great graphical illustration

have a look at this, nicely done by the NYTimes.

the big picture Q&A

Following the last post, a couple of questions came up:

How could it be that bad quality mortgages in the US could have such an effect on the global economy? Is it because we are so tightly connected to the US economy or is it because something similar happened everywhere?

I would say it's a mixture of both. As is explained in the video, bad quality mortgages were repacked and - above all - revalued, and sold all over the place. So any financial institution you might think of - pension funds, commercial banks, investment banks, hedge funds, even governments - could have bought that stuff. And yes, something similar happened elsewhere, since credits were relatively cheap more or less everywhere, and were given away with too little scrutiny. We were all on a happy spending spree over the past decade.

[At the end of the movie] it is actually astonishing that we didn't explode all along with our financial assets [as in the movie], but would is going to happen now? And what did you mean by "regulations"?

To be honest, I have no idea whatsoever what is going to happen now. However, this is not so bad, since pretty prominent thinkers don't know either. They just try out all sorts of policies and hope something is going to nail it. Take "quantitative easing", for example, this weird policy were the central bank starts buying real assets from people like you and me for (just printed) cash. I heard an economist from the Bank of England the other day (unofficially, obviously) admitting that they had no clue if that was going to work or not. But given that traditional policy instruments have been exhausted (lowering the interest rate, say), it might be a good moment to try something else.

What did I mean by "regulations"? Well, one cornerstone of stricter regulations - among many other measures - would be to simply require banks to hold more capital. There is such a regulative body in place actually, called by the well-sounding name of "Basel II", but let's face it: given our current experience we should rather bin that and find something better. As far as I understand it, it is just about assessing the riskiness of the portfolio of loans of a given bank and relating this to a certain amount of capital (money you and I would deposit in the bank) the bank must hold permanently. Think of this as a simple table, where in one column you have a number which tells you how risky the loans of the bank are, say from 0 to 100, and in the column next to it we have the amount of money, the bank must have in the safe. 

Basically, what has to be done, among lots of other things, is to redo this table, because it's wrong. That is not as simple as it sounds - you want to get the risk-numbers right, which is quite tricky - but it is absolutely doable. What it's going to do, however, is to slice off a chunk of bank profits, because they have to back up loans with more cash than before. So bankers are never happy about regulations like that. But, as before, now might be a good moment to try out all sorts of new things.

the big picture

Hi guys.

this week we have some "light entertainment". I found this little film about how all the strings (could) get together to fabricate what we call "the credit crunch". Needless to say that in a 10 minute animation one can hardly explain anything in great detail. Nevertheless I have found it quite interesting and very entertaining. The creator raises some interesting issues; on the other hand it seems that he draws a lot of conclusions about causality, in other words, whose "fault" this whole mess is.
I want to emphasize, before you watch the clip, that people respond to INCENTIVES. Suppose there is an action which a person could take: it is known to be very risky and even dangerous to the entire system, but it promises enormous profits if successful. Now imagine that it is legal to take this action. Some people will take the risk and take the action. You bet they will. It is a simple as that to explain what happens if you let regulation on financial markets loose. Now have fun with the movie!

(note that you can make it full screen by clicking the outward pointing arrows next to the time bar)

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

LFL 4: Why give money to Carmakers?

An interested reader asks:

And what about the government? Does it make sense to pump billions of dollars into the auto industry - as is happening in the US at the moment? In the end this is money that is taken away from taxpayers, because sooner or later they will have to pay it back - regardless if they want a car or not! Is this economically efficient? And why are there no calls for governemnt help from Asian carmakers, do they solve their problems differently? [my translation]

Excellent question! Let's step back a moment and gather some thoughts about this. On the one hand we have the carmakers, who design new cars, produce them, and hope to sell them (for a profit). On the other hand, there are consumers, who choose the model they best like, given the amount of money they are willing to spend.
What we see at the moment, is that consumers stop buying things like cars. "Things like cars" include all the items a consumer might want to replace for a newer model, even if the old one is still working: a car, a refridgerator, a DVD player, a portable computer, etc. The list of "things like cars" is long, and the more expensive the new model would be, the less likely our consumer is to buy it at the moment. Our consumer is as scared as everybody else, and probably even more so. "Let's just wait another couple of months and see, I can still buy my car then."

