The Power and the Money

Why I would not want to be the next president of the Bolivarian Republic

Reader Shah8 asks about the problems is Venezuela’s economy. It’s a good question.What are the time bombs waiting to go off?

Before I start, let me present the case for the defense. The linked paper argues that Venezuela’s economic expansion is sustainable. The linked paper, however, is incorrect.

First, the authors sustain that payments on Venezuela’s foreign debts are manageble. They are correct. (Figures 3 and 4.) The problem is that the interest burden is not the problem. The problem is that government of the Bolivarian Republic requires capital inflows around $15 billion every year to stay in balance. If those inflows drop, then BLAM ... sudden stop.

(The authors are convinced that China would not allow Venezuela to collapse. I am unclear as to why they believe that.)

Second, the authors argue that the bolívar is not overvalued. They base this on a scatterplot of countries. On the Y-axis they put the ratio between the official (or market) exchange rate and the exchange rate at which a basket of goods and service would cost the same as in the United States. Venezuela is not out of the pack.

The problem is that this measure has a lousy track record of predicting currency movement.

There is better measure of the bolívar’s overvaluation: the difference between the official rate and the black market rate. (The black market rate is tracked, more or less, at this website.) The gap has now approached three-to-one. It hard to see how Venezuela can sustain that without worsening shortages of imported goods or a major devaluation.

The only other country in the hemisphere in a similar situation is Argentina. When I was in Argentina in May and June of 2012, I was very tempted to blog about the controls despite a lack of time. (I wish I had; perhaps I still will.) Pesos were pegged at 4.5 per dollar, but while I was there the “blue market” rate hit 6.15.  A Brazilian couple was arrested by dog-using police teams practically in front of me; they were carrying several thousand dollars. (The papers reported that they were acquitted.) That was legal, but the dollar-sniffing dogs were hunting black marketeers. The controls made (and make) life difficult for small manufacturers, which often find it difficult to buy the dollars they needed to import specialized goods.

But Venezuela’s exchange controls are in a whole different level from Argentina’s. The Argentine blue rate is around 60% above the official rate; the Venezuelan parallel rate is almost three times the official rate. Argentine controls hurt some importers who cannot get dollars, but they are not noticeable in the shops and streets. Venezuelan controls, on the other hand, cause cooking oil, margarine, and toothpaste to disappear. Venezuela has been plagued by periodic shortages for years, but they are now becoming pervasive.

That is not sustainable. Well, it is ... but at the cost of ever-worsening import shortages. Either Venezuela will develop an extensive set of import-substituting industries (a la Mexico circa 1980) or most Venezuelans will lose access to manufactured goods. There is no sign of the first thing happening.

Both these problems — a dependence on foreign borrowing and unsustainable capital controls — come together in the electricity crisis. I blogged about it in 2009: it is not getting better. Other countries have experienced temporary shortages (Ecuador in 2009) but none have suffered ever-more-erratic service for four years. (Ecuador has resolved its problems.) Installing thermal generators requires the government to borrow to get the dollars, and the refusal to charge market prices for energy drives up the budget deficit. Then, to make things worse, the exchange controls drive up construction costs. (I explain why that happens here.)

In other words, there are three ticking time bombs waiting to hit the next Venezuelan administration. First, capital inflows could slow; at some point they will slow. Venezuela is not in a position to handle that without a severe recession. Second, at some point either the shortages will become unsupportable or the bolívar will be devalued. Shortages will not be good for the party in power. A devaluation is equally problematic. With inflation already running north of 20%, it could (oh, heck, almost certainly will) cause large price spikes with all the ensuing damage to living standards. Third, the electricity crisis shows no sign of abating. Maduro blamed the blackouts on gringo sabotage; I do not think that is an effective political strategy.

There is a fourth time bomb: crime. Hugo Chávez was seemingly immune to criticism on the topic; the next administration will not be.

And there is a fifth: Chavista foreign policy. More on that in a future post.

I make no predictions about which will blow up first or how badly. But at least one of them almost certainly will. The next administration will have to fix the problems or deal with the aftermath ... but there are no painless fixes.

Mexico is gaining jobs, not wages, part 2

Part 1 is here.

Part 2 is based on a stunning report from Bank of America: nominal dollar wages in Mexico are now lower than in China. (Hat tip: Beyond Brics. But note that we here at TPTM called it first!)

This is a great thing for China, obviously, and it has benefits for Mexico. It means that “nearshoring” will continue, as Mexico gains competitiveness against China. In fact, Mexico became competitive back in 2008, right after the big depreciation in the peso. The below chart shows Alix Partners’ decomposition of the landed costs (i.e., wholesale cost for U.S. sales) for five representative goods. In 2005, China was cheaper than Mexico; by 2008, that was no longer true.

But is it a good thing for Mexico? I am less certain. A boom based on nearshoring and continuing low wages ($2.50 an hour from BofA; $4.53 from the BLS) is a good thing for investors and the resulting employment boom is a good thing for Mexicans, but it does not presage much future growth. (In addition, the gains from the good news are already priced into the markets; ship-sailed if you’re looking for easy returns.)

Mexico is a solid middle-income democracy with a serious (but not existential) organized crime problem. It has made amazing strides in eliminating unnecessary volatility. The country works. But looking over the recent hype it’s attracting (see here and here and here.) I feel a little like Chris Rock. “You’re supposed to have a democracy! You’re supposed to have a middle class! You’re supposed to have factories! What do you want, a cookie?”

In other words, Mexico is performing just as you would expect a stable middle-income country with substantial long-term problems to perform. The expectations of super-returns and blather about Aztec Pumas (or whatever) is just hoping for a cookie.

P.S. Noah Smith expects rising demand for Mexican manufactures to raise wages. (You should all read his blog! It is a very good blog.) His error is simple: the demand for Mexican manufactures is extremely elastic, because Mexico is not the only country in the world.

P.P.S. No, I have not started to follow Twitter feeds. I hate that thing even more than Facebook.

Observatorio argentino 19: Poverty in Argentina

Argentina turns out to be a poorer country than we realized.

