Casting some doubts

I shall most likely respond to Andre's piece next week. I am currently undecided when it comes to the bailout, but I would like to raise some doubts. The bailout bill passed, so the question is not if it should be implemented, but whether it is a correct policy.

Firstly, although Wall Street firms are in turmoil, this is not the case for Main Street commercial banks. As Alan Reyonold from Cato Institute writes in Forbes:

Contrary to many comments, consumer and industrial loans actually increased in the latest week. Troubled giant banks have cut back on lending, but smaller banks have picked up the slack. Consumer and real estate loans dipped insignificantly through Sept. 17, remaining much higher than they were a year earlier.

Reynolds proceeds with presenting FED data. The question, however, is for how long that is possible. What will happen when commercial banks are hit by current deleveraging in financial markets? Some of commercial banks may have some ties to financial markets and if they lose due to deleveraging, they may seek more cash and limit their credit supply. As the Economist writes:

What hurts finance affects the rest of the economy in spades. Tim Bond, of Barclays Capital, reckons that, thanks to the gearing effect, a shortfall of bank capital of around $170 billion may reduce the potential supply of credit by $1.7 trillion.

Secondly, Professor Eichengreen points out that dollar going down together with fast-growing BRICs will put the American economy on the right track soon. This is self-explaining - decreasing dollar makes exports more profitable. As Eichengreen writes:

And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analog for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the U.S. economy, notwithstanding the admirable flexibility of its labor markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10 per cent.

Here understanding Professor Eichengreen is a bit difficult: we can't say if the crisis will touch the economy at large or just the financial sector. My intuition tells me that a 5% increase in unemployment cannot be caused just by layoffs in financial sector, so the latter is most likely true. Nevertheless, the question remains how fast the effect of dollar going down will be, relatively to problems in financial markets affecting other industries.

A glooming bright future for the non-financial sector

Which is likely to be true?

The Paulson Plan, whatever its final form, will not bring this upheaval to an early end. The consequences are clearly spreading from Wall Street to Main Street. The recent performance of nonfinancial stocks indicates that investors are well aware of the fact.

So comparisons with the Great Depression, which have been of academic interest but little practical relevance, take on new salience. [...]

It is hard to avoid concluding that the Fed erred disastrously when deciding that Lehman Bros.

Or:

The non-financial sector today looks nothing like it did in 1930. The weak correlation between asset prices and non-financial sector performance and the strong profitability of today’s non-financial capital are two good reasons to scoff at the idea that the non-financial sector will collapse because of the recent events on Wall Street, and even better reasons to scoff at the Bernanke-Paulson-Bush idea that a massive bailout of financial firms is the key to avoiding a non-financial collapse.

[...]

The Treasury and the Fed should let Wall Street drown alone, to be replaced by new financial service providers who can swim as robustly as are non-financial American businesses.

Before pointing to the authors, take a look at the graphs below. That's the Brazilian stock market main index (IBOVESPA) and the tipping point is just after US House of Representatives' rejecting the edited version of the Paulson plan. This is relevant not only because of the time frame, but because the Brazilian stock market has evolved a lot in the past years and - unlike its Russian counterpart, for instance - had not faced severe swings in a long time. Oh, and the fact that I'm Brazilian may have something to do with it...!

It would be great if the markets were always efficient and we could let havoc take place, relying confidently in creative destruction. This, however, is not the case and professor Barry Eichengreen's warning - that US unemployment rate may reach 2 digits - should be taken very seriously. He's the author of the first quote, taken from And now the Great Depression, at Vox Eu. Professor Barry Eichengreen, from University of California, Berkeley, has been frequently quoted these past days thanks to his Anatomy of a Crisis. He seems to be inspired and we'll be keeping an eye out for more insights.

The second quote is from Casey Mulligan's Wall Street Will Drown Alone. His core argument can be found in Greg Mankiw's A Note of Optimism. Oh, yes, professor Mulligan is from (surprise, surprise!!) University of Chicago.


PS: After writing this, the Bovespa reopened... Let's see where it goes now.

Economics International is back

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Economics International is back after the vacations break and ready to bring you new insight on international finance, trade and business.

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As to the latter, the article on the interactions between Eastern philosophies and economic life of Chinese diaspora by Lea Tan will be ready soon.

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On Death, Pestilence and War

I picked up my copy of The Economist today and I read an article which made me shiver. It was from the Middle East and Africa section and it was entitled Ethiopia. Will it ever be able to stave off starvation?

The article spoke about famine in that country:

“Life here is still akin to serfdom […]. The government owns the land […]. Yet
labourers get by in Goru Gutu district much as they have always done, tilling
soil by hand, digging ditches, doing whatever it takes to buy a few cups of
grain to keep their families alive. […] As you head deeper into the hills, the
animals get thinner, the children more listless. The food on the market is too
expensive, and there are no informal sales on the road-side No one is eating.”[1]

Food shortages have always been problem in the Horn of Africa, especially in Ethiopia, Africa’s second-most-populous country – we all remember the 1985-1985 famine in Ethiopia where Bob Geldof and Phil Collins others organized Live Aid and Band Aid to help the millions effected by the famine – and they seem to be occurring again.

