serving his year in Iraq lost his paid-off house for two missed dues payments of $250, because the homeowner’s association foreclosed on it. Under Texas law, the courts never entered into the process. A municipal government couldn’t foreclose that quickly, but the de facto private governments calling themselves “associations” easily can. (Hat tip: Andrew Reeves.)

The Texas story gets better. The association sold the house for $3,500 to somebody who flipped it for $135,000. I strongly suspect that the flipper was connected to the association. Perhaps I am too cynical about the way human beings behave when the state refuses to police them.

When New London, Connecticut, seized a private home (with full compensation) in order to aid the construction of a new downtown, it provoked a national outcry. Any takers on the reaction to this Texas outrage? And can somebody explain to me the philosophical difference between a homeowner’s association and a municipal government? Because I can’t for the life of me see one.

Policy of repulsion, part 1

 “Policy of detraction” didn’t seem quite right. This post deals with Philippine independence, and the unwinding of the American “policies of attraction” that I will continue to sporadically post about. 

 

The Republic of the Philippines gained sovereignty on July 4, 1946. In theory,the economic separation of the Philippines from the United States was hedged by the Philippine Trade Act of 1946.   The Truman Administration persuaded Congress to allow free trade for eight years, after which tariff privileges would be slowly withdrawn until July 3, 1974. The U.S. would subject the Philippines to quotas on sugar, cordage, rice, cigars, tobacco, and coconut oil, but that was nothing new. In addition, the law provided for a fixed exchange rate of 2:1 between the peso and the dollar, gave the nationals of each country full freedom to invest in the other, and prevented the Philippines from imposing capital controls “except by agreement with the President of the United States.” 

For all the claims of Philippine nationalists, the Trade Act was almost entirely a Philippine initiative. Washington had little desire to admit Philippine products. Nor did it have much desire to maintain an open market in the Philippines — major U.S. corporations, in fact, lobbied in favor of import controls during this period. Their reasoning was simple: in a small protected market, the first company in gains an enormous advantage. Scale economies would limit the establishment of competing plants, and trade barriers would keep out imports. Voila! Washington did, however, have reasons to keep the Philippine economy marginally viable and maintain favor with the Republic’s leaders. 

It was much easier for Truman to shepherd the Philippine Rehabilitation Act, an agreement to turn over U.S. property to the R.P., and an extension of Philippine access to the American market if he could claim that American business was getting something in return. That something was the freedom to invest and temporary free trade. According to page 17 of the U.S. Survey of Current Business, Volume 31, the U.S. granted the Philippines $166 million in grants and $64 in loans between the end of the war and mid-1948, followed by an additional $488 million in grants and $36 million in loans in 1948-50. 

This was a substantial, but far from overwhelming, amount of money. In nominal terms, it came to about $5 billion in grants and $800 million in loans, plus $6 billion in transferred property. Of course, the U.S. economy was much smaller then. An equivalently-sized foreign aid program today would cost $35 billion in grants, $5.6 billion in loans, and $44 billion in transferred property. Looking at it from the other perspective, U.S. grants averaged about 4% of Philippine GDP, with loans coming to another 1%. 

The catch? (You knew one was coming.) The Philippine government quickly figured out a way to protect the domestic market, with the full cooperation of the U.S. president using his power under the Philippine Trade Act. In essence, Manila managed to get the “best” of all worlds: access to the U.S. market, very high levels of protection at home, and essentially unconditional American aid.

Details forthcoming, as I drive through violence-torn northern Mexico on my way to the D.F.

Why oh why oh why would Germany leave the eurozone?

 A long time ago, the group bloggers over at a Fistful of Euros gave me the okay to join them. I turned it down. Who needs a bigger platform? People might notice when you say something dumb. I felt very good about my decision when the New York Times wrote about “the influential Fistful of Euros blog.” (Didja know about that, Doug?)

That said, being obscure has its downside, especially since nobody will answer your question: why would Germany want to leave the eurozone? Edward Hugh said it again. Others have intimated it. But nobody explains why this would happen! Now, I know Ed is important and all these days, but I really would like to know why this logic is wrong. C’mon, Ed, somebody, help a brother out. Alex, can you poke him again?

De tocho morocho, dice el IMF a la madre patria

 The IMF just published its report on the Spanish economy. It isn’t good. As for what to do? Well, the boffins at the Fund recommend a little of everything:

• Fix the wage-bargaining system ... the IMF thinks an agreement will be ready by May, not apparently realizing that it already is May;
• Lower severance payments to fired workers;
• Change to an “opt-in” rather than “opt-out” system for collective bargaining, whatever that means;
• Eliminate indexation;
• Speed up implementation of the E.U. Services Directive (although the madre patria has done pretty well on this tip;
• Liberalize more product markets (big boxes and power centers, here you come!);
• End the subsidies to homeowning over renting;
• Cut the deficit by 5 percentage points in 2010 and 2011;
• Cut tax subsidies and raise VAT and excise rates;
• Raise the retirement age to 67 right now;
• Do something to get spending by the Autonomous Communities under control — they recommend Belgium as a role model;
• Fix the damn banks, mostly via consolidation;
• Reform the savings banks, basically by eliminating them as a category.

Sort of like an evil twin version of Wilson’s Fourteen Points. It might even work. But it is a very full menu — the government is being asked to reform basically everything — and it will require a great deal of social solidarity. It is not clear to me that Spain has it. The unions don’t really trust the Socialist Party, and the People’s Party hasn’t been able to resist making political hay out of the eurocrisis. (I mean, really?) It is asking a lot of a government to try to alter the labor market, financial system, pension scheme, tax structure, and federal relations all at once. De tocho, indeed. Of course, presumably the consequences of doing nothing will be worse, but it is hard to sell people on stuff that will make them suffer by using counterfactual reasoning.

That said, Spain is in the lucky position of being able to get rid of its army if need be. How many other countries have gone into fiscal crises with that luxury? Maybe tis time to revisit that old EDC treaty ...

Do tax systems matter? Evidence from Mexico

 Many politicians like to claim that low taxes are good for growth. it is not at all clear that low taxes do anything for growth. What makes me say that? Well, if they were, Mexico should be a powerhouse. After all, KPMG just declared that it had the best tax system in the world, with an overall burden only 60% of the United States and a third of France! So it should be growing like gangbusters, right?

Some argue, sensibly, that low taxes only work when budget deficits are low. Otherwise the beneficiaries of low taxes act as if they have received a tax postponement rather than a tax cut. Anticipating higher taxes (or inflation) in the future, they work less now. The problem? Mexican budget deficits are very low, as are its overall debt burdens.

 

Obviously, other things are going on. But having slow-growing Mexico get the top score for a business-friendly tax system should make one wonder about the importance of tax systems to actually doing business.

Llamamiento a las armas para todos los empresarios de la madre patria

 “They say this is not a crisis, just a deceleration. Deceleration? Let me know where the pedal is and you’ll see how I accelerate it.”

—Paco Fernández, madrileño cab driver

I am a believer in Delong’s dictum about Paul Krugman: “(1) Remember that Paul Krugman is right. (2) If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.” So let me speak as a modest man with much to be modest about: I do not think that Paul Krugman is wrong when he says that no country (and certainly not the madre patria!) can easily force wages down 20% in a reasonable amount of time.

What I want to suggest is that there is a second moving part: productivity. Spanish businesses are remarkably unproductive, and productivity growth has been flat for a decade. Last year, my colleague Diego Comín travelled there to write a case about the country. He asked why productivity was flat, and generally received boilerplate about professional oligopolies, retail regulations, and the high cost of starting a business ... all of which are problems elsewhere in Europe. But he received one very interesting answer from the head of the Comisión de Industria at the Confederación Española de Organizaciones Empresariales: “During the boom, there was no pressure to increase productivity because demand was very high anyway.” After all, building houses better is tough, but why bother when you could sell all you could build at whatever price? Moreover, the massive immigration of the period pulled in migrants who had an overall educational level similar to the native-born, but may have had less tacit knowledge (and, in the case of the 64% not from Latin America, less language ability) and therefore been less productive.

 

The implication is that in the new environment, with profits squeezed and less need to integrate new arrivals into the labor force, Spanish businesses may be able to get a lot more production out their workers. There is a lot of room for improvement. Freeing up labor markets would help, not by allowing for a big drop in wages, but by giving management more leverage to threaten workers and force them to work harder. That is not a good thing, of course, unless you believe in the value of labor for its own sake. But it is a necessary thing if Spain is to avoid an even more painful recession.