Argentina, like the United States, measure the poverty line against a basket of goods. The rate of absolute poverty is measured against the monthly cost of a minimum amount of food; the regular poverty rate is assessed against a broader basket which includes a bare amount of housing, energy and manufactured goods. According to the official agencies, in 2011 the monthly food basket cost ₱205 per person while the broader basket cost ₱449.

The Universidad Católica Argentina (UCA) used unofficial sources to revalue the official baskets. They found that the food basket cost ₱351 and the broader one ₱720.

As you might imagine, the mismeasurement of inflation has significant effects on the poverty figures. (The data is at the above link.) According to the Argentine statistical agency, absolute povery (“indigence”) afflicted 1.7% of the population in 2011, while 6.5% suffered regular poverty. The UCA conducted its own survery of urban areas, using the official poverty lines, and found slightly different numbers: a few more in poverty (7.8%), a few less in indigence (1.5%).

But when they used the actual cost of the basket, the numbers leaped: 21.9% in poverty and 3.3% in indigence, meaning that one in thirty urban Argentines did not earn enough to avoid malnutrition. (The survery did not include rural populations, so it is unlikely that the indigent had access to much non-market food.)

Let me be clear: the poorest Argentines are much better off than they were under the old regime. In 1998, right before the country began its grinding depression, almost a third of urban Argentines were poor and almost a tenth lived in households that did not earn enough to pay for their caloric needs. Even with the revised numbers, the situation has improved markedly.

But two things stand out. First, Argentina did not avoid the Great Recession. Well-being degenerated markedly in 2008 and 2009.

Second, the Argentine government probably played games with the indigence statistics in 2008 and 2009 (but not thereafter): the official numbers and the survey numbers diverge rather dramatically in those years, even without the inflation adjustment.

In a way, the numbers make the games the government has played with the statistics even more incomprehensible. The Kirchners have a great record on poverty: this is not the Bolivarian Republic. The uptick in 2008-09 is entirely understandable, given the Great Recession ... and I very much doubt that the families thrown into poverty were unaware of it.

Given that, what is the point of the obfuscation? 

Singapore is not serious ...

... about raising fertility.

Over at Demography Matters, my friend and occasional co-blogger Randy McDonald brings our attention to the Singaporean government’s preoccupation with below-replacement fertility. They seem quite worried about it, to the point of calling for ever-greater immigration designed to keep up the population at 5.3 million.

The thing is, “seem” is the operative word. Judging from actions, the Singaporean government does not care that its native-born population is going to fall. And it is probably right not to care! But I find it mildly vexing that it makes so much noise while doing so little.

You can find the current natalist policies on page 72 of this population white paper. The highlights:

• 75% of the cost of fertility treatments;
• $4,800 (U.S., at an exchange rate of 80¢ per Singaporean dollar) for the first and second child, rising to $6,400 for the third and beyond;
• A deucedly vague “affordable” rental scheme for people with enough money to buy an condominium but are waiting to move in;
• $480 a month for day care;
• A tax rebate of $4,000 for the first child (doubling to $8,000 for the second and $16,000 for later ones ... but not refundable);
• A cumulative tax deduction for working mothers of 15% of earned income for the first child, 20% for the second, and 25% for the third.

So what does this all come to? Well, the median income in Singapore is $28,800 per year. For a couple with two children, you get a one-time gift of $9,600. Then you get $5,760 for day care ... which drops in half when the child is no longer an infant. (And does not get you much unless day care is much cheaper than in the United States. Unlicensed housefront operations in Queens Licensed home operations in Upper Manhattan cost more than about $480 a month.) Our hypothetical two-income couple has an income tax liability of $2,232 (calculated using this chart from the Singaporean tax authorities) which unless I am greatly misunderstanding means that the value of the subsidy is effectively capped.

Total annual payments for a first child in a two-income family, with both earning the median: a one-time first-year gift of $12,792, followed by $5,112 per year until the child enters school. Life-changing, this is not. And worse yet, if you needed fertility treatments, which most older couples do, you needed to think about the cost. (Israel does it differently.)

This is not serious.

What would be serious? Ah. Well. In 2011, the Singaporean government ran a surplus of $21.3 billion. There were 42,600 births in the country. A fertility rate high enough to replace the population (in fact, a bare tad higher) would imply roughly 70,000 births. $21.3 billion ÷ 70,000 ≈ $300,000 per child.

OK, then: offer $300,000 per child. Tweak as desired. That would be serious policy. Of course, I am not saying that paying a $300,000 child bonus would be good policy.

But it would be affordable. And it would live up to Singapore’s reputation for social engineering! So before they give up and say it cannot be done, they really should at least try. Or stop complaining.

The Alaskan way in Venezuela?

 The great state of Alaska has a fairly unique way of handling hydrocarbon revenues. According to Article 9, Section 15 of the constitution of Alaska, “at least 25 percent of all mineral lease rentals, royalties, royalty sales proceeds, federal mineral revenue-sharing payments and bonuses received by the state be placed in a permanent fund, the principal of which may only be used for income-producing investments.” In 1980, the legislature set the actual pay-in requirement at 50% of the above revenues.

The Alaska Permanent Fund Corporation (APFC) then invests the proceeds. For reference, in 2012 the Fund received $915 million from the state, up $28 million from 2011. (APFC annual reports can be found here.) The APFC is more-or-less free to do what it wants; it is fairly conservative but not as much as some other sovereign wealth funds.

Roughly 53% of the investment income earned by the APFC is then paid out in dividends (calculated here) to citizens of Alaska, i.e., any U.S. citizen resident for at least six months. (Alaskan law previously favored longstanding residents, but the U.S. Supreme Court threw that out in 1982.) Dividends are based on a five-year rolling average, so it is unlikely that a crash (like, say, 2008) would axe dividends although. That said, it is possible. Last year the APFC transferred over $605 million; in 2011 it transferred $801 million. (The link will take you to the web page of the organization that distributes the dividends, called the Permanent Fund Dividend Division; that is different from the APFC.) Historical data on dividends can be found here.  