It’s difficult to say whether or not the current crisis in Ethiopia should be viewed as a consequence of the current global food price crisis – which has already sparked riots in some other African countries – or as an independent case, but what is made clear by the article is that the government of Ethiopia has brought this onto itself to some extent.

“The government is supposed to have 450,000 tonnes in a grain stockpile, with
100,000 tonnes in reserve to keep prices from rising too much. But it has only
65,000 tonnes left.
If Goru Gutu district is an indicator, things will get
far worse; many people will starve to death. Ibsaa Sadiq, a local government
official, reckons that nearly half of the 116,000 people who live here,
especially women and children, need food aid to survive. A feeding centre run by
the government, assisted by Catholic nuns, cares for some 800 of the hungriest
children. They spend days or weeks in a metal shed smelling of diesel and
disinfectant.”[2]

Of course a major part of this problem is beyond anyone’s control; it has to do with failed harvests, high fuel prices, and lousy weather. But it is without a doubt in my mind that this tragedy is also the fault of the Ethiopian government. This is another clear-cut example of a failed system of state control over the economy. “Aside from coffee, qat (a narcotic leaf chewed by Somalis), horticulture and a little tourism, Ethiopia is one of Africa’s very few countries that still has virtually no serious private business – and thus few jobs – outside the state sector. Almost three-quarters of the population may be under- or unemployed.”[3] It is without surprise that in a country that can almost be described as still rather communistic there be problems with food production. There are few jobs, so there is very little wealth; this means there is little or no savings; people are thus penny-less and at the mercy of the weather when it comes to food.

This article once again confirms my belief that the free market is the best way to create wealth and avoid the tragic human misery that is described. This is especially important in the field of development. For developing countries such as Ethiopia, it is essential that they reform and adopt market-oriented approaches to economic growth. Is it a simple coincidence that the poorest countries in the world also happen to be the least free? Ethiopia is a prime example: it is ruled by an authoritarian strongman, Meles Zenawi, who has done little to reform the country to promote private enterprise, who violently oppresses the opposition, and who even attempts to hide that there is a famine going on by holding back information and banning photographs being taken in affected areas – reminiscent of Stalinism in the USSR. Is it really that surprising then that Ethiopia also ranks amongst the poorest countries in the world? Of course not! There is a connection between the level of economic freedom and the level of development.

Anther important issue the article mentions, but only briefly, is population. The problem with Ethiopia, indeed the problem of Ethiopia, is the population problem. “Ethiopia still has too many people eking out a living on too little land, depending on rains that can never be relied on.”[4] With a population of over 77million there is a major cause for concern. With 85% of the people living off agriculture – a very basic form of agriculture mind you – even under the perfect weather conditions and the most fruitful of harvests, many millions would still be left destitute[5]. This of course immediately reminds us of Thomas Malthus and his Essay on the Principle of Population. In Ethiopia it seems, the Malthusian disaster has occurred, and what’s worse – from a Malthusian perspective – even war, famine and pestilence have not been enough to keep the population in check.

The Economist article ends with a very pessimist look at the chances of Ethiopia’s progress. I personally hate to agree with this pessimism but unless real reforms occur in that country, I’m going to have to. What Ethiopia needs if it wants to avoid periodic famines is a change in leadership; economic reforms (beginning with the introduction of private property); and encourage foreign investment – now I’m not necessarily advocating Jeffery Sachs’ “Shock Therapy”, but some major reforms in the economic system are dreadfully needed. Ethiopia also needs to make some deep-rooted changes in its culture with regards the family; nearly half the population is under 15 years of age. It is with no surprise that under such a situation, you will have a population problem. In order to fix this, major family planning programs need to be implemented; better education and higher availability of contraceptives is needed – perhaps dictator Meles could divert some of the 350million dollars he spends on defense every year[6] and direct some of it towards education and family planning schemes.

-------------------
[1] The Economist, Ethiopia. Will it ever be able to stave off starvation?. June 14th 2008
http://www.economist.com/world/africa/displaystory.cfm?story_id=11549764
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] http://www.voanews.com/english/archive/2006-03/Ethiopian-Population-Expected-To-Grow-by-More-than-100-Percent.cfm
[6] http://chora.virtualave.net/budget-2002.htm

An interesting cross-country test for the Ricardian equivalence

Tim Harford comments on the practical impacts of American and British tax plans, and defends that their impact will be the same, despite the different reasoning behind them.

"Here's why: Since neither the U.K. nor U.S. government intends to alter its spending plans, these tax holidays will be funded by government borrowing, borrowing that must eventually be repaid. That will require taxes to go up in the future or not to fall when they otherwise might."

By his concluding remark, Mr. Harford's interest is the political economy of the measure - whether people be fooled by this measure and vote for the wizard politicians. I personally wonder whether consumer behavior will vary between the two sides of the Atlantic. Could British people be more concerned about the well-being of their children than Americans are, or vice versa?


Other references about the tax-rebate:

• "Consumer response to tax rebates [PDF]", by Matthew Shapiro and Joel Slemrod
• "Honey, I ate the rebate", by Daniel Gross