And given the low productivity of Spanish businesses, it may be a very possible thing, even without major labor market reforms. In short, the madre patria may be able to pull out of the eurocrisis with only a small  “internal devaluation,” when nominal wages and prices in a region or country drop relative to elsewhere. If Spanish businesses can rise to the occasion, then the euro will be more robust than we may imagine.

Am I underestimating the productivity challenge facing Spanish business?

German public opinion needs to get over itself

 I've already mentioned how German public opinion about the economic crisis in southern euroland annoys me. “Poor naïve Klutzes” my foot. The truth is that Germany has greatly benefitted from being able to force its eurozone partners into a monetary policy that generated speculative bubbles and drove up their price levels. A nice essay on the topic can be found here.

One thing that I do not understand are the strange allusions that Germans might benefit from leaving the eurozone. Their exchange rate would rise, making their exports uncompetitive and reducing the value of their substantial holdings of foreign assets. I suppose that those assets, denominated in euros, would be a bit safer at the new values ... but I am still not seeing it.

I do not know if Spain can survive inside the strictures of the eurozone. I suspect that it can, but I do not know. I certainly am beginning to revise my priors on the worth of the single currency. That all said, I still find the sanctimonious German attitude most annoying. The bailouts will not cost the German taxpayer a nickel, the PIGS will be forced to reform their labor markets, and Germany will continue to enjoy the benefits of export competitiveness for several years to come. The worst thing that could happen to Germany would be slightly higher inflation ... and that would be a good thing for German pocketbooks, if not for Germany’s pathological public opinion. I mean, when the head of the Austrian central bank calls German inflation fears “hysterical,” then something is wrong.

The madre patria is in serious trouble

 I find the German response to the euro crisis irritating in the extreme. German taxpayers will not lose money in providing support to Greece, even when the inevitable haircut comes along. German exporters benefit from the eurozone. Avoiding competitive devaluations is a good thing; the single market is (I believe) unsustainable in the long-run without exchange rate stability. Etcetera. Sanctimoniousness gets you nowhere; they have become a country of Alfonse D’Amatos.

Truth is, the fiscal problems of the eurozone are small beans. They would be there even with flexible exchange rates, and Germany would still be making the (repeat: profitable) loans needed to tide the southerners through. See Mexico 1995.

But there is another truth, which is that Spain is in serious trouble. Why? Simple: wages far outran productivity over the past decade.

A bit more detail: Spanish wages are set under the 1980 Worker’s Act. Bargaining generally takes place at the industry and province level, with agreements covering all of a province’s firms in a given sector. (The provinces are smaller than the “autonomous communities,” which are what most foreign observers probably think of when they hear the word “province.” They’re the rough equivalent of a U.S. county, with the municipalities being more like eastern townships.) Such agreements cover about half the labor force; another quarter are under industrywide agreements negotiated at the national level. Details here.

Industrywide negotiation is already a problem. High-productivity firms like generous agreements, since they hobble the competititon. Low-productivity firms might prefer to negotiate on their own, but once they get locked in, they have less incentive to fight a generous agreement since they know that their competitors (good or bad) will be equally disadvantaged. Worse yet, if no agreement can be reached, the existing agreement (along with its escalator clauses) is automatically extended ... about a third of the labor force is covered by agreements that effectively last more than two years.

Labor economists have found (and found again) that completely centralized national wage bargaining often leads to wage restraint. So does decentralized firm-level bargaining (or, more accurately in the American case, an almost complete lack of collective bargaining). The worst outcomes appear in Spanish-style half-centralized systems. The (unsatisfying) explanation is that a national labor union internalizes some of the problems of national industry: killing troubled firms to benefit good ones does not benefit them.

In short, Spain is neither Florida nor Sweden. When there is a shock to Florida’s economy, wages plummet because workers are powerless. (Real wages fell 2.5% in 2009.) When Sweden has a shock, the unions (thinking nationally) accept wage restraints. Spain, neither.

Which means that it is going to be tough push wages down enough. In fact, it will be tougher, because Spain has such high levels of personal indebtedness: grinding wages down will smack Spanish banks right in the face ... and by extension the foreigners who have lent to them. (See Felix Salmon for more on this point: private debt is as big a problem as public debt.)

Now, Spain can adjust. But it will be hard. It would be nice to see the E.U. seriously thinking about the problem. Instead, we have posturing Germans. I am much more sympathetic to the Spanish governments ranting about speculators, because the truth is that Spain can bring its public debt into line even if growth grinds to a halt. But growth grinding to a halt is a bad outcome. Breaking up the eurozone still looks like a worse one, so in the absence of any kind of collective spirit, a grinding painful lost decade is what we are going to get.

Unless we grind along too long and a Spanish government decides that leaving the E.U. is a better option ...

Anna Gelpern makes the case for optimism

 I met Anna Gelpern at a conference on sovereign debt held at American University in Washington, D.C. She is one of the smartest people I’ve had the honor to meet, so when she writes that the giant E.U. move towards federalism makes her believe that Greece can avoid default, you should listen to her. Albeit not about the weather.

Thing is, the numbers for Greek debt dynamics are still pretty damn grim, almost as grim as the weather that day in D.C. If growth doesn’t materialize by 2012, all bets are off.

Things fall apart

 So when I mentioned the “imminent collapse of the Eurozone” my old Army buddy Malachi Wolfe expressed some surprise. “Awww man you're kidding me,” he said. Some academics also seem surprised. When I sent an email around to HBS professors noting this story, a Spanish colleague said, “It’s only one observation. Maybe the manager’s bonus depends on deposits. What bank is it? I’ll move my money into a bank paying four percent.”

Sadly, no. I am not kidding. And while I am going to try to move some money into Spanish banks, I would be lying if I said that I was not nervous about it. 

 

The above are nominal yields on two-year bonds. (The eurozone countries that are not in chart are paralleling France and Germany.)

Brad Delong: “In Europe, the Creditanstalt's bankruptcy and what followed was what turned the recession into the European Great Depression...”

The Portuguese for Creditanstalt is “Instituição de crédito.” A few days ago, events reminded me of 1982, and the onset of the Latin American debt crisis. I am now getting a frightening whiff of 1931. Somebody please tell me why I’m wrong.

Asustado

 OK, now I’m scared. If bank managers are cold-calling small depositors and offering 4% interest to convince them to keep their money in the bank, then Spain has a serious problem.

The worry seems to be exposure to sovereign debt. Or is it? Color me confused. 

“What do the Greek rioters want?”

 Thanks to reader BPH for catching a major bonehead error in comments. The mistake is now fixed. Apologies!

The title of this post is a question asked me today yesterday by a Columbia student Guy Tower. The correct answer is probably, “to express an unfocused floating rage,” followed by “a miracle.” In fact, the last time Amma and I were in Greece, the place had just been hit by riots. That said, there are three possible concrete things that a tear-gas-dodging rock-throwing rioter might actually want the Greek government to do.

  

In order of reasonableness:

(1) Make sure that rich Greeks pay there fair share of the adjustment burden. Sure, taxes amount to only 32% of GDP ... and that assumes that GDP is properly measured ... but tax rates in Greece are not low.  Tax  collection is low. Considering how royally Greek governments have screwed up tax collection, anger at this would get me on the streets too. Raising VAT when you can’t collect a swimming pool tax? WTF? Bring in Crown Agents!

Don’t forget that Greeks are poor. (Albeit not as poor as in the first version of this post! Thanks again to BGH.) The below chart gives the bottom nine deciles of each country’s income distribution, in euros per year at PPP. The median Greek would fall below the Austrian, British, Danish, Dutch, and Swedish poverty lines. They would be in the bottom 30% of the income distribution in Belgium, Cyprus, Ireland, France, and Finland. The lowest tenth of the income distribution is poorer than anywhere else in the Eurozone except Italy, Slovenia, Spain, and a very few Cypriots. 

Source: Tárki European Social Report 2008, Chapter 3. Data from 2005. A larger version of this chart is available by clicking on it.

In short, Greeks have ample reason to suspect that rich people are getting away with murder, and ample reason to be angry about it. 

(2) Push back on the creditors. Yes, Greece has been irresponsible. Hell, it’s been malfeasant. But recent months show all the characteristics of a credit spiral, when bad things happen to good countries. (Or in this case, a badly-behaved one.) If were Greek, I’d want the Greek government to take a harder line with its creditors. Extend maturities, reduce interest payments, basically make ‘em take a haircut. Another way to think about this is that if Greece were a corporation it would be in bankruptcy protection right now. Greece would still need to make budget cuts (its interest payments are lower than its deficit) but they would be less painful and much more politically palatable.

(3) Get out of the euro.