You got it: every man, woman, and child in the State of Alaska gets a check ($1,174 in 2011) cut to them by the state government from the proceeds derived from the state’s titular ownership of all subsoil resources. Which is why, obviously, Alaskans hate socialism. 

Could this system work in Venezuela? Pedro Rodríguez, José Morales, and Francisco Monaldi suggest that the answer is yes. Oil has been a net benefit to Venezuela, but the country has clearly wasted most of the income; giving cash to citizens could solve that issue. Still, there are a couple of rubs. They address all of them in their paper, but not in sufficient detail:

1. How much is needed to keep the Venezuelan state running? Alaska set up the Permanent Fund fairly close to the beginning of the oil boom. Venezuela, on the other hand, will be doing so after a decade of high oil rents and almost a century of oil dependence. The authors are probably correct to argue that a new government could shut down most of the “misiones” without too much trouble. The authors are certainly correct to argue that the country would be better off getting rid of its idiotic fuel subsidies. It is less clear to me, however, that starving the rest of the bureaucracy would be wise, regardless of how bloated it may be. Venezuela right now suffers from too little governance in some very big fields (police, courts, schools and infrastructure, just for a start) and fixing the mess left over from President Chávez and his feckless Punto Fijo predecessors could easily require more money, not less;
2. How do you deal with disincentive effects? The amounts that would be distributed under the Venezuelan plan are a much larger share of income for the median (let alone poor) Venezuelan than for the median Alaskan. Alaska in 2011 had a median income of $67,825 per household, against an average APF check of ($1,174 × 2.65 people per household) $3,111. Call it 5% of per capita income. In Venezuela, though, similar numbers would have in 2008 represented “31% of per capita income for those at the bottom 25% of the income distribution, 15% for the next quartile and 8% and 3% for the top two quartiles respectively” at official exchange rates. Unofficial exchange rates could as much as triple those figures;
3. The volatility problem follows. Alaskans just have 5% of their income tied to swings in oil prices plus financial markets. (To be frank, the Alaskans have not solved that problem despite using the mechanisms proposed by the authors to do so.) In Venezuela, it will be much higher; 
4. How do you get past the unpopularity of the plan? The Venezuelan opposition proposed such a thing in 2006. The authors have evidence that a lot depends on how the proposal is phrased, but those results do not take into account the inevitable opposition campaign;
5. If you solve problems (1) and (2) by allocating only a relatively small percentage of the oil money, what exactly is it that you have solved? I am honestly unclear. Is it the management of the hydrocarbon sector? Well, lots of countries have more-or-less solved at problem in various ways: Brazil and Algeria come to mind. Is it to weaken political machines? OK, but populists could still play with payouts, no? Is it to insure that benefits flow to the poorest? I am with them on that one, but it might be hard to sell.

In short, the authors make a compelling case, but I think the devil really is in the details. I would like to see a more detailed proposal.

Natural gas prices will rise and tight oil will not peak for decades

I tend to avoid blogging about the stuff that I teach about in my class. That is probably a mistake.

A recent presentation by J. David Hughes about shale gas and tight oil has gotten some recent attention. It makes two conclusions. First, the price of shale gas is going to go up. Second, the tight oil boom is a chimera.

The conclusion that the price of shale gas is going to rise is true. It is also not news. (Why was it treated as such?) For example, I made a presentation on October 4th, 2012, to the Business and Environment Initiative at HBS on fracking and shale gas. In that presentation, I pointed out three things:

1. If you assume land costs of $5000 per acre and opex of $1.50 per MMBTU, then the “point forward costs” (i.e., marginal costs including land acquisition) of shale gas are $8.31 in the Fayetteville shale and $8.75 in Haynesville;
2. ARC Financial estimates that $22 billion per quarter in capex is needed to maintain production, up from current expenditures of $12bn;
3. Shale gas drilling has gone off a cliff (rigs in operation have crashed from a little over 1500 at the beginning of 2008 to only 500) ... and given the well-known hyperbolic decline rates of shale wells that meant production would soon decline unless prices recovered. (I reference those hyperbolic declines in this January 2012 post on Argentina.)

In short, Hughes is correct (his back-of-the-envelop calculation of the needed capex is actually only half that calculated by ARC) but his conclusion is not news and should not be treated as such. There are industry professionals who claim that well costs will fall and that land costs are not sustainable, so the marginal cost data should not be taken as data from on high. (Chesapeake has said that its magic spot for the Marcellus shale is around $5.) That said, few believe that natural gas prices will remain below $4 per MMBTU for much longer ... but “much longer” probably means more than a year. I do not expect U.S. prices to suddenly jump.

What about tight oil? Well, we already know that the marginal cost of tight oil is at least $60. When you add in the realization spread (the difference between the companies’ realized revenue per barrel and some benchmark price, usually Brent) you get a marginal cost of at least $90.

Hughes goes on to argue that the Bakken will peak in 2017 and then decline, but that rests on some dicey assumptions. First, that the 2010 EIA estimate of 9,767 potential wells remaining is correct. It is probably not: it assumes spacing of 2 wells per square mile, when four is already occuring and eight is already feasible. Second, it includes only discovered reserves. Finally, it assumes that oil prices will not rise further. The first two are relatively improbable.

Moreover, the Bakken is only one of many plays in the United States. It will start to decline relatively soon, if not by 2017 ... but other plays are expected to increase. The EIA really does know what it is doing when it makes its projections.

In short, it is true that the Citigroup analysis seems breathlessly out to lunch and it is true that tight oil plays require high prices. But we are not facing peak-tight-oil anytime within the United States. And while natural gas prices are fated to rise, the rise is not immediate.

Intangible drilling costs

This issue came up off-line, so I figured I should post about it. Some people in the oil industry claim that the deduction for intangible drilling costs is not a subsidy but an allowance for real expenses. And they are correct! Which is why nobody proposes to eliminate it.

When oil and gas companies drill, they incur all sorts of expenses beyond the cost of the materials used in the well. They need to prepare the site, build roads and gathering fields, install tanks, etcetera and ad naseum. In addition, they often pay service companies for, you know, services. These costs are real costs (there is nothing intangible about them) and the companies should be able to deduct them. Otherwise the tax code would be treating expenses as income, and that would be crazy.