Should we give money to failing carmakers? We bailed out the banking system, so what about manufacturing? As the economist newspaper puts it in its lead article of this week, "next to scheming bankers, factory workers look positively deserving". And it goes on to say that letting down a huge company such as US carmaker General Motors (GM) would do no good to the confidence of our scared consumer. They employ, what, 30.000 people in the US alone? So this is obviously a big issue. It is a big issue for politicians, who are confronted with cries of help from GM.
In times like these, you have to make tough decisions as a government. Sending 30.000 to the streets is not an easy thing to do. But there are some important things one must not forget when considering giving money to manufacturing right now:

a) If anything, those firms need loads of money, and better today than tomorrow. Government programmes, however, are slow and cannot keep pace with the fast-changing environment of industry. That's why governments don't produce cars - they don't know anything about it, so they are not good at it, and the money would be given in a wasteful way.
b) Giving aid to carmakers would help keep them afloat for another while, but doesn't solve the problem: Our consumer, remember, is still scared of making such a big investment as buying a car.

The carmaking industry is obviously over-sized, has too much capacity. So however much money we give to firms, some will inevitably have to go out of business. So which are the firms we want to receive any money? What are the conditions that are attached to this aid (if any)? If the government could require a car-manufacturer to down-size capacity, which capacity would be the right one?
The take-away from this is that consumers, once they get back to buying stuff, can decide over those things much better than any government could. Their choices will reveal which firms are the right ones, and which size is the best.

But then the natural quesiton to ask is, "why, then, did we give money to the bankers?" They don't seem to deserve our help any more than carmakers, given their profits in the last couple of years. Still, the problem is that we need the banks to work. We need them, because THEY must give money to firms, find out which ones are most productive and lend to them. The argument from above, that state money is not going to create an efficient industry, holds true for carmakers as well as for bankers. There are probably some banks which got government help, and are not efficient at all; We'll have to live with that for the moment.

Unfortunately I don't know much about the situation of Asian carmakers, but I suspect they have similar problems.

LfL 3: Banks

I hope you are doing fine. The snow is gone and London is as grey/green as ever - everything back to normal.
As normal as it can get those days, that is. And apart from the weather, there are few things you would label "normal" around here. (it's raining, obviously.) Just consider the Bank of England (BoE), whose monetary policy committee last week in a historic motion slashed the interbank lending rate - what we commonly call "the interest rate" - to 1%. Unheard of.

But what does that mean? And why would they do something like that? In order to get a grip on that, we first have to talk a bit about banks in general. Please notice that this is all stripped down to a very very simplified level; My hope is to get the main points without getting lost in the nitty-gritty.

Frequently Asked Questions about BANKS:


• What is the purpose of a bank?

A bank takes money from people who earn more than they want to spend at the moment (it stores savings from savers), and gives it to people who want to spend more than they earn at the moment (it gives loans to borrowers).

Is this a difficult task?

It is not trivial, because it involves making sure that loans are given only to persons who will be able to pay back the loan; This depends on what they propose to be doing with the loan, often it depends on whether their project, which is financed through the loan, is a success of a failure. The problem: We don't know if a project is going to be successful with certainty.

• Why would anybody open a bank? (What is the incentive to run a bank?)
  

It is a lucrative business. Very lucrative, until recently.

• What is the problem with banks' incentives?

On the one hand, in order to attract customers, banks must promise to savers that their savings are absolutely secure with them: "At any point in time, and under all circumstances, do we promise by the Queen's head that your savings are secure and that you can withdraw them whenever you want."
On the other hand, banks must keep up with competitors who offer to pay high interest rates on savings. They must at least offer the same, or even more.

• The Problem?

The problem is that in order to be able to pay high interest rates on savings, a bank must make a lot of profits.

• How does a bank make profits?

It charges fees for its services. Most importantly, it charges a fee for lending money. In order to generate the profits needed to stay in business, any bank will have to embark on projects that become riskier and riskier, because it is the risky projects that generate the biggest profits. And the biggest losses.

• If this is so straightforward, why do we see so many bank failures? Aren't bankers supposed to be smart people?
  

This is a good question. But complicated, we'll have to think about that another time. And yes, they are supposed to be smart people. Until recently they were, that is.

• Why has the BoE lowered the interest rate so much?

Banks can lend money from the BoE and from one another at a rate which is set (roughly speaking) by the BoE. The BoE, then, wants to get banks to lend again to people and businesses by making it very cheap for them to get money.

• Why is lending so important?

A lot of businesses need credit at some point in their life-cycle. Most need it to get started, others need it to pay wages in a month with poor sales, and still others need it to buy new equipment and plant in order to be able to compete with other firms. If there is no way to get this credit - and currently there is no way - those firms go out of business.

• So, does it work?

No. Bankers are being too afraid to lend to businesses. Most banks have accumulated a sizeable load of "toxic assets", basically loans, which they should never have made, or other investments which failed. In other words, they are in a pretty bad situation, and giving money to people doesn't seem a good idea to most of them right now.