Okay, that last one is crazy. What would Greece need to do to leave the euro? Well, it would have to freeze bank deposits, in order to prevent a flight of cash to the rest of Europe. The problem with that is that doing so would violate European law — Greece would need either a special mulligan from the European Commission (which would set an awful precedent) or quit the Union altogether.

Of course, it is possible that runs on Greek banks will happen anyway. Thing is, the ECB is moving to prevent that, by continuing to accept Greek bonds. Even if the ECB fails, rumors of euro-exit could produce something far worse than bank runs: consider what happened to Argentina in the run-up to its big devaluation. If Greece looked to be reintroducing drachma, nobody would want to spend euros. After all, they’d all be expecting the drachma-euro exchange rate to plummet the second the drachma became legal tender. The economy could go back to barter in the run-up. That happened in Argentina in 2001.

I’ll also add that a devaluation would almost certainly be connected to a default. I’m having trouble seeing Greece suddenly enjoy an Argentine-style export boom without a big drop in the nominal exchange rate. The problem with having a debt burden at 113% is that a big drop in the nominal exchange rate means a big rise in debt burdens, since Greek debts are denominated in euros. Either Greece redenominates its debts — a de facto default, unless the European Court decides doing so is illegal — or it will have to renegotiate them.

In other words, a Greek ejection from Euroland might be good for Greece ... in the sense of being terrible but better than some other possible outcomes ... but it seems to me that it would be rather bad for the rest of Europe. We have, in fact, seen a similar movie before.

Anyway, it seems to me that there are reasons to oppose the current government that go beyond simply wishing for a pony. The 1980s really weren’t really that great a decade. I would like to see more of (1) and (2), with a much more pro-active Brussels. Guarantees for Greek banks would help. (Make ‘em adopt Panamanian banking regulations, and I mean that quite seriously.) More quantitative easing from the ECB. An inflation target of 2%, not just a ceiling. Hell, a target of 3½ percent. British officials running around inside the Greek tax administration. Some of European version of the proposed Sovereign Debt Restructuring Mechanism; e.g., a bankruptcy procedure for E.U. countries.

None of which (except maybe implicit bank guarantees) is going to happen, thanks to Angela Merkel. So unless the Greeks want to flirt with depression and expulsion from the E.U., we are stuck with muddling through. And that means, at some point, a default. 

Good luck, madre patria.

What is the weather service like in Tanzania?

 That is something that I have always wondered. And lo, Doug Muir answers:

Much better than you’d think. Not clear why. But it’s providing good, real-time information for both weather predictions and best-guess seasonal stuff. 

Tanzania has 95% mobile coverage. So almost every community — every dusty little plains village, every wandering band of Masai — now has at least one guy with a cell phone who can get regular text updates on when the rains are coming and how long they’re likely to be.

Satellite data is cheap or free, basic forecasting techniques are known and easily taught. So why don’t other African countries have good weather services too? I’m not sure, but I think this is another positive-legacy-of-socialism thing: lots of little local weather stations, plus a good tradition of a strong government weather service. Apparently the weather guys are something that’s all too rare in Africa: an educated elite who aren’t afraid to spend time out in the villages or get their hands dirty. 

Anyway, good weather service = huge, huge difference in quality of life. If nothing else, it dramatically reduces the uncertainty.

A old idea

 Matt Yglesias suggests that most capitalists don’t like competition. That is true, but it isn’t new: Adam Smith said it a long time ago, and I doubt the observation was particularly original to him. Harvard has an entire course called strategy that is, quite a bit, about how firms engage in what economists call imperfect (or “monopolistic”) competition. It’s all about increasing the “wedge,” i.e. raising your customers’ willingness-to-pay while driving down your costs. (This is entirely legal and often great for customers ... but it isn’t growing wheat.) Meanwhile, there’s a whole literature about “rent-seeking” behavior, some of which I have contributed to in a small way.

It may be that Matt really didn’t read it anywhere specific, or it may just be that he read it in too many places to remember. 

Another beautiful day in Paris during which I have not left the apartment. Ah, well, it beats not leaving the apartment in Boston.

Overwork, French neocolonialism, and the economics of labor migration

 One thing that truly does suck is being in Paris on a rainy weekend with your wife and being utterly unable to enjoy the city, let alone take that side trip to the south of France, because a chapter of your next book (and an article for a conference) is taking much longer to write than it ought to. This post therefore gets a leisure tag, because of the lack thereof. But now you know why I haven't finished the Dubai posts (one more is waiting about Iran) or said more about nuclear power, the reason for my trip.

One thing that doesn't suck is Doug Muir's explanation of Comorian independence. It may be unsatisfying, but so is reality. It does leave me wishing that Julius Nyerere, a heroic man of heroic accomplishments, hadn't been so ... well ... unyielding in his anticolonialism. The world, I think, would be a marginally more happy place with 800,000 additional French citizens in the Indian Ocean, rather than 800,000 poor victims of lousy institutions wedded to French neocolonialism.

Something that doesn't suck but is, I think, incorrect, is Charlie Stross's analysis of the economics of restrictions on labor mobility. The discussion gets started at comment #27. Go, argue!

Of course, I have a dangerous streak of Francophilia, and am therefore not to be trusted.

Dubai in debt

 On November 25, 2009, Dubai World announced that it intended “to ask all providers of financing to Dubai World and Nakheel to ‘standstill’ and extend maturities until at least 30 May 2010.”  The problem was Nakheel, the real estate arm that had (among other things) created the artificial Palm and World islands. Nakheel had $4.05 billion in debt coming due on December 14, and it couldn’t finance it. Stands to reason that Nakheel was overleveraged, right?

Well, not really. According to Nakheel’s June 2009 filing, it possessed $20.0 billion in liabilities against $40.0 billion in assets, which isn’t bad at all. Of those assets, $30.7 billion were “properties under construction.” Since Nakheel acquired land for free from the Emirate’s government, those costs were actual construction costs, and didn’t reflect overheated land values. Sounds good, very responsible. They could sell the properties for a full third less than they cost to construct and still be solvent.

The problem was cash flow. Sometimes nobody wants to buy gold-plated bidets at any price, whether at cost or ⅔ of cost or whatever. On a gross profit of $175 million for the first half of 2009, Nakheel took impairment costs of $3.3 billion. Now, that might be theoretical — but cash flow from operations was negative $948 million in the same filing.  That is not good when you’ve got a lot of debt coming due and a world financial system in the midst of freezing up. In normal times, Nakheel might have been able to brazen through, even with the 50% decline in Dubai property prices between September 2008 and September 2009. This was not a normal time.

 
The IMF put together a handy time series on the cost of insuring debt from the government of Dubai and Nakheel. There are two interesting things and a mistake in the time series. First, it looks like the markets didn’t pay any attention to Moody’s. Second, they paid a lot of attention to Sheikh Mohammed bin Rashid Al Maktoum. (Strangely, the first turned out to be right and the second wrong.) Third, the $10 billion support package wasn’t really a support package from Abu Dhabi. Rather, the Emirate of Dubai sold $10 billion in bonds to the central bank of the UAE and used the revenues to backstop its public entity debt. The actual bailout didn’t come until December 14, when Abu Dhabi stepped in to lend Dubai World $10 billion to pay its sukkuk.

 

So where to from here? Well, there is a lot of debt coming due over the next few years. In millions of U.S. dollars: 

	Dubai Holding	Dubai World	ICD
2010-Q1	$ 600	$ 1,199	$ 3,250
2010-Q2	$ 2,933	$ 3,140	$ 294
2010-Q3	$ 0	$ 0	$ 0
2010-Q4	$ 295	$ 140	$ 920
2011-H1	$ 0	$ 4,455	$ 1,544
2011-H2	$ 3,161	$ 2,192	$ 6,044
2012-H1	$ 500	$ 0	$ 3,702
2012-H2	$ 330	$ 4,592	$ 2,191
2013-H1	$ 260	$ 1,000	$ 1,222
2013-H2	$ 246	$ 550	$ 2,640
2014-H1	$ 1,511	$ 0	$ 154
2014-H2	$ 632	$ 350	$ 1,957
Beyond 2014	$ 4,621	$ 4,534	$ 4,357

The Emirate of Dubai certainly can’t pay it. The government is in already in deficit. It will need to raise taxes to maintain basic services and pay the interest on the $18.7 billion that it currently owes — yes, the UAE central bank wanted interest, and lots of it. Raising taxes even further to support the development companies seems, well, not that likely.