The rub is that all companies incur similar costs. When Nissan builds a factory, it pays for all sorts of things beyond the cost of materials for the buildings and machinery. These costs are deductible. But when costs are used to build an asset that will produce for a long period of time, then the standard rules are that the company has to deduct those costs over a long period of time. For example, if you build a $5 million factory in one year, you cannot deduct the expenses the year you make them. You need to spread them out, (say) one million per year for five years.

Oil and gas companies, for some reason, are allowed to deduct those expenses up front, in the year that they are made.

The debate is over whether that special treatment should be allowed. (An overivew of oil and gas tax issues in the 2012 budget can be found here.) There are reasonable arguments on both sides of this debate, but do not allow oil company representatives to mislead you into thinking that anybody is considering the nutty idea of removing the deduction for intangible drilling costs.

That is all.

A too-brief history of zoning

As most of you know, I am not a big fan of zoning. In fact, my wife and I recently made the mistake of attending a Cambridge zoning hearing. It does bad things to my blood pressure to hear people state with apparent sincerity that limiting buildings to three stories will keep rents lower.

Seriously, this building should be at least as tall as the 1970s-era one right next to it.

Here is a nice short economic history of zoning. The argument is that the streetcar first enabled the creation of informal residential districts. (Before that, you just could not cleanly separate residential and commercial functions, since city size was limited and commutes painful. Workplaces and residences had to be close.) Then the truck and bus came along and busted up the informal zoning that had emerged. Ergo, formal zoning.

I am only partially convinced. After all, it should not have been surprising to anyone that apartment buildings would follow townhomes along the streetcar lines. Why wait until cars and trucks came along? In addition, the explanations for the 1970s spread and tightening of zoning laws are ad hoc. I would like to know more.

Matt Yglesias is wrong!

I like Matt’s work a lot, which is why I am getting frustrated at his continual repitition of the incorrect claim that energy independence is meaningless. This is just plain wrong.

First, he ignores natural gas completely. He needs to stop and state that he is talking about oil independence. Natural gas is extremely difficult to transport across continents, which is why it is so much cheaper in North America than elsewhere. We have already seen big and positive effects from energy independence in natural gas!

So let us focus on oil.

Oil is not some super-fungible instantaneously-transportable commodity. It is much more like lobsters than it is like ... uh ... well, the mythical conception of oil as some super-fungible instantaneously-transportable commodity. Oil prices vary by geography and by quality. There is something called the realization spread, which is the difference between the Brent benchmark oil price and the price actually received by oil producers. In 2011, it was $45 per barrel.

Infrastructure bottlenecks create all sorts of odd overland pricing differentials. (Ocean transport is different: the cost of shipping from Venezuela to China is not much more than shipping to the Gulf coast of the United States.) A Kinder-Morgan report, for example, estimates that if the Northern Gateway pipeline from Alberta to the west coast is built, then the price of crude oil in Canada will rise. (Canadian Western Special fetches a higher price in Asia than it does it North America, where it sells for about $20 less than West Texas Intermediate.) In total, the firm estimates that the pipeline will cost Canadian refiners $432 million a year. If the refiners pass that on to consumers, then it will raise prices by 6¢ per gallon. The converse, of course, is that preventing the pipeline will save Canadian consumers 6¢ a gallon. That is from one pipeline. One unpopular pipeline.

Third, it is completely legal for the United States to stop exports.

Now, in a perfect world, it is true that limiting oil exports would not make economic sense. Why not? Well, a government could limit exports, thereby lowering domestic prices ... or it could sell the stuff overseas and use the profits to subsidize domestic consumers. The problem is that the United States does not practice the sort of socialist resource nationalism that would make the second option feasible. The government does not own the subsoil rights, nor are confiscatory windfall taxes particularly likely. That leaves export restraints as the only way to transfer rents from producers to consumers.

Now if Matt wants to attack the idea that oil independence will do any good, he has many solid arguments:

1. North America (e.g., the U.S. and Canada) will never become oil independent;
2. North America might become oil independent but domestic production costs will be so high that it won’t mean anything;
3. North America might become oil independent but (2) will apply and domestic supply and demand shocks will produce significant price volatility;
4. North America might become oil independent but refiners will capture any and all benefits (there is some evidence that refiners are already capturing the benefits from the price differentials between the central United States and the coasts);
5. The idea that a U.S. administration will use its authority to limit exports is a political fantasy;
6. Limiting exports is a bad idea for other reasons. For example, high oil prices at home help phase out a fuel that is wrecking the planet, and it would be stupid to try to lower them.

In short, Matt Yglesias is wrong! Energy independence will have economic impacts: it already has in natural gas. Even oil independence will have economic impacts. It will (to a small extent) even if we do nothing because oil is not a free-to-transport completely-fungible product. But it will to a very large extent if we do what other oil-producing countries regularly do, which is restrict exports.

What he should do is rephrase . Right now, his arguments are akin to the Republicans who claim that Obamacare will raise the deficit, when what they really mean is that they do not believe that the Medicare reimbursement cuts will actually happen. He claims that energy independence is meaningless, when what he really means is that doing what you would need to do to make oil independence meaningful is a bad idea.

If that is his argument, then I wish he would make it. The conflation of oil and natural gas combined with the silly rhetorical flourish that energy independence is a myth strikes me as most unbecoming.

The end of progress? Probably not.

Robert Gordon just published a paper that is very pessimistic about long-term economic growth. It essentially argues that the big wave of innovation from IT is over. Infotech may radically reorder our lives in the coming decades, but it won’t allow us to make more stuff. Moreover, the big important inventions have been made. His example: would you rather give up all the electronic and IT stuff invented after 1975, or keep all that but have to abandon indoor plumbing?

As a metaphor for the state of play, that nails it. If it doesn’t for you, that is because you have never had to live without indoor plumbing. At night. In the rain.