• And where do they put all the cheap money they are getting now?

They invest it in government bonds, which have practically zero risk. Their low level of risk comes at the cost of a low rate of return, currently a 10-year US treasury bill yields 2%. Compared to that, they could make loans to businesses at any rate from 5% up to 10% - but they are afraid to do that, because everything seems to go down.

• Is this the end?
  

It's not the end. In England at least, we still have the Premier League (Football) and the Kenton Arms (the Pub around the corner). Apart from that, the central bank has resorted to a practice called "quantitative easing", basically buying all those bad assets and failed projects from banks for newly, shiny banknotes; At the same time, the BoE goes out and starts to buy back government bonds from the market. This increases the demand for bonds, which increases the price of bonds. But given that bonds pay out a fixed amount after a fixed period of time (which is what defined them as being "safe"), paying a higher price now means that bonds become less profitable! And if bonds loose their profitability, the hope is that bankers might take a closer look at those ordinary businesses and get back to what they came for: make loans to businesses.

• Are we finally done?

Yes, we are.

LFL 2

this week has seen some spectacular action in the UK. We started off with heavy snowfalls in sunday night, covering London and the southeast of the country by as much as 20 cm of snow. In a country where the transport infrastructure is prone to failure caused by gusts of fallen leafs, it is not hard to imagine the consequences: In fact, London was down by monday morning. For the first time in living memory the London Buses network was suspended from service. It is curious to note that snow would deal a fatal blow to the transport system, when German aerial bombs would not (buses were running during the "Blitz" 1940). The rarity of such heavy snowfalls, however, means that big investments into snow-clearing kit are without much sense. Accusations and "guesstimates" (half guess, half estimate) about costs of the two-day inactivity of the capital were abundant, but none is worth mentioning; on a personal note, it was the first time that people on the street wore a smile and actually greeted me. More snow would be good for Britain.

There was some intense strike action going on throughout the country this week. French oil firm Total had subcontracted extension works at their plant in Lindsey (somewhere in England) to an Italian firm (IREM), which would bring it's specialist workforce, composed of Italians and Portuguese, with it to England. A fatal promise made by British Prime Minister Gordon Brown in 2007, going along the lines of "British Jobs for British Workers", was the cause for some 6.000 workers across the country to lay down work for several days.
This is by far not the most significant incidence of union action in the UK, but it is significant under the current circumstances: when the economic climate turns rough, protectionist calls from the far-left and nationalistic ones from the far-right find wider resonance in the population.
Under EU legislation, any EU citizen is entitled to work in each member state. Furthermore, firms are entitled to use their own staff on temporary projects elsewhere in the EU. At the moment, there are by far more British citizens working in the EU than are citizens from other EU countries in Britain. But who said that EU laws are a good thing?
This topic is obviously highly controversial in the public. Citizens of a certain country are keen on getting jobs in their country before anyone else does. Most of the time this will be the case, because foreigners, by definition, life abroad and would have to travel farther than any resident, which is a deterrent. But if foreigners take the burden of travel, enter the local labour market and - on top of that - get a job because they are more suitable than a competing resident (as judged by some employer), all hell breaks loose. I do not pretend to offer any type of solution here. However, and as a small aside on that, the economic case for the issue is quite clear: economists tend to strongly advocate a free labour market, based on the rationale that, the greater the competitive forces in a market, the higher it's level of efficiency. Efficiency means in this context that

1. job vacancies can be filled faster
2. job seekers can find jobs faster
3. those who get the job are the ones that can do it best among all those workers who can do it for the lowest wage.
   
4. The last sentence was tricky - read it again.

So much for that. I attached the economist's wrap-up of the story for the interested reader.

I am working on a short explainer on banks, why everybody is so concerned about them these days, why unstable banks threaten "the system", what an "unstable bank" is, what "the system" is, and what it means for the British Central Bank to lower the interest rate to 1%, as it did yesterday. For the sake of brevity and continuing high attention among the readers, I'll postpone that to another letter.

Letters from London 1

I hope this message finds you well.

For all those of you who

• want to brush up their English,
• wonder about what the heck is happening these days with the world, related to events headlined by "global financial crisis",
• have recurring spells of boredom during a typical day,

I present the first email of a potentially to be continued series named "Letters from London (LfL)", where I will try to provide the reader with digested and selected information (i.e. I have the work, you have the pleasure) on the current crisis as experienced in the British capital.

We start out with an easy piece from this week's edition of the economist newspaper (attached). It talks about the evolution of nicknames of London over the past 20 years, quite instructive.