 

Dubai could default, but that would pose a bigger problem. First, as readers of this blog certainly know by now, sovereign immunity basically doesn’t exist in the United States or European Union. Creditors could go after any and all Dubai-owned assets used for “commercial purposes.” Dubai has already started “ringfencing” its bad debts, for example by listing DP World on the London Stock Exchange as a separate entity, or transferring Nakheel’s overseas property holdings to Istithmar World. Those strategies, however, depend on laws in the U.S. and E.U., and so they have limits. (Judge Griesa would have a field day.) Second, Dubai depends on debt. An Argentine-style strategy would wreck Dubai’s entire development model.

	Disclosed debt	Other liabilities	Total  liabilities
Dubai World	$ 26,219	$ 7,866	$ 34,085
Dubai Holding	$ 15,090	$ 4,527	$ 19,617
ICD	$ 28,275	$ 5,655	$ 33,930
Dubai government	$ 18,700	$ 0	$ 18,700
Other Entities	$ 1,885	$ 0	$ 1,885
Total	$ 90,169	$ 18,048	$ 108,217
Total (ex-government)	$ 71,469	$ 18,048	$ 89,517

It’s a problem. But it isn’t necessarily a killer. First, Abu Dhabi knows that world markets will be rocked if Dubai entities start defaulting. Since Abu Dhabi has invested billions and billions in those very markets, it has an interest in making sure that Dubai debts are restructured in an orderly fashion.  In fact, the Abu Dhabi government has stated that it will continue to “support Dubai in its efforts to achieve a viable position.” Second, of the $22 billion in Dubai debt that the IMF estimates has been affected by the standstill, $12 billion consists of syndicated loans and $7.5 billion of individual loans, with only $2.5 billion in bond issues. The prevalence of bank debt makes restructuring easier, since Dubai can assemble and talk to a small group of creditors. Finally, Dubai may have overbuilt, but there is still a reason for there to be a city there: it probably isn’t going to go the way of Detroit. With debt-to-asset ratios around 50% (pre-crash) the city-state’s public development entities will probably be able to find some combination of debt restructuring and price cuts that keeps them solvent.

California didn’t go away after 1873, Panama remained a great place for a canal after 1888, and Miami remains a very nice city in 2010, for some values of “nice” anyway. The go-go days may be gone, but I suspect that a major trading center will remain.

 

Then again, that trading center may be rather smaller than the current one. This will, finally, bring us to Mr. Cotter’s question in the next GCC post.  Until then, any questions, criticisms, requests, or ideas?

Iceland, European empire, deposit insurance, and terrorism ... really

 Why is the Icelandic taxpayer on the hook, asks Jonathan? The short answer is: blame Europe!

 
Everyone knows about the European Union, the big confederation (with some federal characteristics) of countries sitting there on the Old Continent. Fewer people know about the European Economic Area. The EEA is basically an agreement under which Iceland, Norway, and ... er ... Liechtenstein get access to the European market in return for adopting some E.U. laws and regulations. (Switzerland has basically replicated the same arrangements without formally signing on to the EEA.)  The EEA required its members to adopt European law on deposit insurance in return for granting EEA banks the right to branch into the E.U. As a result, Iceland adopted a deposit-insurance scheme in 1999.

Click the link on the Icelandic scheme. (Or keep reading.) Scroll down to Chapter 5, Article 10. It reads: “This amount shall be linked to the EUR exchange rate of 5 January 1999.”  The reason is quite simple: the E.U. law required countries to create schemes that insured deposit accounts with a value of at least €20,000. Ergo, the Icelandic scheme guaranteed €20,887. Now, the scheme was financed by a 1% levy on bank deposits and was rather vague about what would happen if it could not meet its obligations. Was the government then responsible? Were savers then on their own? What?

The 300,000 British depositors who fell in love with the 6% rates that Landsbanki offered through its “Icesave” accounts did not seem troubled by these distinctions. They deposited £5 billion. In an Icelandic bank. A bank they had never heard of before 2006 based on a tiny island of 300,000 people. Any resemblance to Barbados is entirely coincidental. Barbadian banks do not do this sort of thing. This may be because Barbadian bankers have banked for some time, while the Icelandics were pretty green.

 
Maybe the Britons thought that Iceland was in the Caribbean? More likely they were taken in by a message that Britain’s financial regulators allowed to stand on its website:  “You can also rest assured that with Icesave you are offered the same level of financial protection as every bank in the U.K.” 

Well, when Iceland finally went kablooie, worried Britons began a run on Landsbanki, which led to a rather remarkable conversation between Iceland’s finance minister, Árni Mathiesen, and Chancellor Alistair Darling of the United Kingdom:

Darling: “Do I understand that you guarantee the deposits of Icelandic depositors?”

Mathiesen: “Yes, we guarantee the deposits in the banks and branches here in Iceland.”

Darling: “But not the branches outside Iceland?”

Mathiesen: “No, not outside of what was already in the letter that we sent.”

Darling: “But is that not in breach of the EEA treaty?”

Mathiesen: “No, we don’t think so ... Since we can’t cure the domestic situation, we can’t really do anything about things that are abroad.” 

Darling:  “See, I need to know this in terms of what I tell people. It’s quite possible that there is not enough money in [Iceland’s depositor guarantee] fund. Is that right?”

Mathiesen:  “Yes, that is quite possible.”

Darling:  “You have to understand that the reputation of your country is going to be terrible. It really is a very, very difficult situation where people thought they were covered and then they discover the insurance fund hasn’t got any money in it.”

After hanging up the phone, Darling did something even more remarkable: declare Iceland a terrorist state. It was the easiest way to freeze Landsbanki assets inside the U.K. (Sadly, most of Landsbanki’s assets were not in the U.K.) He then guaranteed that British depositors would be repaid in full. Good politics, of course, and probably needed to prevent crippling bank runs in Britain, where a lot of foreign banks operate.

At that point, Darling went back to Iceland — which desperately needed financial support from other Nordic countries to prevent runs there and obtain IMF money — and convined them to pass a bill that would pay Britain back for the money it spent supporting the deposits of its citizens who had placed their money in the banks of a terrorist state. Icelandic voters, for some reason, were miffed by that ... and the result was the referendum.

 
What happens now is anyone’s guess, although I am fairly confident that my most excellent proposal will not be adopted. Answer your question, LT?

Dubai, Incorporated

 State capitalism is an interesting term. What does it mean? Some definitions, like Rothbard’s, include everything outside perfect laissez-faire. Most Marxist definitions include everything other than complete Soviet-style central planning. Finally, others effectively define it as a synonym for crony capitalism or resource nationalism. None of these definitions strike me as particularly useful.

But state capitalism exists. When I parse the Potter Stewart definition inside my head, I wind up with a a system in which profit-maximizing state-owned companies operate in ostensibly competitive markets. I say “ostensibly,” because both profit-maximization and competition exist mostly in the eye of the beholder.

 

The Emirate of Dubai is the epitomy of state capitalism. The state’s investments run through three holding companies: Dubai Holding, Dubai World, and the Investment Corporation of Dubai (ICD).  Sheikh Maktoum directly owns Dubai Holding, while the latter two are formally owned by the government of Dubai … of whom Sheikh Maktoum is the absolute ruler. All three holding companies have real estate arms charged with developing land granted to them by the emirate. ICD’s Emaar Properties developed the Burj Khalifa, while Nakheel created the offshore Palm and World developments on reclaimed land.

Dubai built its airport in 1960 — over the objections of the emirate’s British advisors — and then borrowed against oil revenues to expand it to handle jumbo jets in 1968. The airport (separately from the airline) directly generates a lot of ancilliary economic activity: landing fees, retail sales, warehousing, maintenance, etcetera. The airport generates even more indirectly … not least the tourist industry. Things like the Burj Khalifa might seem like wasteful ego-driven expenditures. And they are. But they’re also the sort of over-the-top more-Vegas-than-Vegas kind of thing that draws in the tourists, along with the indoor ski slopes and the “seven-star” hotel. Visitor expenditures made up another 8% of GDP.

 
In 1985, Dubai established Emirates Airlines. At the time most air travel between the Gulf and other points was handled by Gulf Air. Mohammed Al-Maktoum worked secretly with Maurice Flanagan, a former British Airways executive who had run the Dubai National Air Travel Agency, to launch the airline with $10 million in seed capital. The Sheikh supplemented that with subsidies Flanagan estimated at $90 million, including two barely-used Boeing 727s, help with aircraft purchases, a training building, and $64.7 million in other off-the-books investments. As you all probably know, the investment paid off: by 2007, Emirates flew 119 aircraft to 101 destinations in 61 countries, earning a profit of $1.4 billion.  Think about that number for a second.  In 2007, the profits from that one enterprise alone contributed 2% of Dubai’s GDP. And 2% is a minimum estimate: Emirates’ total turnover came to $9.6 billion … 15% of GDP. (Obviously, not all of that number accrued to Dubai — but even a quarter would put the airline’s direct contribution at 4%.)