There are three ripostes to this thesis. The first is that Moore’s Law ain’t over yet. (More to the point, Koomey’s Law ain’t over yet: it states that the energy efficiency of computers doubles every 18 months.) If Moore and Koomey hold for another decade or two, then there is the possibility that AI will emerge seemingly out of nowhere, sometime in the 2030s. Economic growth will surge, but prepare yourself for the robot riots. (I will be joining the rioters, and training my young son to lead them.)

There are reasons to think this will not happen, possibly ever. (I can hope!)

The second riposte, then, is that even without singularian magic, better computers will improve productivity the old-fashioned way. Consider construction robots. My co-blogger and I went back-and-forth on this with our friends Will Baird and Carlos Yu. We concluded that construction is a super-conservative fragmented industry, so there will be no revolution (or robot riots) ... but there will be a slow trickle out of construction (and vehicle operation) just as there was out of agricultural labor, elevator operation, and telegraph delivery. That could keep growth going for a while yet. (Matt Yglesias points out some other sectors ripe for growth here.)

But there is an even more convincing riposte than the above two. It comes from Carlos Yu, and it is based on work by Alexander Field, an economic historian who has pointed out that the Depression-wracked 1930s were likely the most technologically-productive decade of the past century.

What then is the third riposte?

SHORT VERSION: Stop focusing on the damn computers!

LONGER VERSION: “After reading Alexander Field’s book, I distrust the simple correlation in timing between technological improvements and productivity growth. In any case, Gordon is over-focused on the immediate implications of information technology, and he’s missed the one under his nose: biotechnology.

“The Green Revolution doesn’t show up much in American productivity statistics, since our crops had already been improved through a hundred-plus years of scientific selective breeding, but it does show up in global productivity. (Though biotechnology is probably keeping our crop yields high in the biological arms race against disease and pests, but that’s hard to quantify with typical productivity measurements.)

“Cheap effective medicines is another. For many health issues, we can actually buy a few more years of life — or more than a few — at prices far below the break-even point. If we take his question about toilets versus computers and switch it to toilets versus postwar improvements in the applied biological sciences, I think we’d be carrying our chamberpots to the outhouse.

“And now we’re entering the second wave of improvements in biotechnology, ones based on the information technology revolution. It might be a dud. I strongly suspect not.”

Keystone and U.S. oil markets

One new thing in oil markets is the persistant breach between the price of West Texas Intermediate (WTI) and Brent, ranging between $8 and $27. At the same time, the differential between Louisiana Light Sweet and Brent has remained under $3.

Why is that? Well, the answer is that American production has boomed in places like North Dakota. The price of WTI is actually set in Oklahoma (just to confuse you) and it is hard to get oil in large quantity from Oklahoma to the coast for export.Louisiana crude, on the other hand, is right there on the coast. As a result, the shale oil boom in the Dakotas (and to a lesser extent booming oil sand production from Alberta) causes crude to pile up in the Midwest, depressing prices relative to the coasts.

So who benefits? If the lower prices of Midwestern crude are passed on to Midwestern consumers, then they should oppose the Keystone pipeline. After all, Keystone will only make it easier to export oil to the coasts, where prices are higher. On the other hand, if the benefits of cheaper crude are not passed on, then consumers in the Midwest have few direct self-interested reasons to oppose it, at least in the short run. (They may, of course, have other valid reasons not to like the pipeline.)

Severin Borenstein of the Haas School of Business and Ryan Kellogg of the University of Michigan decided to take a look at this question. What did they find? Simply put: Midwestern refineries are running at capacity and can’t satisfy Midwestern demand. As a result, gasoline needs to be imported from the East Coast ... where crude is more expensive. Wholesale refined product prices, therefore, are not any cheaper in the Midwest.

There are three implications to this. The first is that in the short run, building Keystone will not drive up the prices faced by Midwestern consumers.

The second is that Midwestern refineries are significantly more profitable than refineries on the coasts.

The third is that if Keystone is not built, then refining capacity in the Midwest will rise, and eventually the Midwest will in fact enjoy cheaper gasoline than the rest of the country.

There are second-order implications about the desirability of whether U.S. oil exports should be allowed at all, but those will only be relevant when the U.S. achieves net crude oil balance. That is still some ways away, although it is now possible to imagine it happening with two decades ... perhaps much less.

A hidden blow for the workers of the world

Doug Muir pointed out to me that something interesting happened in 2009, to the attention of pretty much nobody. That something got the World Bank to change how it reports on countries’ labor regulations ... and by so-doing, remove a long-standing anti-labor bias at the Bank.

The World Bank has a set of indicators called the “Doing Business.”  It measures how easy it is to do things like start a business, get a loan, etc. One of the indicators used to be “Employing Workers.”  The index penalizes countries that establish minimum wages above a quarter of average wages, set maximum weekly hours below 66, require any advance notice for dismissal or specific procedures for job termination.

The index is problematic. First, when you dig down into the data, you can find some odd judgment calls: the United States, we’re told, has no restrictions on night work and no mandatory notice period for dismissal ... which I suppose is true in some states, but not most. Saudi Arabia gets a perfect score despite regulations that ban women from particular professions.

Second, labor unions have protested that the index assumes, without much empirical backing, that labor market regulations are all cost and no benefit. The unions are correct on this point: the empirical evidence is very much lacking that the Bank’s indicator has any consistent effect on employment levels or growth. 

But nobody cares about unions, and so nothing happened until 2009, when somebody introduced this paragraph into a supplemental spending bill in the U.S. House of Representatives:

SEC. 1626. REFORM OF THE ‘DOING BUSINESS’ REPORT OF THE WORLD BANK.

(a) The Secretary of the Treasury shall instruct the United States Executive Directors at the International Bank for Reconstruction and Development, the International Development Association, and the International Finance Corporation of the following United States policy goals, and to use the voice and vote of the United States to actively promote and work to achieve these goals:

1. Suspension of the use of the “Employing Workers” Indicator for the purpose of ranking or scoring country performance in the annual Doing Business Report of the World Bank until a set of indicators can be devised that fairly represent the value of internationally recognized workers' rights, including core labor standards, in creating a stable and favorable environment for attracting private investment. The indicators shall bring to bear the experiences of the member governments in dealing with the economic, social and political complexity of labor market issues. The indicators should be developed through collaborative discussions with and between the World Bank, the International Finance Corporation, the International Labor Organization, private firms, and global unions.
2. Elimination of the “Labor Tax and Social Contributions” Subindicator from the annual Doing Business Report of the World Bank.
3. Removal of the “Employing Workers” Indicator as a “guidepost” for calculating the annual Country Policy and Institutional Assessment score for each recipient country.