Figures of the day:

Unemployment rates
US: 7.2% (Dec 08)
UK: 6.1% (Nov)
Austria: 3.8% (Nov)
Spain: 13.4% (Nov)
Italy: 6.7% (Q3)
France: 7.9% (Nov)
Argentina: 7.8% (Q3)

% change in GDP on year ago
US: +0.7
UK: -1.8
Austria: +1.5
Spain: +0.9
Italy: -0.9
France: +0.5
Argentina: +6.2

Yesterday on a party 3 out of 3 architects were unemployed (my girlfriend was not there).


[It is important to distinguish between "evidence" and "anectode". Which is which?]

Summer in London & little Italia

Hi guys!
Look at what I see on my desktop today! July 20, 18 degrees is quite a shame, yes, but look at the next couple of days. Seems impossible, but it must be that somebody up there is finally feeling pity for us...thanks, Peter.



Oh, by the way Saint Peter: Today I was watching the annual parade of the St. Peter's church here in London, very entertaining. And quite as kitschy as in that little Italian village from your favourite mafia movie. A colleague of mine was actually posing as Jesus Christ himself, on top of truck displaying some worshipping scene; another friend of mine was taking part as pretorian (a kind of guard from Jesus' times); there were all sorts of angels and virgins, all played by most devotional (looking) young girls, they as well on the roof of a truck. I have a weakness for traditions and parades. There was even a little marching-band playing pipes and drums.

Exams are over

I am leaving for 10 days of vacation. Exams were horrible. Tell you more about it soon. Will get sun-burned first.

Prose from Argentina

If you are interested in prose, find a lot of it (and other stories) in Pablo's blog. He is based in Buenos Aires. This link goes to one of my favourite stories:

pablejacio

British people like butter

I bet you knew that (and thank heavens, I like it as well, which makes survival here much easier). Some clever people took notice of this fact and subsequently turned it into an amazing marketing strategy. Below you can see just one example I came across recently.

I can assure you that the salad you see on this picture doesn't taste AT ALL buttery. Buttery: "resembling or containing or spread with butter"; wordreference.com

Obviously it doesn't matter if the lettuce resembles butter or not. As long you can suggest to buyers that this salad is "buttery", whatever they make of this attribute, chances are good that they connect "I like butter" with "buttery" and come up with "I like this lettuce as well".

Really clever, these people.

Moral Hazard?

Credit Crunch explained. Hillarious. Outstanding.









via: http://arielrubinstein.tau.ac.il/

Now it's on

exams:

12/05: microeconometrics
15/05: economics & psychology
19/05: industrial organisation
21/05: microeconomics
23/05: econometrics
27/05: game theory
29/05: macroeconomics

And then I'll go on holiday. Some island in the sun. No money.

More money on the island

Despite the apparent danger that this blog is slowly degrading into a "lonely island in the pacific"-blog, here is yet another story. I have to cite Russell Roberts on econtalk, where I first heard the following story, which I find quite interesting (I think I remember him mentioning it was on one of his exams while at U Chicago):

Here we are again, back on our decent island in the sun. It is completely isolated from the rest of the world. Imagine one day there arrives a visitor. He comes to the island and consumes beach, sun and accomodation in the hut of the only inhabitant who is willing to accomodate a stranger. The visitor enjoys lying on the beach and painting pictures. He asks his landlord if he would agree to trade accomodation for his recently drawn picture, and the landlord, after carefully examining the work or art, says yes.

A year later, the visitor comes back. He draws another picture for the landlord and is also able to trade a second picture for some artesanal souvenirs with one of the inhabitants. There is also a picture in exchange for a dinner at the beach, carefully prepared by a couple who enjoys cooking for others.

Now imagine that the visitor comes back every year, constantly producing pictures and trading them for goods and services. After a while the population of the island picks up on the habit and starts using the pictures as a means for exchange.

Question: Are the vacations of the visitor for free? If not, who is paying for them? What are the welfare implications in the long run?

Endowment Economy for dummies

Let's think about an "endowment economy", i.e. a very simple (hypothetical) economy where people are "given" some endowment of non-storable consumption good in each period of their life. We can analyse this fairly simple. Then we can go on and ask the silly question: "why is there no role for money in this economy?"

In an endowment economy, as the name indicates, people are endowed with a certain amount of a perishable (or non-storable) good. What follows immediately from this is that there is no production sector in this economy: the source of the endowment is not specified, but rather taken as given, paramount to stating that the endowment fell from heaven. (Or so.)