And then there are the free zones. I’ve already mentioned Jebel Ali, but there’s also the Dubai International Financial Center (DIFC). The DIFC has a special legal regime modeled on the United Kingdom, allows for 100% foreign ownership, and guarantees no taxes on profits or income for fifty years. (Inasmuch as that guarantee means anything in an absolute dictatorship.) Then there’s Dubai Media City, which offers a similar deal to firms in media and marketing services, printing and publishing, music, film, internet-related activities, video games, leisure and entertainment, broadcasting and information agencies. Running free zones has become an export industry. The Orangeburg Industrial and Logistics Park in Santee, South Carolina, won’t be able to offer the same range of tax breaks as the Dubai zones, but it will offer whatever the State of South Carolina can provide over two square miles. Ditto, Economic Zones World is neck deep in the Indian government’s attempt to emulate China’s “special economic zones” and has sunk a lot of capital into trying to turn Djibouti into a second Dubai.

So what’s the catch? Simple. The Emirate leveraged the oil money into the financial center, the port, the free zones, and the tourists in part by real estate profits ... but mostly by actual leverage. As the cost of running the government inescapably grew, taxes + profits generated from real estate provided the necessary income. Unfortunately, once the rate of growth in the value of real estate slowed — reversed, actually — the system became unsustainable.

That said, Dubai Incorporated has one advantage over other places that have tried similar development models (everywhere from Singapore to, well, the State of California), which is that it can treat most of its labor force the same way that a real company would. That, however, brings us to Barry Cotter’s question (and eventually Randy’s) and another post.

Questions, comments, requests? I am going to make a strong effort to get around to them.

Build it and they will come

 Dubai received a boatload of oil money. Still, that boatload wasn’t quite enough to float the immense edifice that is the modern city. (I take a perverse delight in metaphor mixing.) It needed to be leveraged.

 
There were two ways to do that. The first was to leverage. More on that in a later post. The second was to build the city the same way the United States built the railroads: ahead of demand, and financed by land grants.

The idea was fairly simple. The emirate sat in a great location and had a first-mover advantage over its competitors. As of 1971, Abu Dhabi and Qatar had chosen to move slowly, Bahrain faced Iranian hostility, Oman had to fight off the Popular Front for the Liberation of the Occupied Arabian Gulf, and South Yemen had gone Communist. Everyone had been held back by the British, especially poor South Arabia ... geographically-speaking, Dubai (as a transshipment port) should probably be in Aden or Djibouti. So the government built the transportation infrastructure, which increased the value of the land around that infrastructure. It then started to rent land to ancilliary enterprises. The profits from land development went to build more infrastructure and subsidize the overhead costs of running the city. They also went to subsidies for international businesses, which received cheap rents and tax abatements.

 

The above chart shows the government’s income in constant 2009 dollars using UAE price deflators. (Since the UAE had a fixed exchange rate over the period, the calculation is fairly straightforward. The use of a deflator matters, however: UAE inflation has far outpaced American over the period.) The “other” category is made up primarily of land sales, rent taxes, user charges, and other fees. To give an example, in 2009 road tolls generated 17% of all government revenue, and airport charges an additional 6%.

What did the government spend it on? See below the fold.

Nuclear power in the UAE

  The below picture does not show a nuclear power plant.

 
While cooling towers can bear a resemblance to the onion domes, I suspect that the nuclear reactors that Korea will build in the UAE will not be as pretty.

The Korean victory in the UAE bidding process came as a huge surprise to Areva, the French nuclear conglomerate. They had the EPR design ready to be rolled out. President Sarkozy had pulled out all the stops. France had a military base in the country and was training Emirati troops. The President had visited Abu Dhabi. Areva could offer a long-term fuel contract, delivering fresh uranium from its mines in Niger (enriched, of course, in France). Moreover, Areva could accept used fuel and reprocess for reuse it at its plants in La Hague and Mercoule. France meant nuclear. It had to happen.

Yet suddenly the South Koreans came out of nowhere. Huh?

I’d been wondering that myself. So I asked some fellows I know in the Abu Dhabi government. They gave me a simple answer. The Koreans offered a cheaper price, guaranteed that price, and offered a long-term service contract. The Korean price came to $3.64 million per megawatt for a 1400 MW reactor. The French offered something similar, but they refused to take on the risk of cost overruns. When pushed to offer a fixed-price turnkey project, they came back with a price of $5.45 million per megawatt for the 1650 MW EPR design.  Now, Areva’s ability to guarantee fuel for a decade or two is a big advantage ... but Areva will sign such contracts with anyone. No need to buy one of their reactors. In fact, the Koreans already have a 10% stake in Areva’s new mine in Niger, which guarantees supplies to their domestic plants under long-term contracts.

Does the deal make sense for the UAE? The UAE government takes a rather long-term view, so a 5% discount rate seems reasonable. (For comparison, EDF uses an implicit discount rate of 13% in its investment decisions.) Assuming that the reactors manage to reach the 89% capacity utilization reached in the United States, the Korean price implies a capital cost around $23 per megawatt-hour. Fuel costs about $4. Operation and maintenance costs are harder to know, but the word is that the Koreans offered to run the plants for their useful lifetime (presumably 40 years) for roughly $5 billion each. That implies a cost around $11 per megawatt-hour, which is in line with the $8 estimated by the OECD for South Korean reactors. Total cost, $39 per megawatt-hour, assuming that Kepco absorbs the inevitable cost overruns.

What about the other options? At those prices and discount rates, nuclear is competitive with coal. Coal costs quite a bit in peripheral areas — $19 in Finland, for example, and $20 in Japan (per megawatt-hour of electricity produced) — and in a world where the United States has begun exporting the stuff to China via the Panama Canal those costs are unlikely to decrease.  The capital costs of your typical coal plant come to about $11 per MWh, but political pressures would almost certainly drive the UAE to purchase the most advanced “clean coal” technology, which would push the cost up to $20. (No, it isn’t that clean, but it emits less carbon by dint of burning the stuff at higher temperatures.) Adding in the O&M costs from the Japanese coal plants (which use high-temperature furnaces) drive total coal costs up to $50 per megawatt-hour.

The rub is gas. Gas is cheap. Capital costs are tiny; less than a quarter of nuclear. Fuel costs are relatively high in most of the world, except the UAE, where Qatar stands poised to export endless amounts of the stuff via the Dolphin pipeline.

Why choose nuclear over gas? Abu Dhabi is making a strategic calculation, not an economic one, at least not in the short term. Perhaps they think that the local price of gas will rise, either due to increasing demand or because the cost of making LNG for export will fall. Perhaps they are making some sort of inexplicable calculation about foreign exchange. Perhaps they are taking a long-term bet on nuclear power. Or they might simply think that Qatar will be unable to supply them with the quantities they will eventually need for electricity generation at any price, considering that the UAE isn’t their only GCC customer.

I honestly don’t know, although I am trying to find out. What I do know is that they aren’t making a political calculation ... otherwise they would have gone with the French.

Should I add some graphs and charts?  

Natural disasters and and wealth

 I’ve checked, and everyone I know in Santiago seems to be all right. The earthquake has been incredibly severe, but the state is responding.

Here is a brief overview of what we know about the economics of natural disasters. Here is another paper by one of my favorite economists. (He has been really helpful to Kris and I in our ongoing work on Crown Agents.) Yang’s paper looks at hurricanes, not earthquakes, and finds something interesting: in very poor countries, foreign aid plus increased remittances helps recovery along. In richer countries, however, increased inflows from abroad are more than offset by huge declines in private investment. Paradoxically, richer countries take longer to recover than poorer ones. (Places like Puerto Rico and Martinique are not in his sample; I doubt that the result would apply to places that are parts of larger political units.)

Then again, there is economic recovery and there is death and destruction. These are very different. So even if it is the case that richer nations take longer to recover from natural disasters, far fewer of their citizens are likely to die.  Moreover, citizens of functioning democracies are also more likely to make it through, even after adjusting for income.

Chile is both relatively rich and a functioning democracy. Today is a nightmare; but nothing along the lines of what is going on in Haiti.

American Airlines, I should say, is running flights for relief workers out of both Miami and Fort Lauderdale. Kudos.

A modest Greek proposal

 Greece may be facing a serious debt spiral. Governments of the Eurozone appears concerned for two reasons. The first and smaller reason is that many of their financial institutions may be exposed to Greek sovereign debt. A Greek default could therefore have repercussions across the Continent. In that sense, European governments are concerned for the same reason that the U.S. was concerned about Latin American defaults in the 1980s. This reason does not seem to be enough to account for all the concern.