(b) Within 60 days after the date of the enactment of this section, the Secretary of the Treasury shall provide an instruction to the United States Executive Directors referred to in subsection (a) to take appropriate actions with respect to implementing the policy goals of the United States set forth in subsection (a), and such instruction shall be posted on the website of the Department of the Treasury.

Within 90 days, the Bank dropped the indicator. It’s still being tracked, but it’s no longer included in the international rankings, which means nobody cares.

There is a mystery here. Somebody inserted that provision, but it was done very quietly and even development professionals didn’t pick up on it at the time. Oh, they noticed that the indicator was dropped, but not that it was in response to a legislative threat from the United States. It was a very discreet threat, buried 1600 paragraphs down in a supplemental appropriations bill. Obviously this was only a meaningful threat in the context of the last Congress — today the Bank would be able to ignore this, confident that the Republicans would strip it out. But in the summer of 2009 someone was able to push back against the Bank and force it to abandon, in Doug’s words, “a pretty aggressive anti-labor position which was already having noticeable effects across the developing world.” The Bank would say it was anti-regulation rather than anti-labor, which is not completely unfair, but ignore that for the moment.

Who was the responsible party? Some staffer? A senator? President Obama? I would like to know.

Money-laundering 101: Wachovia and the casas de cambio

Mónica in comments is gobsmacked by the amount of money that Wachovia handled in wire transfers from Mexico without “applying the proper anti-laundering strictures.” $373.6 billion over three years, reported the Guardian last April. What does that number mean?

Well, as Mónica surmised, it means less than one might think. What happens when somebody in Mexico goes to a casa de cambio and gives it a dollar to wire to the United States? The casa de cambio acquires the dollar bill. The casa de cambio has an asset: the dollar. Double-entry accounting means that it creates a corresponding liability: it owes $1 to whomever gave it that dollar to send. 

Now it wires the dollar to Wachovia. It gets an asset: a $1 deposit at Wachovia. It also gets a liability: Wachovia will at some point want that dollar bill, or some corresponding dollar-denominated liability. (The deposit at Wachovia then cancels the $1 owed to the customer, since the customer receives the deposit account. But the other asset and liability generated by the transaction remain.) In other words, that $373.6 billion is a gross flow: the change in the casas’ liabilities generated by wire transfers to the U.S.

Is that gross flow big or small? Clearly a lot of money sloshes back and forth between the U.S. and Mexico. But even more money sloshes around within Mexico. For example, in the first quarter of 2012 the Mexican payments system processed about $193 billion in checks and $1.2 trillion in other transactions. Over three years, that would be almost $15 trillion. (Wow!) Given that baseline, the cross-border figures do not seem out of line. Rather, what is surprising is the implication that Wachovia (and its 22 correspondents in Mexico) appear to have captured so much of the business. Even so, there is an explanation for that: the DOJ indictment against Wachovia mentions that other banks were getting out of dealings with the casas de cambio precisely to avoid problems with illicit transfers.

The indictment also says that these transfers occured on behalf of the customers of the casas de cambio, but I suspect that much the flow consisted of the casas’ own accounts. After all, they probably wanted to earn interest on their dollar balances, and this was a way to do it.

What was the net flow, then? After all, whenever the casas needed dollars the process would go into reverse. Fortunately for us, Wachovia offered two services to the casas de cambio to help them net things out when the time came for them to make good on the claims against their dollars. First, it helped them physically move dollar bills to the U.S. That came to $4.7 billion over the period. (See page 5 of the indictment.) Second, it allowed the casas to accept checks, travellers checks, and other dollar-denominated liabilities, digitize them, and use the digitized documents to effect settlement in the United States. Those transfers came to $47 billion.

In other words, the net flows were a lot smaller. $52 billion over three years is still a lot of money, but remember that is only a net flows from the point of view of the casas de cambio. From the point of view of Mexico as a whole, they are still gross flows. The Department of Justice, in fact, found that only $110 million of the flows were clearly crime-related. (The link goes to the settlement agreement.) Wachovia failed to monitor its activity, but the bank retroactively analyzed its transaction: little suspiscious was found.

The amount Wachovia processed is staggering. And the bank did a lousy job of real-time checking. But the amounts are not out of line for two adjacent countries with economies as large as the U.S. and Mexico. And neither the amount nor the malfeasance implies that most, or even 99.9% of it, is illicit or criminal. After all, how much money to you think Mexican drug cartels want to transfer into the United States?

Oliver stoned

 In a recent interview on “Piers Morgan Tonight,” Stone used a series of unfounded statistical assertions to justify his opposition to the war on drugs, the theme of his movie “Savages” which opened in the U.S. earlier this month. Among his comments, as compiled by the Los Angeles Times:

The Mexican economy would die without [drugs] because they need the money. It goes into their legitimate economy. It’s bigger than tourism. It’s bigger than oil. It’s bigger than remissions from their Mexican emigrants back to their country ... Fifty percent of our prison system is victimless crimes. People who’ve never hurt anybody, they’re in for marijuana and it has nothing to do with punishment. It’s a medical issue, and I think we have to move to decriminalization and legalization.

Stone is right to point out that the mass incarceration of drug offenders is demonstrably inefficient and in many senses immoral, but his facts are incorrect. Drug offenders do not constitute 50 percent of the US prison system’s inmates, but just over 20 percent. There are certainly more effective and humane ways to deal with the issue than tossing these people behind bars, but the opponents of the largely mindless approach to drug policy that has dominated in the last 40 years only hurt their case by casually tossing out falsehoods.