Notice also that the non-storability of the consumption good is crucial here. If it were possible to store the good, we would convert our problem into one of optimal saving, where people have to decide on the fraction of good they want to consume and which amount to save. But not here.

Well, to cut a long story short, people receive their endowment each period, and, believe it or not, the best thing to do is to consume the entire endowment each period. We didn't explicitly assume so, but let's say that people always like more of the good (and don't get fed up at some point). What is not consumed, perishes and goes to the bin, there is no market where to sell the good, nothing, so really this is the only possibility.

So why is there no money here? What would happen if there were any money? To get a feel for that, consider the following (quite stupid) example I cooked up:

Consider an economy on an island somewhere in the Pacific, completely isolated from the rest of the world, where people happily life their lives, consuming the fruit which grows on the local tree. The fruit is perishable, thus it can't be stored. 

In fact, each inhabitant has his favourite tree, and all the fruit it bears is just enough to feed him for one year. One day, a big ship arrives and drops a suitcase full of dollar bills (10.000.000 $). The inhabitants wonder what to do with all that colored sheets of paper and decide to distribute it equally among all of them. Then comes the next year. Trees are loaded, and one of the guys has the glorious idea to actually give some of his fruit away in exchange for the colored paper. "Why would want to do that?" the others say. "Well, you know, I can exchange back colored paper for fruit later on." The others happily hand him all of their money and drown the extra fruit right away. Great deal.

On comes the next year. The seller from last period (who already didn't have enough to eat last year, because he gave away his fruit) grabs 1.000 $ and wants to buy a decent load of fruit. The problem is: nobody wants to exchange any fruit for paper. "What should I do with the colored paper? The fruit I have is just enough to survive the current year, my friend. I will stay hungry despite all of that fancy paper in my hand" the others say, when asked.

The same night they burned 10.000.000 dollars and had some fruit watching it.

Fascist Rome

The fascist candidate Alemanno (what a coincidential name) has won the mayor's election in Rome. This picture shows some of his supporters celebrating. Make what you want of the way they salute, I for my part know what to think of it.

Italy's going down. What a pity.

(I would wish that I have to revise that post in a year or so and have to admit that it all turned out well. I am extremely pessimistic in this respect.)

just great

have a look at this video from the economist's Kal.

Pareto improvement: London special constables

Policing a city is a costly issue. Full time officers have to be paid decently, firstly in order to attract enough recruits and secondly in order to forestall corruption. So, maintaining a working police force costs a lot of money. In London, you can sign up for a voluntary police unit, policing the city as a support officer ("special constable") for two 8-hour shifts a month. That's 16 hours of free policing-time per volunteer per month. Volunteers are trained and have the same powers as professional officers - note that in the UK "normal" police are not equipped with firearms. Only special police units carry these (and they don't have volunteers).
As the scheme is voluntary, you can argue that people who sign up were just looking for an activity of the kind. And as the authority has an additional officer on the streets for free, it is better off as well. This is a pareto improvement.
Critics might think that this is actually an exploiting scheme, taking advantage of these people. First of all, they are not obliged to sign up. And secondly, we know that payment can actually "crowd out" intrinsic motivation (think of blood donations, or charitable work in your local church: would you donate more blood or volunteer more if they paid you? would you stop doing so altogether?)

check out what economic research tells you about that question:
intrinsic motivation, Tirole and Benabou
Frey and Oberholzer: crowding out of volunteering (empirical evidence)
cool experiment on blood donations coming up from Lorenz Götte (couldn't find any paper online)

6 months in london - first shopping

yes, after more than half a year of living hear, I finally could not avoid it any longer. Had to buy a decent outfit for an upcoming ocassion. I went to Oxford Circus, today, which is Saturday, so there were quite a few people there. I don't overly enjoy shopping, I'm not really interested in fashion, but rather complying with social norms, if you know what I mean. And I would freeze if I'd go naked. Anyway, I got something quite wearable and not too expensive, so we might as well call my first shopping tour in London a success. But hang on, I haven't got any shoes yet - and all the stuff I saw till now (which was the really dreadful part of today's tour) were pretty ugly. I don't understand anything about fashion, as already mentioned, I just know that any of those men's shoes I saw today are compatible with my taste. Why do they have to make them so ugly, either in the form of rectangles or cowboy-boots cut above the ankle? In the end I will have to back down, I know. Or find a better store - but that would mean to spend more effort on search, and I am reluctant to do so.

elezioni politiche: foodstock vs grillo

Have you ever thought that in order to make your point in a political debate, it is a good idea NOT to cast your vote in an election? If you know a bit Italian, find out here or there (there the quality is better):

via: foodstock