The second reason is that they are terrified of contagion. We have a lot of evidence that investors panic and do bad things to good countries. (Consider the Argentine experience in 2001.) The Europeans might be terrified that a Greek default will drag down Portugal and Spain, possibly Italy and Ireland, countries that might muddle through in the absence of a panic-inducing shock. Large defaults would have two very bad effects. First, financial institutions in northern Europe are very exposed to their bonds; the risk of a super-1982 would be huge. Second, all of the PIGS right now are dependent on current borrowing to finance their government spending. If they defaulted, they would have no way to finance their deficits. Demand would collapse, plunging those countries into depression and dragging their trade partners down with them. (There may be a third reason to worry that I am missing.)

I will admit, however, that I am not entirely clear as to why these worries for northern Europe would be less in the absence of a currency union. Presumably the model is that (1) a country with a depreciating currency is less likely to default on its debt; (2) the loss in value from a default will be higher than the loss in value caused by depreciation; (3) foreigners would have held less sovereign debt in the first place in the absence of single currency; (4) the country would have been able to borrow in its own currency; and (5) the hit to the net exports of the other eurozone partners will be less in the case of a big depreciation followed (hopefully) by recovery than it would be in a depression caused by Hooverism. That seems reasonable to me, but I am not sure that I have it right.

So what to do?  Bail Greece out, obviously, with some sort of temporary low-cost finance. The problem, of course, is whether Greece’s fiscal problems can be solved. Well, it does seem as though tax evasion and inefficiency are a big part of the problem. Even without the crisis, these were bad things, as the linked paper demonstrates.

Well, there is an organization with expertise in managing tax-collection ... Crown Agents. They have an entire department dedicated to it. It would certainly be more palatable to Athens to have the Crown Agents denationalized (if somewhat British-heavy) workforce managing Greek tax collectors than it would be to bring in, say, Germans.

It is time for the E.U. to call them in.

Failure modes of the United States, part 3

 Carlos Yu proposed five possible failure modes for the American system of governance. We have discussed the proliferation of veto points and the glorification of the military on this blog. Since we began, worry about veto points has gone mainstream.  The best (or at least most entertaining, while remaining intelligent) piece about America’s political dysfunction is by James Fallows; I highly recommend it. Meanwhile, nobody worries about a military coup ... although it is a little worrying that somebody as grounded as Mr. Fallows felt the need to discuss the possibility.

The third failure mode was, “The monetary and regulatory agencies might be too slow or too unwieldy to deal with unexpected changes in the global economic system.”  It would be hard to find any sign of that in the last year.  I sat through a number of seminars where all we did was try to figure out what was going on with the Fed’s balance sheet as it tried creative way after creative way to rescue the financial system.  The regulators fell down before the crash, but that was the fault of a bad administration following bad legislation and the general zeitgeist. I won’t go so far as to exculpate them, but it wasn’t like they were sitting down as the world crashed down.

That said, I would not discount the possibility of this failure mode. Consider that the Federal Reserve under Chairman Bernanke appears to have ruled out raising the target rate of inflation. He also seems to have ruled out further quantitative easing. (Which is, I think, trying to do the same thing without making an explicit announcement.) One can make a very good argument that this decision is going to prolong the Great Recession and ruin millions of lives.

OK, that isn’t a failure mode. Not yet, at least. But we have seen the movie before (in 1929-32) and in other times of trouble I could easily see it becoming one yet again. At the very least, it could worsen the effect of other political failings.  It certainly isn’t helping now.

Thoughts?

Inflation-fighting credibility!

 So the Bolivarian Republic recently devalued the bolívar. As you might expect, there were some fears that the move might cause inflation as import prices rose.  IMHO, those fears are simultaneously unfounded and irrelevant. “Unfounded” because the difficulty of getting foreign exchange at the old official price of 2.15 bolívares per dollar meant that imported goods were relatively scarce, and their domestic price correspondingly high. “Irrelevant” because inflation in Venezuela is accelerating regardless of the exchange rate, so who cares?

Anyway, the government worried that the devaluation might cause inflation. So what do they do?  Nationalize a supermarket chain for raising prices!  The President announced the bold move during a seven hour episode of his television variety show, Aló Presidente. The chain will join the other stores of the wonderfully-named Socialist Market Corporation.

That’s inflation-fighting credibility!  Richard Nixon, eat yer heart out.

In housing-related news, the President also gave out 175 socialist apartments, which cannot be rented or sold by their occupants, because that would be capitalism.

I have your Chinese consumer price inflation right here

  I figured out a back way to get in to the account, but it took too much work to post regularly.  I’m here in the UAE on business, and have an impossible amount of other stuff to complete, so adding on hassles with proxy servers and the like was a large disincentive.  The government appears to have let up on Typepad — meaning that they’ve likely identified and blocked the offending sites — so I’m back on board.

Which is why my first post, of course, will be about China.  Why isn’t there more inflation in China?  We looked at that on December 28th.  On January 6th, Brad Delong wrote: 

Every month the People’s Bank of China pays 200 billion renminbi to China's exporters to buy up the dollar-denominated assets they have accumulated and so prevent those assets from generating upward pressure on the value of the renminbi. It gets those 200 billion renminbi by borrowing them from the good burghers of Shanghai. By now the central bank owes the good burghers of Shanghai some 16 trillion renminbi. To them, this wealth is nearly as good as cash. It has been piling up for years — and because it is nearly as good as cash, the good burghers of Shanghai should be spending it.

Here is a picture of the assets held by the People’s Bank of China (PBOC).  It shows fairly awesome growth, driven entirely by foreign asset accumulation.

 

They should be spending it. But the goods that are the counterparts of this financial wealth have been shipped via container to Long Beach. So demand in China should be massively outrunning supply, and China should be seeing strong and rising inflation.

Professor DeLong then links to James Hamilton, who suggests that the reason is that monetary growth in China leads to asset price inflation rather than goods-and-services price inflation.  He concludes:

The fact that our standard models do not appear — so far — to apply to Chinese inflation is yet another disturbing feature of today's world economy.

I’m not so sure that is correct.  Below the fold is a graphical representation of the liability side of PBOC balance sheet:

Where is the inflation in China?

 I have been resisting it, mostly because I don’t want to have to go back and reclassify all the China-related posts, but I have to add a China tag to this blog.  Ugh.

A few years ago, before I started my second-year course on geopolitics and the energy business, I taught in HBS’s first-year required political economy course.  In it, we had two cases on the collapse of Bretton Woods.  One of the teaching points of the Bretton Woods cases was that small countries effectively give up control of monetary policy when they fix their exchange rate.  During the class, I put up the following 1970 quote from Time magazine, which sums up the economics pretty well:

Foreign central banks have no practical alternative but to support the value of the dollar by absorbing any surplus dollars that are offered in their own market places.  If the Bank of France, for example, failed to do this, the resulting glut of dollars in the hands of French bankers and businessmen would cause the value of the dollar to fall in France and the value of French francs to soar.  This would raise the export price of Citroëns, Camembert and other French products, hurting sales abroad.  To avoid all that, the Bank of France buys up surplus dollars. But in order to make those purchases it must increase the supply of French francs in circulation. Thus, France and other foreign governments correctly complain that they are forced to adopt inflationary policies to cope with the dollar flow.

People forget this now but it was actually France, not Germany, what blew up the system.  (Which is not to say that Germany would not have blown it up, if France hadn’t taken the lead.)  It was De Gaulle who said, “There can be no other criterion, no other standard than gold.  Yes, gold ... which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence.”

A fixed exchange rate is (outside Venezuela) a promise by a central bank to swap one currency for another at a fixed price.  If that promise is credible than nobody has any incentive to make a deal at any other price, for the simple reason that one of the parties could always get a better deal at the central bank.  In France’s case, back in the day, everyone wanted to buy its exports.  So they took their dollars, and swapped ‘em for francs at the Banque de France.  Where did the Banque de France get the francs?  It printed them!  That is what central banks do; they cannot hold their own currency as an asset, any more than a company can buy up its own debt and book it on the asset side of the balance sheet. 

Well, the People’s Bank of China (PBC) today is piling up bajillions of dollars in its vaults.  In theory it would have to print bajillions of yuan for that.  In practice, the Chinese government sterilizes the inflow by forcing the banks to buy government bonds.  In essence, a Chinese exporter turns over his or her dollars to the PBC for yuan accounts at a Chinese commercial bank.  (They have to do this, by law.)  The government, however, forces the commercial banks (which are mostly state-owned) to use the yuan deposited in them to buy central bank-issued bonds.  An utterly stylized way of thinking about it would be:

1. The central bank prints yuan in exchange for dollars.
2. The yuan are deposited in commercial banks.
3. The commercial banks lend the yuan back to the central bank in exchange for bonds.