The problem continues with Stone’s statement that flows of drug money in Mexico are larger than those from tourism, oil, or remittances. Estimates for the value of the Mexican drug trade are all over the map, but the most rigorous analyses have concluded that export revenue from the drug trade is far lower than Stone suggests. Alejandro Hope, for instance, places the figure somewhere between $4.7 to $8.1 billion, while the RAND Corporation estimates that Mexican traffickers earn roughly $6.6 billion per year from sending drugs to the US.

In contrast, remittances sent by Mexicans living abroad in 2011 amounted to $22.7 billion. Mexico’s tourist trade, notwithstanding the nation’s unfortunate image in the international press, still managed to generate $11.9 billion in 2010. Stone’s claim is even further from the mark with regard to oil: the revenues for Pemex, the national oil company, amounted to $125 billion in 2011.

Consequently, Stone’s statement that the Mexican economy “would die” without drug money drifts into the terrain of the indefensible. Unfortunately, Stone is not alone in this exaggerated view of drug money’s role in the Mexican economy. One story, put forward by authors like Richard Grant and Charles Bowden, holds that a 2001 study by CISEN, Mexico’s intelligence agency, found that an end to the drug trade would result in a 63 percent contraction of the Mexican economy.

The study is not public — citing a story from El Diario de Juarez, Bowden wrote that it was leaked to the media in 2001, though InSight Crime’s online search for the original study turned up nothing. It is difficult to know, therefore, if its authors were perhaps making a more nuanced point that was lost in subsequent references to it. However, the scenario posited by Grant and Bowden, and the implicit idea that the Mexican economy would “die” without drug money, is simply absurd. [Note: Alejandro Hope and Jaime López-Aranda do not believe that the study exists.]

The most obvious flaw is the very idea that drug trafficking could disappear entirely. Though the size and composition of proceeds from the illicit trade may vary, longstanding industries, especially those that feed upon deep-seated human desires, don’t simply disappear from one year to the next.

Moreover, as demonstrated above, the total revenue generated by the drug trade is relatively small. Even using a methodologically suspect high-end estimate, such as the $39 billion cited by the US National Drug Intelligence Center, the figure amounts to less than 4 percent of total Mexican output. Using the more rigorous calculations of the industry’s size, drug trafficking probably accounts for roughly 0.5 percent of the nation’s economy. Eliminating the proceeds of drug smuggling would certainly have a significant impact on the GDP, but such an event, aside from being virtually impossible, would be nothing like the economic apocalypse posited by Stone.

Beyond simply being incorrect, Stone’s comments fuel a dystopian narrative of Mexico that has done the nation a great disservice over the past few years. They also help feed a belief that Mexico’s criminals are invincible supermen, against whom capitulation is the only solution. This is wrong, just like Stone’s facts.

Mexico is gaining jobs, not wages

In 2009, in the wake of rapid inflation, Chinese unit labor costs were 72% of Mexico’s. (See page 19 at the link.) By early 2010, Chinese unit labor costs had risen to 86% of the Mexican level, and Mexico started to export cars to China. For some goods, landed costs (i.e., the cost of manufacturing and moving to the mainland U.S.) are much cheaper in Mexico than in China.

If you only look at the Chinese side, there seems little prospect of these trends turning around. China is experiencing bad labor shortages. Moreover, China has an inflation problem (the strategies described in this post seem to be hitting their limit) and its low inflation of 3% is not much lower than Mexico’s higher-than-expected 3.9%. Meanwhile, the peso is falling, while the yuan is likely to head nowhere but up. (If that turns out to be wrong, expect bad political consequences.)

On the other hand, if you look at the Mexican side, the reason Mexico is gaining competitiveness is that wages are flat. And flat at a low level. The good news is that Mexico is seeing rapid employment growth (see chart below) but Mexico no longer has endless millions of peasants to pull into the cities. Job growth is a good thing, of course, but it can go only go on for so long. (Mexico rebased its employment measures in 2010; thus the two indices.)

Translation: this is good news for Mexico, but it is a one-time thing. Without productivity growth, either within industries or by shifting into new products, Mexico wll remain relatively poor.

Implication: if the U.S. economy ever picks up again, so will emigration.

Omission: the effect of violence and extortion. The jury is out.

El perro que no ladra

 One strange thing about the upcoming Mexican election is how little the economy seems to matter. I don’t mean questions of long-term growth or distribution; those are very much an issue. I mean short-term business cycle stuff. Manufacturing output is up. The peso is down, but the central bank seems relaxed. Judging from the results on inflation-linked bonds, so are the markets. Consumer confidence has followed suit. Nobody is running a campaign like the ones in the United States or Europe. Growth since the 2008 shock is slow, but steady, as the below chart of GDP (in millions of 2003 pesos) shows.

To be frank, I was worried three years ago. But the bad economy dog did not bark. Why not?

Well, I was worried that Mexico was going the austerity route. But it didn’t! Mexico was no paragon of countercyclical fiscal policy, but it avoided anything that could be called austerity. I wrote the above entry in the third quarter of 2009 ... during which government spending was essentially flat, much less than the programmed 0.7% drop. (See below chart, which shows growth in GDP expenditures between government purchases of goods and services and everything else.) In short, my fear didn’t materialize because the PAN government never followed through with its own austerity rhetoric.

Still, simply not being stupid isn’t really enough to explain Mexico’s quick recovery. Lots of countries failed to implement sufficiently large stimulus packages and suffered for it. To explain Mexico we need to turn to two other Mexican strengths and a bit of good luck.

The first strength is, paradoxically, also a weakness: Mexico had a terrible terrible financial system going into the Lesser Depression. But from the point of view of protection from the effects of a worldwide financial freezeup, it was a great thing to go in with banks that did not lend and firms that did not borrow. (I do not recommend this as a long-term growth strategy.)

That meant that the Lesser Depression hit Mexico as a good old-fashioned trade shock. The below graph measures quarterly percentage changes in the final demand for Mexican production. (It is not the same as GDP, since GDP nets out imports.) You can watch exports plummet in the last quarter of 2008. Net exports barely budged (in fact, they grew) but all those unemployed export workers dragged down private consumption and all those hurting export manufacturers stopped investing. Thus the vertiginous decline in GDP in the first quarter of 2009 that you can see in the above two charts. (Demand continued to fall in the second quarter of 2009, but manifested as a drop in imports, leaving GDP flat.)

