Amidst the financial crisis, Forbes publishes a very interesting appeal to Silicon Valley Entrepreneurs. After enumerating various achievements of Silicon Valley, Sramana Mitra starts here main point:

In all this, leaders of Silicon Valley, you have identified problems, found technology-leveraged solutions and built industries, not just companies.

I ask you, then, to rise up to the challenge again. Education, health care, social security: These domains need your voices, your intellect, your credibility, your time and your money. In each of these domains, there are some early successes. Edward Fields is breaking through the morass of education problems with his start-up, HotChalk (see "A Technological Fix For Education"). Kirk Loevner is cracking health care with Epocrates. Their experiences offer some insight into alternative business models, marketing models and approaches to problem solving--most notably using advertising dollars to fund resources for teachers, students, doctors and patients. In education and health care, a tremendous amount of inefficiencies can be tackled with technology.

For me, the appeal is interesting - it does not call only for a government action, but also for a grassroot approach to problems. The question is, however, whether technology and new business models can solve very intricate reality of American healthcare. They may solve the problem of costs, but coverage may pose greater political challenges. Whoever heard what happened to Hillary Clinton's efforts know what I am talking about.

A physicist's view on the current crisis

As an addition to my last week's piece, I would like to quote a very interesting opinion of a theoretical physicist, Mark Buchanan, writing for New York Times:

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. [...]

Nearly two decades ago, a classic economic study found that of the 50 largest single-day price movements since World War II, most happened on days when there was no significant news, and that news in general seemed to account for only about a third of the overall variance in stock returns. A recent study by some physicists found much the same thing — financial news lacked any clear link with the larger movements of stock values.

And later:

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Buchanan does not only criticises the view, but provides support for his arguments by writing information about computer models of financial markets, based on the behaviour of individual actors. The models go deeper than classic equilibrium theory and allow to determine at what point a financial meltdown could take place, i.e. when market stability disappears and panic sell-offs start.

Sadly, at least according to Buchanan, economists look not very favourably on the models.

Is it a problem of the dominance of an old scientific paradigm (in the way Kuhn saw it), or maybe mainstream economists have valid claims? We shall return to the problem soon...

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

Dear Readers!

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

In the coming academic year, we aim at enlarging the number of authors, obtaining more academic articles written by PhD students and touching upon topics not covered anywhere else.

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.

We hope that you will find the visit on our website interesting, entartaining and inspirating!

Best wishes,
Economics International