And voila, inflation is kept under control. 

The point, however, is that the inflationary pressure is caused by the fixed exchange rate.  Only now the Chinese are claiming that their fear of inflation is a reason to keep the fixed exchange rate!  Whaa?  Paul Krugman and Dean Baker point out allowing the yuan to appreciate would reduce import prices, and thus lower inflation.  This post is reinforcing their arguments by pointing out that the pileup of reserves — which an appreciation of yuan would slow or stop — also causes inflationary pressure.  In short, Chinese policy makes no sense in terms of inflation.

I am coming around to the unfortunate conclusion that it may be time to credibly threaten to slap some pretty significant tariffs on Chinese goods.  Right now, that country is acting as an international demand suck, earning foreign income and then sitting on it.  Sure, it is nice that they invest those reserves in Treasury bonds ... but with American savings rates rising and interest rates as flat as they can get, now is the time for them to start buying less. 

I find this sort of thing irritating.  I found it irritating when the Chinese government, which quite successfully engages in massive buy-Chinese policies (google “State Council Document 18”) criticized the buy-American provisions of the stimulus.  That was small beans, however.  The Chinese government right now is playing with fire in refusing to allow its exchange rate to appreciate.  During the Great Depression, countries imposed tariffs in lieu of devaluation.  The U.S. can’t unilaterally devalue the dollar against the yuan without Chinese cooperation.  The implication is left as an exercise for the reader. 

(To be fair, the Eichengreen and Irwin paper makes a very different point.  Unlike the countries hit by the Great Depression, the U.S. is a gigantic economy, and the fixed exchange rate with China does not impose deflationary pressure that the Fed cannot fight.  But it does reduce aggregate demand, and it is a growing problem.  I hope the Chinese see the light before we slap tariffs on ‘em.)

Thoughts?

Trills, warrants and kickers

  This post is not about organized crime.  This post is about a proposal from Robert Shiller and Mark Kamstra featured in today’s New York Times.  (Sanchez got the first down!  At the opposing 46.)  The idea is for the government to issue bonds whose payout is linked to GDP.  (Sanchez sacked!  Commentator yells, “Are they trying to kill Sanchez?”)  In the case of Shillers proposed “trills,” the payout would be directly linked:   each one would yield one-trillionth of quarterly GDP every three months.

It’s a fine idea, although I suspect that the benefits would be, well, limited.  They protect against inflation, but so do inflation-linked bonds, and investors would presumably demand some sort of equity-ish premium.  That said, they’d offer an easy way to diversify ... you get to buy a security linked to the income of every single income-earning entity in the country!  On the other hand, the income stream won’t come directly from those entities, but via the tax revenue that they generate for the federal government. 

(Holy s--t!  Did that just happen?  Challenge.  Why yes, it did.  Two-point conversion, 18-15.)

But that is not what this post is about.  This post is just to point out that Argentina issued something not unlike the trill back in 2004.  The “GDP kicker,” pronounced “keek-air,” aka a warrant, offered creditors payments equal to one-twentieth of the dollar value of all GDP growth above a threshold of 4.2% per year.  Bosnia, Bulgaria, Costa Rica, and Singapore have issued similar securities.  None of them are as simple as the trill, of course, but still.  When have you heard of Argentina being a financial pioneer, in a good way?  (Field goal! 21-15.)

Of course, there are some people who think that Argentina gave away the store with the kicker.  And they may be right!  Which is what worries me about the trill.  It might turn out to be a rather expensive way to finance the borrowing needs of the government ... and that, ultimately, is what I tend to think government debt is for.  Although Alexander Hamilton would not agree.

The Rwandan empire in Congo

  A “stylized fact” is a fact accepted as true for the sake of argument.  Good stylized facts are true statements that have been simplified in order to allow the creation of tractable arguments.  Bad stylized facts are oversimplified at best, and false at worst. 

One stylized fact is that Rwanda extracted great economic resources from its control of eastern Congo in 1998-2004.  It is accepted.  But is it true?  The answer is not as clear as you might think.

The Rwandan-backed RCD collected fees from local producers.  In Bukavu, merchants who commercialized peasant production were forced to pay a $1,300 fee, in addition to a $3,000 deposit.  In addition, the RCD used military planes to export palm oil to Kisangani.  The rub, however, is twofold.  First, there is not any evidence that the RCD taxes on commerce flowed to Rwanda ... although they did obviously reduce the subsidies that needed to flow the other way.  Second, according to merchants involved in the trade (HBS is very well plugged in to Rwanda) palm oil exports were barely able to cover their costs during the period; Rwanda in fact subsidized the RCD’s profits by providing the planes.

Following the general pattern of the Mexican Revolution, Ugandan and Rwandan troops did not destroy the Sotexki textile plant during their invasion and occupation.  On the other hand, the plant did basically shut down.  The gave an advantage to Rwandan exporters, but it is hard to believe that the additional profits were significant, even in an economy as poor as Rwanda.   

The Sominki gold mines (which also produced coltan and cassiterite) would have been, well, a gold mine, had they not gone bankrupt in the 1980s.  The mine holding company was renamed Sakima, and wound up in the hands of a Canadian corporation, Banro.  In 1998, the DRC expropriated the mine.  (Banro sued Congo at the all-powerful ICSID ... the panel wisely decided to use the fact that Canada had not signed the Washington Convention to punt and let the DRC get away with the expropriation.  Otherwise ... ugh.)  The RCD took over the mines in 1998 and quickly requisitioned 312 tons of coltan and 190 tons of cassiterite.  The DRC gave the concession back to the Canadians in 2003, but the RCD continued to pick over the bones until 2004.  Still, they really were bones, at least in terms of gold; the mines were dead, even by Central African standards. 

So far, so little.  Rwanda “let them [the RCD] exploit the sub-soil for their survival,” and that certainly made it cheaper to maintain control of the area in an international environment that precluded formal annexation.  (There is some evidence that Rwanda wanted to annex the region, which would have completely altered the game, quite possibly for the better.)   That, however, was not a reason for Kigali to continue its occupation; it merely made it cheaper to continue a policy that it wanted to pursue for other reasons.

But that isn’t quite right either.  The U.N. argued that the Congo Desk of the Rwandan Patriotic Army came up with a number of schemes to extract resources from its Congolese territories.  There is even an unconfirmed report of Kagame calling the war “self-financing.”  Thing is, theU.N. report really seems a bit dodgy.  Its estimate of $320 million a year comes from one unidentified source.  It also comes to 20% of Rwanda’s GDP, an four times its official military budget, an enormous sum.  The report gives percentage breakdowns of coltan exports, without mentioning either prices or quantities.  As social science, it is really really bad, inexplicably so.  I could have done a much better job ... but I don’t have reasons to want to find evidence of massive resource extraction. 

I don’t have reasons not to find such evidence either.  In fact, there is solid data regarding diamond profits.  The RPA and RCD apparently set up a powerful monopsony, using force to insure that exports went through their hands.  In 2001, the RCD even studied how their designated tax farmer was performing.  The quota was about $500,000 per month, and the fellow was meeting it ... but the market value of the quantity exported was over $2 million.  The U.N. concluded that the Congo Desk diverted the difference, but in the absence of data on how much was paid to producers and middlemen (and harder price and quantity data) that conclusion is dodgy.  In addition, the maximum estimate of diverted funds comes to a little less than $17 million per year.  That is a lot of money by Central African standards, but it is not $320 million.

In short, it is undeniable that the RCD financed itself from local resources.  It is also undeniable that the RPA got something from the occupied territories.  What we do not know is whether it was anywhere near enough to provide an incentive to prolong the occupation in the absence of security concerns. It really depends on the coltan numbers, which AFAIK we do not have.  Inexplicably.  Here is a pretty bad journalist’s report.  It has numbers, though, and it might be possible to use it to ballpark Rwandan coltan profits, if any. This report seems better, and it might be possible to tease out some real numbers.  I am sure that there is other data available, for anyone with the time and the interest.  (I have only the second at the moment.)

The really interesting counterfactual is whether the Second Congo War and its aftermath would have been as prolonged or as destructive in the absence of an effective taboo against de jure border changes.  And that counterfactual, of course, depends on the amount of resources that could be extracted and the security concerns faced by the relevant parties.  But it is food for thought:  do our post-1945 institutions really contribute to peace and well-being?  I honestly think that they do — but like all stylized facts, it bears the occasional reconsideration.