But this brings us to Mexico’s second strength: a flexible exchange rate. The peso plunged from a little under a dime to a low of 7¢ before recovering. (In point of fact, the Banco de México intervened to stop the fall, too soon in my opinion.) By the third quarter of 2009, exports had started growing again. By the second quarter of 2010, they surpassed their previous peak. In point of fact, Mexico became even more export oriented than before: exports grew from 26% in the middle of 2008 of GDP to 35% by the middle of 2012.

And that brings us to the good luck. Any guesses before I post? It seems to have been in the news lately.

Internal devaluation does not work very well

So I read in the New York Times that Greek private sector salaries fell a punishing 22.5% in 2011 in real terms.  That stunned me. So I went to Eurostat. Their figures for nominal labor costs were slightly less impressive, but still shocking. (2008 = 100.)

Internal devaluation at work! Sure, Greece is still working off earlier excessive wage gains, but that should presage an export boom, right? Cheaper workers, cheaper vacations for foreigners, more tourism, more exports.

Except ... well, according to OECD data, output is declining along with wages. (See below; 2005 = 100.) Unit labor costs are down, but not when seasonally adjusted, and really not relative to Germany or the rest of the Eurozone. Maybe that’s not relevant. After all, as long as output per worker in potential export sectors isn’t falling, then economy-wide unit labor costs should not matter ... but only for those industries. They will matter a lot in other industries, which are seeing demand (foreign and domestic, as proxied by the value of output) drop as fast as their wage bill.

Add to that (1) rising debt burdens for Greek workers, since debts aren’t indexed to wages; (2) rising taxes on Greek workers; (3) people’s desire to save in euros (outside Greece or in cash) in the face of a possible Grexit; and (4) the awful awful feeling that comes with people as they watch their nominal incomes plummet.

Put it together, and it isn’t clear to me that the rather surprising unstickiness of Greek wages is going to produce much of a quick recovery even if wages fall substantially more. (There have been a lot of reforms to Greek labor law in the last few years.) Of course, the Argentine experience implies that a Grexit won’t be better ... Argentine GDP plunged 15% in the year after the devaluation, and recovery took place in the context of strong external demand.

I am not optimistic.

Postscript: see “Is Increased Price Flexibility Destabilizing?” by Brad Delong and Larry Summers. (Also found here.) See also “The Barber of Buenos Aires.”

It is not unreasonable to cry for Argentina in most of its cases at ICSID

Bernard Guerrero asks: “You mentioned in an earlier post that Argentina had justice on its side with regards to the various ICSID cases. How so?”

An excellent question! Short answer: most of Argentina’s cases are a direct result of the 2001 devaluation. The Argentine government acted prudently and responsibly in the aftermath of that economic collapse. In the face of 1.2 million job losses, and riots in the streets, it was entirely reasonable to freeze rates, cancel contracts, default on debt, and pesify dollar-denominated bank accounts. (The scale of the turn-of-the-century Argentine depression is immense.) Such actions were legal under Argentine law, and would have been legal in the United States. (FDR confiscated gold back in the day.) Unfortunately, the Washington Convention and associated bilateral investment treaties are more restrictive, which gave foreign companies operating in Argentina the right to sue for damages from the price freezes.

In other words, until Repsol, none of the Argentine cases at ICSID involved straight-up opportunistic property seizures without fair compensation. Rather, they involved emergency measures taken in the midst of a Depression-scale crisis. The companies could not have possibly expected the real value of their tariffs to quadruple in the middle of a 20% crash in GDP and 10% plunge in employment, which is what sticking to the original contracts would have meant. Argentine law sees things that way. American law sees things that way. European Union law sees things that way. But international law, as codified in the Washington Convention of 1965, does not. That is unjust.

Longer answer: Of Argentina’s 46 post-2001 arbitration cases, 32 are a direct result of the 2001 devaluation. If you add in the three cases brought by bondholders, that number rises to 35. Most of the remainder are contract disputes, which also come out of the turn-of-the-century Argentine depression: frex, a cancelled contract with Unisys to modernize the judiciary’s IT systems, or an abandoned project with Impregilo S.p.A. to build a highway. 

It is not hard to find the texts (or at least decent summaries) of the ICSID decisions. Latin Arbitration Law is a good source. UNCTAD also maintains a good database. The Investment Treaty Arbitration site has a list of cases, with all intermediate and annulment decisions. Finally, an easy-to-use list with summaries of the outcome can be found at the IIAPP website. I also recommend the Kluwer Arbitration Blog and (if you can get access) the Investment Arbitration Reporter.

All of the Argentine cases reject expropriation claims, but provide compensation for lost revenues due to contract violations. You can see the frustration by the Argentine lawyers when they argue that expropriation law should not apply in these cases. In fact, most of the arbitral decisions have a very sympathetic tone towards the Argentine arguments. But the law is the law, or at least what the arbitrators say that the law is, and that is that.

To be fair, Argentina has not done badly at ICSID. (If there is interest, I will put up another post with some data about that.) But it is understandable that the government feels that most of the post-2001 cases should not have been brought at all. This is not to support the YPF nationalization, or to claim that Argentina is run by a saintly government interested only in the public good. (To give one egregious example, Argentina settled the Unisys claim for $8 million in April 2007 ... but made no move to actually pay.)

It is to say that there is something wrong with the international system. It was designed to protect natural resource investors against predatory states without the need to call on their home governments. It is becoming a system of unlimited liability which essentially locks governments in to the letter of their initial contracts in a rigid way with no parallel in any domestic legal system on the planet.

In fact, the standards have been getting stricter, to the point where governments are required to grant a “guarantee of stability in a secure environment, both physical, commercial and legal” that may, for some countries, be impossible ... and is certainly more protection than that granted to domestic investors.

Practical upshot? Hard to say ... but the illegitimacy of most of the claims against Argentina will make life much harder for companies with a decent case in a straight-up expropriation. (You can guess which firm I might be talking about.) That is not, I think, a good thing ... but I may be wrong.

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.