So ... I ask you all for two things.  (1)  Hard evidence on Rwandan extraction; and (2) thoughts on the impact of the effective end (with a few exceptions, here and there) of de jure annexation?

Dubai bailout, nothing to see

  No, really.  Here’s the opinion of a Saudi Arabian banker on the Dubai default, dated November 27th:  “We believe that Abu Dhabi will come to the rescue… but like all rescues it would have a price. In that case it may well be first of all a political price.” Why did they believe that Abu Dhabi would rescue it’s neighbor?  Simple:  ADIA, Abu Dhabi’s sovereign wealth fund, has enough assets that if it seemed like bailing out Dubai world might preserve market values, then ADIA had enough of a stake in those markets to make the bailout a paying proposition.  Saudi did too, but Abu Dhabi, unlike Saudi, could more easily extract political gains in addition to the economic returns from a bailout.  

Thus, the bailout.  Stocks still seem to have reacted well, despite its wholly predictable nature.  Ni modo.

Beer, banks, and revolution

  Doug Muir observes that breweries and banks seem to survive civil wars.  Now, Doug would never tell you, because he’s modest, but it so happens that he has a friend who’s a little bit knowledgeable about the effects of political violence and instability on economic activity.  His friend has even written an entire book about banking and instability. 

So, is Doug correct that banks and breweries tend to make it through political instability?  Short answer:  yes. 

Long answer:  well, let’s examine the data from one of the worst bouts of political instability to afflict any country with a substantial financial sector and developed manufacturing, at least outside the benighted continent of Europe.  Between 1910 and 1929, Mexico suffered a revolution, two insurgencies against the winner of the revolution, a counter-revolution, a counter-counter revolution, a civil war among the winners of the counter-counter-revolution, a military coup, another bout of civil war after an attempted coup by the Secretary of the Treasury, a presidential assasination, three more attempted coups, and a third civil war fought by angry Catholic guerrillas with a penchant for dynamiting passenger trains.  Among all that, what happened to the banks and breweries? 

Let’s start with the breweries.  Mexico’s domestic industry was created almost overnight during the last decade of the 19th century, with local monopolies established in virtually every major city by the 1900.  One of the industry’s leading firms (the Cervecería Cuauhtémoc of Monterrey, Nuevo León) came to control 28 percent of the national market.  It went on to spin off a glass bottle making company (Vidriera Monterrey) that quickly established itself as a domestic glass monopoly.  The other two major breweries were the Cervecería Moctezuma (of Orizaba, Veracruz) and the Compañía Cervecera de Toluca y México near Mexico City.  

During the civil wars, armed factions viewed factories as strategic assets that could be used to generate income for the army.  What typically occurred in occupied areas was that a faction would seize the factories and run them for its own benefit, or it would threaten to do so unless the management made a “loan” to the revolutionaries.  In April 1914 the forces of Pablo González took control of Monterrey.  For most of the year González occupied and ran the Cervecería Cuauhtémoc, where he continued to employ the brewery’s workforce.  By November the company’s stocks of raw materials had been used up. 

At that point, having extracted what he could from the operation, González returned the factory, apparently undamaged, to its owners.   

The upshot is that while production dropped during periods of generalized violence — 1914-19 and to a lesser extent 1922-24 — the breweries themselves pretty much came through intact.  In fact, beer was such a good market that the Cervecería Modelo started up in 1925, while the country was still rather unstable. 

So what about the banks?  Well, the banks didn’t fare that well during the civil wars.  They were where the money was. Governments and revolutionary factions plundered their cash reserves, forced them to make loans, and engaged in the unrestricted printing of currency.  It did not do good things for the banking system, which by 1916 ended up in government receivership — although in many cases the Carranza government wound up with little more than a Mexico City branch office and some papers.  On the other hand, the governments that came to power after 1916, however, regardless of their stated ideologies, all recognized that they needed a source of credit in order to restore political order.  

    

It took a while to put humpty-dumpty back together again.  A private banking system came back to life, but a December 1920 banking panic caused most of them to fail.  In 1921, President Álvaro Obregón announced that twelve banks would be returned to their owners; only five were able to reopen.  The government tried to regain access to foreign capital markets by restarting payments on the foreign debt, but the civil war triggered by Treasury Secretary Adolfo de la Huerta’s revolt put paid to that.  On the same day the revolt began, Banamex (the largest private bank, and one that existed before the Revolution) transferred $13.5 million to the International Bankers Committee.   The government simultaneously borrowed $5 million from the Huasteca Petroleum Company against future oil tax liabilities, with the intention of using the funds to make additional payments on the foreign debt.   Instead, the funds went to fight De la Huerta.  The diversion of funds meant that the government had to borrow from Banamex to pay foreign creditors ... on July 2nd, 1924, the government gave up and defaulted once again, this time for good.

In other words, this was not a healthy banking system.  A snapshot in 1917 would have showed it as pretty much dead ... but no matter how you put it, five banks did survive (including the two largest) and the system schlumped along despite the occasional civil war.  The government needed the bankers too much to kill the system dead.  In fact, it went out of its way to reactivate bank lending in 1925.

So how did they reactivate the banking system in 1925?  That’s another story.  The moral of this story is that Doug is right:  banks and breweries can survive even extreme levels of violence. 

The Chávez boom

 Back in the comments on the post about Venezuela’s electricity crisis, Scott expressed surprise at the claim that the Venezuelan economy has grown like gangbusters since 2002.  “Has growth really been that dramatic?” he asked.  “It doesn't square with a lot of what you read about Venezuela.” 

In point of fact, growth really has been that dramatic.  Last year, there was a back-and-forth between Francisco Rodríguez and Mark Weisbrot about the accomplishments of the Bolivarian Revolution.  There was an slight pin-angel quality to their dispute.  Rodríguez’s data on spending shares and literacy changes were fairly incontrovertible. Their dispute over inequality hinged over the treatment of zero-income households, but even if you throw them out of the sample you get generally stagnant inequality, which is less than revolutionary. 

Similarly, the two argued about the extent of poverty reduction, but Rodríguez’s point was that the Bolivarian Republic had done a lousy job of reducing poverty given the extent of economic growth, not that it had failed to reduce poverty.  In short, the dispute hinged on whether the country deserved a mulligan for the oil boom.   Rodríguez wanted to grade the government on a curve, Weisbrot didn’t. 

So how big was the oil boom?  Big.  Real GDP doubled between its nadir in the first quarter of 2003 (when the national oil company tried to overthrow the government) and the second quarter of 2008.  From a base of 100 in 2003, real private consumption leapt to 115 in 2004, 133 in ’05, 157 in ’06, 187 in ’07, and 202 in 2008.  Even the inequality measures that include zero-income households remained basically unchanged over this period (with a weird spike in 2005), indicating that the consumption boom was pretty well spread.  Poverty dropped from a peak of 55% in the second half of 2003 to 26% by the beginning of 2008; extreme poverty fell from 25% to 7% over the same period.  To be fair, the reduction in 2007 is really hard to measure, since the poverty basket uses official prices, and most staples have been rationed at the official price since then.  (Although Mickey-D’s has not been affected, as best as anyone can tell me.  Ditto most private markets.  Weird sort of socialism, that.  But I digress.)

There is some evidence that the boom bypassed the poorest of the poor:  The percentage of underweight babies born in Venezuela, for example, increased from 8.4 percent to 9.1 percent between 1999 and 2006. During the same period, the percentage of households without access to running water rose from 7.2 percent to 9.4 percent, and the percentage of families living in dwellings with earthen floors multiplied almost threefold, from 2.5 percent to 6.8 percent.  On the other side of the ledger, infant mortality dropped from 21.4 per 1000 live births in 1998 to 18.5 in 2003 and 14.2 in 2006, while the number of primary care physicians in the public sector rose twelvefold.  That said, the above is a red herring for the purposes of this post:  the point is not that the Bolivarian Revolution has been less than revolutionary; the point is that the country underwent a huge boom in 2002-08, and that boom trickled down to the bulk of the population, if not necessarily the poorest. 

The boom certainly translated into jobs.  Formal-sector employment grew 42% from 4.53 million in 2003 to 6.45 million in 2008; informal employment stayed basically unchanged, drifting up from 4.99 million to 5.02 million.  Public employment outpaced private, growing from 11.6% of total employment (formal and informal) to 16.6%, but since my readers are smarter than Michael Steele, they recognize that a job is in fact a job.

So, jobs, incomes, consumption, all way up.  Not as far up as in places that handled the hydrocarbon boom better, like Alberta or Trinidad or Bahrain, but still way up.  Which leaves me curious.  Scott, what did you read that left you with a different impression of economic conditions in Venezuela over the last half-decade?